This summer will be the three year anniversary of the passage of the Wall Street Financial Regulatory Reform Bill, aka the Dodd-Frank Act.
The bill laid out goals for the reform of CMBS: requiring issuers to have “skin-in-the-game”, requiring greater transparency, reducing conflicts of interests, and increasing the oversight powers for the holders of the mortgage backed bonds, etc.
It's natural for those of us far from K Street, the DC
confluence of the Federal government and Wall Street, to assume these
reforms are in place. And are they? ... no...not quite...surely, some of them are in
place??
No, not even close!
The earliest any Dodd-Frank mandated regulations could be issued is later this year. And even then these rules will not take effect for two years after adoption.The CMBS 2.0 changes to the loan pooling process, agreements, ratings and underwriting have so far been voluntary. CMBS 2.0 was a way to patch up a leaking boat to get the bond investors back on board. Market participants now see these minor voluntary CMBS 2.0 changes being dissipated by market forces.
Six Federal Agencies are involved in crafting the proposed risk
retention rules; the FDIC, the Federal Housing Finance Agency, the Federal
Reserve, HUD, the SEC, and the Treasury Department. Fine example of the economic principal of “Regulatory Capture”
The various interests in the CMBS industry, the originators, the issuers, the servicers, and to a far lesser extent the investors who buy the bonds (forget about the borrowers and the mortgage bankers), have the ear of different regulatory agencies... and are having these advocate-regulators pull the process of “reform” in different directions. This regulatory uncertainty is not good for the commercial real estate finance industry, but for some of the players involved a stalemate preserves the status quo, which is a win. Certain proposed regulation could blow current players in the CMBS market out of the water. The consequences of regulation on a largely unregulated industry could be enormous. So considerable lobbying effort and funds are being deployed.
Nothing is final, however, a semblance of a compromise is
being put forward on the risk-retention part of the Dodd-Frank regulations of
CMBS:
Original
Concept in Dodd-Frank
|
Compromise
|
First Loss Piece to be held by issuer
|
First Loss Piece to be held by B-Piece buyer
|
Risk Retention to last for 10-years
|
Risk Retention to last for 5-years
|
Issuance Profit to be added to Risk Retention
|
Issuance Profit can be pulled out up-front
|
Amount of retention = 5% of “Pool” value
|
Uncertain: Issuers want 5% of “Nominal” value
|
The Lobbying Battle to substitute a single word... “Nominal”
Millions of dollars of lobbying is being spent on the effort to insert one word into the Dodd-Frank regulations.: That word is “Nominal”. The CMBS industry issues various classes of bonds with a single blended return. These tranches of bonds sell at various premiums or discounts based upon the priority they hold in receiving cash flow from the mortgage pool. Holders of triple-A rated bonds get paid first, then comes the next lower rated bond holders, and so on. The last one to be paid, the holder of the first-loss position holds the B-Piece. Under CMBS 2.0 the B-Piece buyer holds all the bonds below “Investment Grade”, i.e. below BBB-. Thus the B-Piece is the insurance policy for the investment grade bond holders
The securitization world loves to talk about the “Nominal” value of bonds.
If 7% of the bonds stand to be wiped out before you lose a
dollar, that sounds much better than if the bonds standing behind you are
discounted by 30 cents on the dollar.
The typical B-Piece, the below investment grade portion of a
securitization is about 7% of the face amount of the bonds, but only 1.5% to
3.0% of the money raised. This means
that the holders of the investment grade portions of a securitization have a
cushion of protection that does not even add up to the securitization profits plus
the costs of issuing and selling the securities. To get this slimmest modicum of insurance,
the buyers of the investment grade portion of a CMBS issuance are putting up
more than the face amount of the mortgages and giving away substantial
returns.
Conclusion: Buyers of investment grade rated bonds are paying more than the total of the face amount of the loans.
| CMBS Loan Pool Economics - Typical - Simplified | ||||
| Pool of Loans Total Principal Balances | 100.0% | |||
| Total Bond Proceeds (sale of securities and servicing) | 104.8% | |||
| Cost of Securitization | 0.8% | Rough Guess - ratings, legal, sales commissions, etc. | ||
| Profit to Conduit | 4.0% | Based on Industry Reports of 2% to 5% typical profit. | ||
Example
- NorthStar Realty purchased $74 million B-Piece of $1.14 billion
securitization for $23.3 million. (Morgan Stanley, BofA Merrill Lynch Trust,
2013-C8)
|
Bond
Face Amount
|
Cents/Dollars
Discounts/Premium
|
% of Capital
Raised
|
% of Loans
Face
Amounts
|
Typical
Subordination - Below BBB
|
6.5%
|
$ 0.31
|
2.0%
|
2.1%
|
Investment Rated Bonds (plus sale of
Servicing)
|
93.5%
|
$ 1.05
|
98.0%
|
102.7%
|
Total
|
100.0%
|
100.0%
|
104.8%
|
|
Getting investors to line up to
buy the bonds (most of the recent CMBS issues have been oversubscribed)... now
that is the real financial engineering.
