CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

It seems that I use most of my time in this space to rail against an unthoughtful regulatory architecture that will certainly surprise and may ultimately do unintended and substantial harm to our nascent and uncertain recovery. While, from where I sit, it’s still fair to say this market continues to show little real conviction that it’s safe to get back in the water (hardly an irrational mindset) there is, periodically, some good news. So let’s make time for a bit of good news. Ta-da: It was reported recently that average consumer credit card borrowings have dropped below $5,000 per person for the first time since 2002.

This is terrific news. Perhaps not the stuff of rational giddiness, but combine that with the fact that corporate earnings are up, private cash savings rates are at recent highs, the de-leveraging is going great guns (everywhere, that is, outside of our government), house prices seem to be stabilizing in most markets even if sales continue to lag, interest rates are at ridiculously low levels and the reality of the re-set of the valuations of both the commercial and residential property stock has been internalized. A bit of optimism is not wildly inappropriate.

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Covered bond legislation is once again a hot topic on Capitol Hill. Representative Scott Garrett (R-NJ) co-sponsored the latest iteration of his proposed legislation (United States Covered Bond Act of 2010 or H.R. 5823 (pdf)) along with Representatives Kanjorski (D-NJ) and Bachus (R-AL). The House Financial Services Committee recently voted in favor of reporting H.R. 5823 to the full House of Representatives for consideration, which hopefully will be taken up for a vote this fall shortly after the August recess.

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Like a lot of homeowners this summer, my wife and I are looking to put new windows into our home.  We moved last October, leaving our downtown condo when the impending arrival of our second daughter promised to make things a little too tight.  A drafty winter and a number of windows that, well, just couldn’t be opened this spring demonstrated a need – and President Obama’s Energy Tax Credit cemented the deal. As I’ve learned, like almost everything associated with a new-old house, windows ain’t cheap – and the windows that qualify for the tax credit really ain’t cheap.  The increased cost takes 20 years (on average) to recoup based on the marginal energy savings (something to do with U-factors and Solar Heat Gain Coefficients according to Home Depot). But the government wouldn’t have to pay you to do it if it made good economic sense.

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The commercial banks have largely paid it off, GM has paid it off, and even AIG says it will soon pay off the government’s emergency investment to save the Western world as we know it. As to the GSEs: not so much. We’ve got about $150 billion invested in these entities and no end in sight. In fact, as far as I can tell, there’s yet no plan in sight to ultimately come to an end in sight. Clearly, there are hard political questions about these enterprises which the political class have seen fit to dodge or kick down the road. Should they be private businesses? Conduits for subsidized housing? Both? We now know that both is the wrong answer, or at least not a very good answer. Someone said the GSEs are critical because the private markets have abandoned housing. But how can private markets compete with enterprises that have no need to make a profit, and whose debt is backstopped by the full faith and credit of the United States of America. Who’s going to compete in that market place? Moreover, you’d hope Washington is aware that many other advanced Western economies seem to do quite well without such quasi-public vehicles (not to mention without tax deductibility of mortgage payments, but that’s another story).

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As I discussed in my prior blog post, and this article, last September’s REMIC regulations left servicers, lenders and borrowers in a quandary over the effect the new “principally secured by real estate test” would have on troubled multi-property loans with release features. The new rules, in some cases, could have resulted in adverse tax consequences to REMIC containing loans with underlying real estate collateral that had fallen below an 80% ltv. Yesterday, the IRS announced Revenue Procedure 2010-30 which, at first read, provides some relief. The new Rev Proc elucidates the circumstances under which certain modifications will be deemed not to fail the principally-secured test. Specifically, loan modifications that relate either to a “grandfathered qualified mortgage” (generally, a modification effected pursuant to the terms of loan documents executed prior to December 6, 2010) or a “qualified pay-down transaction” (generally, a release of a lien in exchange for a principal pay-down of a qualifying amount) won't result in the IRS asserting a REMIC challenge. Apparently, someone at Treasury recognized the conundrum the new rules created in lien-release scenarios – more information and analysis on the new rules will be forthcoming.
 

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It’s August 6 as I write this, and the finance industry is taking a deep breath after hustling for weeks to get their comments delivered to the SEC on the SEC’s massive restructuring (pdf) of Reg AB and offering reform.  We here at Dechert had been very busy writing the CREFC comments (pdf) and I’m delighted to see that effort coming to a close (it only took 24 drafts to get to our submission).

To be clear, this is merely the opening act of what will be a protracted insect dance between business and government to settle on rules that deliver on the SEC’s goals of transparency and alignment between issuers and investors while not imperiling the restoration of a healthy CMBS market.  This process will consume the time of many of us for the indefinite future.

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Issuers, investors, rating agencies and other industry participants continue to wrestle with the fundamental changes that will come to define CMBS 2.0. Among the (many) issues raised in the "Best Practices" guidelines issued by CREFC during June’s get-together was a proposal for market-wide, programmatic change to the package of representations and warranties given by securitization issuers. Specifically, investors are calling for the formulation of a market standard list of reps and warrants, and for a standard procedure for receiving any deviations on a deal-by-deal basis. One would hope this would sate the appetite of the investing community – a community ravenous after being starved of ground lease exceptions and knowledge qualifiers during the lean years.

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If there’s a worry bead left to worry, hold it in reserve for Basel III. Basel III (its informal name – it’s actually a patch job on the never really fully implemented Basel II) is the most recent effort by the Basel Committee on Banking Supervision to fix the worldwide financial system. I am far from a master of the nuances of this enormous regulatory undertaking, but I know enough to be worried. As a friend and colleague said, “if the only right answer on Jeopardy to ‘What is Basel?’ were ‘a delightful walled medieval city,’ we might be better off.”

Basel II was never fully implemented, certainly not in the United States. While Basel II generally resulted in a significant relaxation of capital requirements for most lending activities, (that worked well, right), it stipulated that many types of commercial real estate loans warranted uniquely higher capital changes.  These loans, called High Volatility Commercial Real Estate or HVCRE, include acquisition and development loans, construction loans and loans to sectors deemed by the applicable regulators to have higher risks of default and greater loss expectancy.  As Basel II was never implemented here, these CRE rules never really bit.
 

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It’s been very difficult to come up with a cohesive theory on what this earnings’ season has meant for the financial sector – and what investors’ reactions could mean for the credit markets. On Wednesday, Morgan Stanley reported earnings of 80 cents a share, crushing analysts estimates and sending its shares up 8% by mid-morning. At the same time, US Bancorp released an earnings report reflecting a 63% quarter-on-quarter increase in profit. Rounding out the morning, Wells Fargo reported an earnings rise of 12% ($0.55 eps vs. an estimate hovering $0.48 eps) and was rewarded with a pre-market rally of close to 5%. Good times.

But these numbers stood in stark contrast to the news a couple of days ago, as Citigroup beat earnings expectations but nonetheless saw its shares price drop. Citi met the bottom line, but missed at the top. The message: investors are increasingly less concerned with bottom line results - something that can be assuaged with cost-cutting and the shifting of one-time charges – and are focusing instead on top line (read: making money). Goldman Sachs did miss and was commensurately punished. But that may not be the whole story – after stripping out the $550m paid to the SEC (something touted as a “win” for the SEC, although it’s clearly a loss for an already slumping credit market), the miss didn’t look nearly as bad. But GS revenues were down 36% - and investors took notice. Conversely, the winners this season tended to be able to demonstrate the ability to grow by getting deals done.

In a lot of ways these greater investor expectations are a positive sign – the market’s appetite is no longer sated by mere survival. But what the investors are demanding now – that the financials go out and spark the credit markets – is a tall task in an environment dominated by high unemployment, continued de-leveraging, and a government policy designed to avoid catastrophe at the expense of generating opportunity. The obstacles to sustained growth being constructed by the government can’t be overstated – something Bank of America shareholders learned when the market departed the stock in droves after an earning report admission that compliance with Dodd-Frank could cost the bank $13 billion. But it could provide incentive for deals to be made (note that US Banc’s increased revenues were reportedly driven by earnings from new loans) and for banks to re-enter lending in greater numbers.
 

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