(Part of my series on the capital markets. Use the term "scorecard" in the search function on the lower right side of this page to find other postings in this series.)
On December 11, the US House of Representatives passed the financial reform bill.
As I've noted before, "tying" the loan originator or some other responsible party to the performance of individual loans in a securitized loan (CMBS) pool is critical to the "good" performance of the pool—which is a concept referred to as "risk retention."
The CMSA has been very focused on "who" could be the appropriate parties to have this risk of a loan going bad.
Below is the announcement made by the CMSA, as the financial reform bill made its way out of the House.
The risk retention provisions are an important step, BUT it only is a short-term band aid for the capital market freeze. As a "fix" it does not address:
- the "tranche warfare" (caused, in party, by the inherent conflict of interest in special servicers affiliated with the CMBS B-piece holder) (granted, some of this is mitigated by the new approach to the "operating advisor" concept in the recent Developers Diversified Realty securitization; however, giving bondholder a degree of voting control over the special servicer is NOT nearly as effective result as the ability, in a covered bond structure, to replace the distressed loan with a performing loan; simply no comparison)
- the need for loan-level transparency and better communication between special servicers and investors
- the real "fix" for the problem is to allow the replacement of a problem loan with a performing loan (i.e., let's shift the focus from a backward look at the value of the "historical underwriting" by the B-piece buyer at pooling to a mechanism that fixes the problem as it happens—in the future)
- the fact that if a property is over-leveraged, and\or has debt service coverage problems, the problem is NOT with the capital markets—the problem is with the property (i.e., the fact remains that commercial real estate markets will undergo market corrections; and that any "fix" should focus on softening the extreme "ends" of the ups\downs in the markets to the extent they are caused by the structures of financial products). And this problem is the "pink elephant" in the room - and is a problem so vast that simply tweaking the CMBS model is not sufficient. (It is the difference between a bar bell and a tetrahedron. {Tetrahedron? I'll get to that in a minute.)
As I'll explore in future postings, I favor the use of "covered bonds" as the better long-term fix. While this might NOT be popular to say, the CMBS model is NOT the long-term fix.
Mercy Jimenez and Spencer Punnett over at the Covered Bond Investor report "bipartisan support" for covered bonds at the hearing. My reading of their report on the one (1) hour hearing does not convince me that pushing for covered bonds is a political reality right now. As I gauge the political winds, the move to make the necessary Bankruptcy Code changes and changes to bank regulations (needed to protect or "circle" the bonded mortgages from issuer insolvency) is not a near-term reality.
So for the moment, we continue to band aid the CMBS model. It is NOT the model that has enough credibility to return sufficient capital to the market in amounts that are needed for mainstream CRE, which some refer to as the middle of the "bar bell" - the trillions of CRE between the two extremes of properties in or nearing special servicing (on one end of the bar bell) and those properties having the best debt service coverage (DSC), loan to value (LTV) and tenants (on the other end of the bar bell).
As an aside, I don't see a "bar bell" in the market. My visual picture is more of a tetrahedron, which also is some times called a triangular pyramid. If that term sounds complicated, then you're well on your way to admitting that the current capital market for commercial real estate is no simple "bar bell" - where the cure is a "return" to the CMBS product (after, of course, tweaking it with risk retention, operating advisors and enhanced SPE provisions).
* #--- # **
* = the "best" commercial real estate
** = the "worst" commercial real estate
# = the majority of the market (to the "right" of center or equilibrium with excessive leverage)
But back to covered bonds . . . .
Covered bonds are our ultimate destination for a capital markets solution that includes the middle majority of the CRE market.
Until then, we're only using a band aid.
We need to admit it, and get behind covered bonds - and pour over resources like the Covered Bond Investor.
(For more postings on my "CMBS Scorecard" series, use the term "scorecard" in a search of this blog.)
Please post your own comments, questions or thoughts.
The CMSA Announcement
December 11, 2009—Today the U.S. House of Representatives passed sweeping regulatory reform legislation that includes language strongly supported by Commercial Mortgage Securities Association, tailoring financial reforms that would support a recovery in the commercial real estate finance market.
By a floor vote of 223-202, the House approved H.R. 4173, The Wall Street Reform and Consumer Protection Act of 2009, which encompasses large-scale reforms the Obama administration sought to prevent future financial crises and to regain stability in the overall U.S. economy.
As passed by the House, the bill includes language that would structure the ‘retention’ or ‘skin in the game’ requirement to account for the unique nature of commercial mortgage-backed securities. Specifically, the legislation grants regulators the flexibility to allow a third-party investor – or B-piece buyer – to satisfy the legislation’s new retention requirements.
Typically bonds rated below BBB are classified as “below investment grade,” otherwise known as the “B-piece.” The buyer of the B-piece takes on the highest level risk in a CMBS securitization because they are exposed to the first risk of loss. CMSA believes recognizing the role of these third-party investors who purchase the first-loss position and re-underwrite all loans during the pre-issuance period is critically important.
H.R. 4173 also includes another measure, one that would require the Federal Reserve and financial regulators to examine the combined impact of new retention requirements and new accounting standards (FAS 166 and 167) on credit availability, and to report to Congress with specific recommendations prior to any rulemaking on the retention.
“A risk retention provision that gives market and financial regulators flexibility in overseeing diverse asset types and structures is essential to support an overall recovery in commercial real estate,” said Patrick C. Sargent, President, Commercial Mortgage Securities Association. “Passage of this language by the full House today is a tremendous step toward restoring access to credit in this market,” he said.
“It is crucial that financial policymakers in Washington tailor reforms to recognize the role of sophisticated third-party investors that negotiate specifically for the riskier classes in a CMBS transaction,” Mr. Sargent added. “We encourage the Senate to support a recovery in commercial real estate by maintaining and strengthening safeguards in the CMBS market.”
The Senate has been working on financial services regulatory reform as well and they are expected to consider such legislation next year.
