WORD ON THE STREET: In the next five years, approximately $2 trillion in outstanding commercial mortgages – including $600 billion in commercial mortgage-backed securities (CMBS) – will mature. Many of them include smaller properties located in secondary markets where traditional portfolio lending often is not available.
The CMBS marketplace faces many headwinds on its road to recovery. The sovereign crisis in Europe affects credit and economic confidence around the globe. In the U.S., we face stubbornly high unemployment and low job growth. Consumer confidence is weak. The business sector is cautious about capital expenditures as it nervously assesses the uncertainty in the public and private sectors.
Against this backdrop, Congress adopted a credit risk retention and transparency framework for asset-backed securities in the Dodd-Frank Act, which requires the agencies to issue an array of implementing rules The agencies have issued a series of proposed rules in accordance with these requirements. We agree with the overarching Dodd-Frank objective that these rules should enhance investors' ability to invest, with the confidence that the investment markets are fair, transparent and safe. Safe markets, however, do not mean riskless markets, as all investment carries some amount of risk.
But investors should have confidence that, with adequate transparency, proper retention, and the ability to conduct their own requisite due diligence, they can fairly, reasonably and reliably assess the risk factors underlying any CMBS investment opportunity. The question is, What is the appropriate level and extent of regulation? If there's not enough regulation, investor safety and confidence can be compromised. If there's too much, industry capacity is diminished with no real marginal increase in benefit to investors.
Larger businesses and high-profile properties in the country's major urban centers will continue to enjoy ready access to commercial real estate (CRE) portfolio financing. But smaller businesses and businesses in the secondary markets that are the core of our national economy – Main Street America cities and towns – will not have adequate access to the financing without a viable CMBS market.
The investors that provide the capital for these borrowers do not benefit from regulation if it erodes their CMBS returns to the point where CMBS is no longer competitive with their other investment options. As the Board of Governors of the Federal Reserve aptly noted, the agencies implementing the Dodd-Frank securitization credit retention requirements must ‘ensure that the regulations promote the purposes of the act without unnecessarily reducing the supply of credit.’
The proposed rules – especially when considered cumulatively – pose a threat to the continued recovery and ongoing viability of CMBS and the credit it supplies. Each rule, in and of itself, may have its own justifiable merit, and its compliance requirements may not seem unduly burdensome. However, the multitude of proposed Dodd-Frank-related rules, including risk retention, will have a significant impact – both individually and when considered as a package – on credit availability in the CRE market.
As the International Monetary Fund has cautioned, the proposed retention rules and ‘effects induced by interaction with other regulations will require careful consideration.’ Unfortunately, the agencies generally have failed to consider the impact of individual rules on credit availability, and they have made no effort whatsoever to evaluate the cumulative impact of all of the proposed rules.
The Premium Capture Cash Reserve Account (PCCRA) rule proposal would require securitizers to retain all revenue from excess spread (which is virtually all revenue) for the life of the transaction, in a separate account for the life of the security and to hold this account in a first-loss position even ahead of (and subordinate to) the B-piece investor retained interest, unless 5% of the fair market value of the issuance is retained in accordance with the credit retention requirements. Such a mechanism will inhibit an issuer's ability to pay operating expenses and transaction expenses, as well as to realize profits from the securitization until, typically, 10 years from the date of a securitization, assuming there were no losses on the portfolio.
Furthermore, this premium not only reflects profits, but also is used to recoup the costs associated with the origination platform used for the securitization process. Essentially, issuers would take a loss on every CMBS securitization if they are required to establish a PCCRA.
Finally, the PCCRA would also fully expose current CMBS issuers to changes in interest rates. In a simple example, if a loan has a 5% origination interest rate, but the market rates drop to 4% at securitization, a 1% premium is charged on the certificates to reflect this change. Unfortunately, the PCCRA, as written, would capture this premium.
In implementing the so-called ‘Volcker Rule,’ which is codified in Section 619 of Dodd-Frank and is intended to bar banking institutions from engaging in proprietary trading activities for their own accounts, the agencies have proposed a broad definition of ‘covered fund.’ This broad definition would sweep in certain types of securitization issuers and activities, even though securitization and securitization ‘market making’ activities are specifically exempt from the scope of the rule under the statute.
Failure to appropriately limit the ‘covered fund’ definition could create a host of functional difficulties for banks and affected non-bank financial companies that have engaged in sound and long-established interactions with these securitization entities. This conflicts with the rule of construction in Dodd-Frank that directs that the Volcker Rule not be construed to limit or restrict lawful securitizations sponsored or participated in by banks and regulated non-bank financial entities.
There are also 12 more regulations with cost-benefit concerns to take into account when looking at the cumulative effect – including, but not limited to, the Securities and Exchange Commission's proposed changes to Regulation AB; the Federal Deposit Insurance Corp.'s final ‘Safe Harbor’ rule; the ‘Franken Amendment’ requirements related to credit ratings for structured products; the SEC's rule 17g-5 credit rating transparency; and the SEC's rule 17g-7 for reporting repurchases.
The combined impact of these proposed rules on the industry is further compounded by recent securitization accounting changes (known as Financial Accounting Standard (FAS) 166 and 167). The new regulatory capital guidelines and accounting changes could significantly limit the capacity and the overall amount of capital that can be directed toward such lending and investing at the same time when the securitization markets are attempting to recover from a historic decline and regulators are drafting new rules intended to govern the industry.
Before promulgating final rules, it is critical that the agencies charged with implementing the Dodd-Frank Act coordinate their rulemakings and consider the cumulative impact of the numerous regulations on credit availability in the CRE finance market. This cumulative impact analysis is important to help Congress and regulators understand the total impact of the regulations on the CRE market.
Today, the CMBS market is showing some positive signs that it is slowly moving toward recovery, but with $2 trillion in commercial mortgage loans maturing in the next few years, it is critically important that regulations under Dodd-Frank be implemented in a way that does not severely constrict or shut down the securitization markets. For it is the small businesses, factories, multifamily housing units, offices, hotels and nursing homes in your home districts where restrictions to CMBS lending will be felt most severely.
Paul Vanderslice is managing director for Citigroup Global Markets and president of the CRE Finance Council. This article is adapted and edited from testimony delivered before the House Subcommittee on Capital Markets and Government-Sponsored Enterprises. The original text is available online.