CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

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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Goldman and Citi are about to launch a moderate size new CMBS conduit deal. This would follow on the heels of JP Morgan’s more or less successful offering in June. Comparing these two deals is going to be a huge “tell” about CMBS 2.0. If market chatter is right, the Goldman/Citi deal will have many of the bells and whistles at the core of the investment grade buyer’s proposed “Best Practices” wish list regarding CMBS 2.0. Let’s assume for a minute that, indeed, the deal includes a bunch of their “alignment” features, such as some form of “skin in the game”, an independent special servicer not subject to being kicked out and replaced by any B buyer, an operating advisor representing the interest of the investment grade buyer, a bond registrar so that bondholders can more effectively exercise voting rights, enhanced data available to all bond buyers or prospective buyers, a robust web-based disclosure add-on, enhanced representations and warranties, and more data about rent roll on the underlying properties. If so, we’ll have set the table to resolve some of the most contentious issues in CMBS 2.0.

In other words, it will be put up or shut up time for the investment grade buyers. If such a deal is deemed to have traded materially inside JP (adjusted for collateral quality, subordination levels and the like), that will be pretty good evidence that investors are really prepared to pay up for these innovations and that should inform the shape of the new market. If the market senses that these new deal features (many of which have a material price to the deal) do not attract noteworthy better spreads, then the great debate over CMBS 2.0 may be over, and 2.0 will probably continue to look a lot like CMBS we’ve known and loved.

Oh, there will be some enhancements to 2.0 whether or not bond buyers swoon over the new structure. Underwriting will be better (for a while), reimbursement of accrued but unpaid interest will be subordinate to the return of principal, we’ll tweak disclosure, and yes, with FinReg in the books, we’ll now have to deal with some form of skin in the game. Otherwise, 2.0 will equal 1.0. That’s the market for you. Just like in TV land, if the consumer, having said they will only watch Masterpiece Theater, really watches Gilligan’s Island, then we’ll get a steady diet of Gilligan’s Island.
 

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Today the American Bankers Association will publish its Summary and Analysis of the Regulatory Reform Conference Report. The project will provide detailed summaries of each title of the Dodd-Frank Wall Street Reform and Consumer Protection Act conference report, as well as analysis of which entities will be affected and how. The conference report has been approved by the House on June 30 and is now awaiting Senate action.

Thomas Vartanian, who recently joined Dechert LLP, and a team of twenty-two Dechert LLP attorneys led the American Bankers Association effort, preparing the summary and providing the analysis of the proposed supervisory structure for the United States financial system, including the role of the new Financial Stability Oversight Council and the expanded role of the Federal Reserve.
 

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Among the most followed business stories of last week was the humbling admission from Apple that the iPhone 4g included a “totally wrong” formula for calculating the number of “reception bars”. Apparently the phone works, just not if you're holding it (something now known as the “grip of death”). The immediate, virulent, nerdy but surprisingly sophisticated response by iPhone consumers to the glitch – a youtube search reflects more than 400,000 videos posted about the three-week old product – is reflective of the enormous importance of wireless computing in our culture. Blackberrys, palms, iPads, iPhones, smartphones and netbooks are critical business tools for millions - and, as anyone that’s ever lost their Blackberry signal during a conference call can tell you - users’ expectations are for information access that is cheap, consistent and unlimited.

In the real estate market, this demand is manifesting itself through continued growth of data centers as a stable asset class for real estate developers, investors and lenders. Data centers are facilities used to house computer systems, servers and components. My IT guy tells me it's where the internet is actually located (sort of). Design necessities - including HVAC, fire suppression, security systems and (especially) power supply considerations – drive exceptionally high construction costs. Environmental concerns among image-conscious corporate tenants are driving builders to produce “green data centers” (i.e. low carbon, energy efficient) – one of the fastest growing sectors in this niche. But with reports of demand outpacing supply by 3-4 times, these properties are being built - and that requires capital.

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Back from vacation … The sheer joy of re-engagement cannot be captured in words.  But, can there be a better way of restarting than perusing FinReg?  Being the parochial structured finance lawyer that I am, I start with Subtitle D with the Potemkin village-like name of  "Improvements to the Asset Backed Securitization Process" and Section 13, which is the Proprietary Trading or so-called Volcker Rule provisions.  I’ve got some thoughts.

Let's start with the improvements to the securitization process.  The good news, as I’m sure everyone knows by now, is that some sensible asset class-specific provisions for commercial mortgages were included in the risk retention language.  More flexibility in sorting out what alignment of interests ought to look like.  Included was the notion that a B piece buyer could meet the retention requirement as could really good reps or underwriting.

The bad news is, just as in almost every other corner of this massive regulatory exercise in political self-indulgence, all the tough and important issues have been kicked down the road to the “Regulators”.  The scope of that delegation is breathtaking.  The regulators have been invited to sort out what is and what is not risk retention (vertical strip, horizontal strip, L strip), what is the “credit risk” for which 5% must be retained, what are good hedges and bad, what is the minimum hold period for risk, what is high quality underwriting, and what appropriate risk management practices of securitizers ought to be.  Wow!  They can do all that?  We won’t have to think at all.

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The push for covered bond legislation – left on the cutting room floor when Fin Reg. was finalized during a marathon session last week (or should I say finalized subject to Senator Scott Brown’s continuing review) – is coming under renewed discussion by Congress (led by Representative Scott Garret) and the FDIC.

The FDIC balked at the proposal that was to be included in the Dodd-Frank bill because of concerns about the effect of certain collateralization requirements on failed banks' balance-sheets. Covered bond terms can require issuers to replace weakening collateral upon the occurrence of certain triggers; in a receivership scenario, this re-collateralization requirement would force the FDIC to re-deploy quality assets to serve as bond collateral and shift the risk of loss of declining collateral from bondholders to the government. The FDIC hates when that happens.

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Dechert has assembled a team to cover the latest legislative and regulatory developments affecting the CMBS, RMBS, and ABS markets. Each Dechert Securitization Update provides timely information on these developments. For a discussion of several recent legislative and regulatory developments that will shape the future of the securitization markets, please see the latest Securitization Update Dechert has prepared. This Securitization Update includes a discussion of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC's proposal to amend Regulation AB, the FDIC's proposed changes to the "safe harbor" rule, and the SEC's new rating agency rules. To be added to our regular Securitization Update mailing list, please follow this link, fill out all required fields, and check the box entitled "Real Estate and Structured Finance", along with any other subject areas that might be of interest.

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