The government's proposals for mortgage risk retention, aimed at getting sponsors of securitizations to retain some skin in the game, could potentially change the commercial real estate (CRE) financing landscape, while creating opportunity for some.
While the proposals are in the right spirit, in their current form they may have some unintended consequences.
CMBS market participants are concerned that the effect of the proposals would be to render CMBS a less competitive financing option and drive up the cost of financing for commercial real estate borrowers.
If B-piece buyers find deals less attractive, there would be a ripple effect up the CMBS ladder.
"The way the rules are currently written, they would effectively make B-piece buying less attractive," said Harris Trifon, head of global CRE debt research at Deutsche Bank Securities. "This would ultimately result in higher coupons for commercial real estate borrowers. As a result, CMBS financing would be less attractive than it is today."
Trifon is particularly concerned about a proposal for a premium recapture account, which he sees as a disincentive for sponsors that securitize loans with an eye to take profits.
The proposal would require sponsors of securitizations to hold in a reserve account any excess spreads they get from bond coupons, after accounting for loan rates, until the transaction is completely paid off.
"Traditionally, CMBS issuers have cut out an IO to monetize the excess spread," noted James Manzi, a senior director with Standard & Poor's structured finance research group. "The proposal as currently written is that they wouldn't be able to monetize the proceeds upfront anymore. It's another way of getting skin -in-the-game from issuers in the case that the B-piece buyer was holding the most risky part."
The proposal allows, as is the current market practice, the B-piece buyers, rather than the securitization sponsor, to retain risk by holding on to a horizontal, risky slice of the securitization.
Manzi and Zachary Wolf, another senior director with S&P's structured finance research group, expect that borrowers in secondary and tertiary markets are likely to be particularly impacted by higher financing costs, considering that not many lenders are interested in targeting these markets.
The proposals also call for an independent operating advisor to monitor B-piece buyers, which would apply in most cases.
John D'Amico, CEO of the CRE Finance Council, expects that the need to have an overseeing operating advisor would likely be priced into the cost of transactions and passed on to borrowers.
"This would result in another layer of review by a third party, whose credentials have yet to be established," D'Amico said. "There is nothing in the regulations as to who the operating advisor has to be, whether they are rated or not. A lot of people in the industry think that there might be an extra layer that's unnecessary."
However, this proposal would also create a need for such entities to be set up, potentially creating opportunity for some.
Another factor that doesn't appeal to industry participants is that the rules would qualify very few CMBS loans to be exempt from the risk retention proposals.
To qualify for an exemption, loans would have to meet stringent requirements, such as a 20-year amortization period, a loan term of at least 10 years, a debt service coverage ratio of at least 1.5, and a loan-to-value of no more than 65 %. There are even specifications relating to cap rates.
"It would be challenging to create pools that met the definition of qualifying collateral where you wouldn't be required to have any risk retention," S&P's Wolf noted. "Specifically, the amortization profile restriction would make it very difficult to create pools of CMBS that would fall into the category of qualifying collateral."
Trifon pointed out that CRE risk analysis is typically based on the risk of individual assets and markets and that coming up with such specific qualifying criteria that apply to all sorts of loans is not a good idea.
He believes that a better solution would be to restrict the number of loans that go into qualifying transactions. He expects this would give investors a chance to do more detailed credit analysis and reach their own conclusions.
Industry participants are concerned that these stringent provisions, if implemented, could adversely affect CMBS issuance, which is slowly starting to revive following the downturn during the recent recession.
If that were to happen, there would be a need for alternative sources of financing to fill the void, especially considering that as much as $1 trillion in CRE loans is coming due for refinancing in the next few years.
During the recent recession, banks and life insurance companies stepped in to pick up the slack caused by the absence of CMBS financing. These financing sources are also likely to see opportunity if CMBS issuance is impacted going forward.
There are also other commercial real estate financing sources such as sovereign wealth funds, international banks and even real estate investment trusts.
For instance, a REIT that PIMCO is sponsoring could invest in CMBS and CRE loans, as well as other real estate-related assets. The giant bond investing fund indicated this in a Securities and Exchange Commission filing for an IPO of shares by the REIT.
The concern is that even with all the additional sources of financing, there may not be enough financing to go around in the commercial real estate sector if these proposals are implemented. This could impede liquidity and lead to defaults as loans come up for refinancing.
"The spirit (of the risk retention proposals) is fine, and clearly there is a need to address some of the excesses that existed in the previous cycle," Trifon noted. "We just want to be careful that we don't over-legislate."