Faced with the prospect of refinancing nearly $1.4 trillion of U.S. commercial real estate debt in the next four years, real estate investors remain skeptical, despite the halting recovery of capital markets in recent months, whether CMBS can restart with sufficient volume to finance the recovery of the commercial property markets.

Poorly underwritten, substandard loans have been blamed on securitizing lenders' failure to retain any risk in the loans originated. But what is the most effective form of risk retention appropriate to the commercial real estate market?

From the inception of the CMBS market until two years before the current crisis began, the most cognizant assessor of risk was the buyer of the lowest tranche or the "B-piece buyer, which paid cash and did its own due diligence on the loan collateral and securitization structure, intending to retain the risk for its own account. But since 2005, risk was no longer assessed for the term of the loan but solely at the point of origination.

The credo became: Make it and sell it. Though intermediaries always export risk by parceling it out to various end users, with different risk appetites, this time the ultimate buyer did not fully appreciate the risk because the credit rating agencies failed to properly identify and consider, in issuing their ratings, the risk of new structured finance vehicles' being used to package credit risk assets such as collateralized debt obligations.

Though many investment-grade investors were relying almost entirely on letter ratings to assure themselves of their investments' prudence, B-piece buyers required full access to information about the borrower, the property, the leases and cash flow, the loan, all third-party and originator reports on borrower and guarantor credit and the collateral, as well as the lender's underwriting to do their own due diligence and evaluation.

Because of the inherent risk of their first-loss position, the due diligence and reunderwriting that they undertook was far greater than that of a primary mortgage market lender — securitized or portfolio — but rather like the specialized real estate diligence of a disciplined junior mortgagee. This analysis should question the wisdom of vertical risk retention as a proposed solution because of the dilution and fragmentation of the first-loss risk to more senior CMBS bond buyers who in most cases lack the specialized realty discipline of the B-piece buyer.

Before 2005, the B-piece buyers, not the credit rating agencies, were the market's real gatekeepers. As a condition of their buying the first-loss tranche, B-piece buyers routinely questioned and even rejected loans deemed substandard. The credit enhancement provided by their first-loss position to the senior certificate holders became a subordination cushion as B-piece buyers focused on understanding and managing the credit risk associated with each asset in the trust.

The Congressional Oversight Panel recently predicted that regional and local banks alone, which supply substantially more capital to the commercial real estate markets than do insurance companies or CMBS lenders, would have losses of $200 billion to 300 billion in their commercial real estate loan portfolios beginning in 2011. Yet the banks' retention of 100% of the credit risk in their portfolios did nothing to prevent "bad" underwriting and substandard loan origination for their own accounts.

The benefit of the risk retention by B-piece buyers is precisely that they are not the originators of the mortgage loans with their own competing motives of originator compensation, interlender competition, borrower relationships, property envy, industry league table standings, achieving CMBS deal size and frequency and PR/marketing opportunities (that is, "bragging nights") which daily color or even sometimes interfere with a lender's clear assessment of a loan's credit risk. A truly independent second review of each loan by a real estate specialist — not the credit rating agencies — is needed.

If CMBS is to be restarted, we cannot revert to the post-2005 fully leveraged B-piece buyers who collect fees and quickly export their first-loss position risk to a CDO. Though the debate over the efficacy of different forms of credit risk retention for different asset classes continues among regulators, a recent report by the Federal Reserve recommended different retention requirements for various types of securitized assets, recognizing "differences in market practices and conventions."

To jump-start CMBS, the "skin in the game" conundrum must be resolved to the ultimate satisfaction of investors — investment-grade and non-investment-grade. Based on the Dodd-Frank guidelines, recovery of CMBS will be best protected against poor underwriting being done and condoned, and substandard loans' being made and deposited into CMBS, if the first-loss positions are sold in arm's-length negotiations by independent third parties for cash. The third parties must have adequate financial resources to back losses and must do due diligence of all the individual loans in the context of the whole pool before, not after, issuance.

Though a B-piece buyer could be permitted to finance a portion of its purchase with an "at-risk" loan (from other than the originator or issuer, or their sponsor), it must retain its first-loss position and not export the credit risk into a financial arrangement like a CDO or otherwise reallocate its credit risk to another.

Ultimately, bridging the gap between originators/issuers and investors will best be accomplished by returning B-piece buyers to their original role as gatekeepers, self-charged with maintaining discipline in the CMBS market and assuring capital markets investors of better-quality pool assets.

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