CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

Now I can’t quibble with the data or much of the analytics. This report looked at the performance of the 7,000 plus insured depository institutions, and focused on those who had high CRE concentrations. By high, we’re talking institutions where construction, land and land development loans (CLD, to the trade) represented 100% or more of a bank’s risk-based capital and institutions where total investment (as opposed to owner-occupied) CRE (including the CLD portfolio) represented 300% or more of an institution’s risk-based capital. That, by the way, describes almost all regional and community banks. So which way is the causation arrow pointed? That seems to be a question the authors found curiously uninteresting.

While many conclusions are drawn from this data, the headline, above the fold, marquee conclusion is:

During the three year economic downtown, banks with high CRE concentration levels, proved to be far more susceptible to failure.

I’m breathless. Really?

I suspect equally rigorous academic studies could have come up any of the following headline conclusions:

• Small, Poorly Capitalized Banks Fail a Lot
• Banks in Geographic Areas Where the Economy Sucks Didn’t Do Really Well During a Really Bad Recession
• Banks With Nothing Else to Do Except Make CRE Loans Probably Didn’t Do Very Well, or
• Banks Run By Dopes Fail a Lot

The 2006 Guidance, which was certainly not a hot read, actually doesn’t impose a cap on CRE lending, but simply suggested that banks with high concentrations of CRE lending should have good practices, protocols and a knowledge base to justify being so concentrated in that space. Nothing to quibble about there. (Although one might observe that our policy of encouraging formation of lots of small banks with limited capital and a limited geographic footprint almost dooms those institutions to embrace over concentration in the CRE space as there is often precious little else to do.)

The problem, of course, is how something like this gets woven into a narrative that commercial real estate is a dodgy business full of executives whose compensation has not been “fairly” restrained by the populism-fed political fury unleashed on the banks and the real estate “moguls” somehow have suborned the world of Jimmy Stewart-led banks to do dumb things that probably should be illegal. It gets wound into the narrative not as a dry, unexciting and perfectly commonsensical notion that small banks with limited management systems should probably avoid excess concentrations of lending activities in asset classes in which they have no strong knowledge base but as part of the broad miasmic hostility to CRE capital formation. We have over 7,000 banks scattered across the country, many of which are in communities where everything is essentially a real estate loan, and those loans are probably as good as or better than the commercial loans which do not have the benefit of a mortgage on some dirt. When the whole world flirts with a depression, these loans will not work really well. I need a long, laboriously compilied academic report full of rigorous mathematics to figure that out?

This is not news and my anxiety here is mostly a concern that some will misuse this report as part of a narrative that commercial real estate is a source of all evil and needs to be more highly regulated (read, constrained) just at the time where we need the banking market, as well as other lending sources in this country, to meet the needs of the commercial real estate industry. Without that support, economic activity in general will be depressed.

We in the commercial real estate industry need to be vigilant that the narrative, like a metastasizing virus, doesn’t get used to further both political and regulatory hostility to CRE capital formation and commercial real estate.

OK, maybe I’m over-reacting, but I was thinking about taxpayers’ dollars at work and wondering why we really needed an interagency report to tell us that a lot of commercial real estate loans went bad when the commercial real estate market collapsed, and a lot of small banks got left holding the bag? A man bites dog moment it ain’t.

By: Rick Jones

Dechert Partner John Timperio once again moderated a panel on the legal and structural considerations in effectively analyzing a CLO, particularly the comparison of the improvements made in the current CLO 2.0 structure in relation to the pre-2007 vintages (typically referred to as CLO 1.0).

CLO issuance has been exceedingly strong this year with north of $29 billion of CLO securities issued in the first quarter of 2013 alone (roughly half of 2012’s total), though industry participants attending the conference were divided on what to expect over the remaining three quarters. At the low end were predictions that 2013 will end up matching 2012 with issuance in the $55 to $60 billion range due to the limited supply of leveraged loans available in the marketplace. However, the general consensus was that CLO issuance will likely not continue on the prolific pace set in the first quarter but will still likely top $80 billion by the end of the year which would make 2013 one of the busiest years on record for CLO security issuance.

There are, however, significant hurdles to overcome if the more bullish of these prognostications are to come to fruition. For example, senior tranche investors have been resisting any further tightening of spreads on such top rated tranches and the FDIC rules that recently became effective (discussed here and here) have given certain of those senior investors leverage to try and push spreads wider or, alternatively, have caused such investors to put on hold any further investment in CLO notes until the effect of the FDIC rules can be further analyzed. Moreover, the most active rating agency in the CLO space, Standard & Poor’s, has recently announced it will be increasing the requirements necessary to earn the coveted “AAA” rating for such senior CLO tranches. Finally, the CLO market as a whole continues its discussions with regulators over implementation of the risk retention rules under Dodd-Frank as it has become clear that there will be no general exemption for CLOs.

In the face of these headwinds, everyone at the conference seemed to agree that CLO collateral managers will continue to require a steady supply of quality credits at attractive spreads to continue to put together transactions that make economic sense in this market environment.

However, optimism abounds as many within the CLO market are betting that these challenges in the structured credit market, as well as those in the wider economy, will not inhibit investor appetite for the yield available on CLO notes. We did not meet any conference commentator that expects a contraction in CLO issuance relative to 2012’s stellar performance.
 

By: Ralph Mazzeo, John Bumgarner, and Sean Solis

Dechert partners John Timperio and Gordon Miller have done an in-depth analysis on the new rules and their potential impact on the CLO market and, as outlined in a recent legal update, see the likely impact of such rules to be less adverse than some of the predictions of other commentators in the market.

Initially published on February 25, 2011, the new FDIC rules replace the existing supervisory ratings-based and capital-based methodology with an asset-based methodology, which assesses large institutions and highly complex institutions for the risk each applicable asset poses to the Deposit Insurance Fund using a “scorecard” that combines any such institution’s CAMELS ratings and certain forward-looking financial ratios, including the ratio of “higher risk assets” (including leveraged loans, nontraditional mortgage loans and subprime consumer loans), and “higher risk securitizations” of such higher risk assets (encompassing securitizations of such “higher risk assets”) to Tier 1 capital and certain reserves.

Such institutions have been required to include such “higher risk assets” in their calculation of their deposit insurance assessment rate during the transitional period that began when the FDIC published the final rule in 2011. However, in making such calculations these institutions have been permitted to identify leveraged loans and CLOs using each such institution’s existing internal methodologies or the criteria in existing supervisory guidance. As of April 1, such institutions will be required to use a new single standard, set forth in revisions to the final FDIC rules issued in anticipation of final implementation, to identify leveraged loans and CLOs. While such single standard may be more or less inclusive than the standards employed using their applicable transitional methodologies, it is likely that for many institutions the new single standard will result in an increase in the identification of leveraged loans and CLOs.

The impact of this new single standard for each applicable institution will be fact specific and particular to such institution’s asset mix. It will also be materially impacted by any material differences between the applicable methodologies employed by an institution during the transitional period and those methodologies required to be used under the terms of the final rule set to take effect on April 1. As each applicable institution assesses the new requirements in identifying “higher risk assets” and “higher risk securitizations”, some institutions that purchase CLO securities may temporarily withhold buying such securities while their internal regulatory experts evaluate the new rules of the road. However, it is possible that other institutions may be incentivized to buy CLO securities if such institution was maxed out under the concentration criteria for “higher risk assets” such that purchasing additional CLO securities would not negatively impact their deposit insurance assessment rate.

For the broader CLO market, the new required FDIC standards may result in an uptick in the pricing of leveraged loans and CLO securities for transactions effectuated after April 1. However, as the market digests the new rules and market participants more clearly understand the rules of the road going forward, it is likely that the impact of these FDIC rules will not result in a significant slowdown in CLO issuance, a material increase in the pricing of CLO securities or any material attrition in the CLO investor base.
 

By: Matthew Clark, John Bumgarner and Sean Solis

Among the joys of the Volcker Rule, and there is much, much more here to celebrate or loath, is a limitation on the ability of a bank to invest more than a de minimus amount of capital in a private equity vehicle or hedge fund. This sort of transaction has been deemed by the political class as an unremittedly bad thing.

The Volcker Rule theoretically became effective on July 21, 2012 in the complete absence of critically important enabling regulations, subject to a two-year conformance period. Back last October (i.e., yes, a year ago now), the FDIC, Fed, OCC and the SEC (but oddly not the CFTC which must, under the statute, join in the issuances of any applicable rules) published a Proposed Interagency Rule. A comment period ensued, about a billion comments were submitted and then…crickets. No Rule. I am shocked to think the thought, and I’ll probably deeply regret it, but we’d be better off if we had actual regulations. The ultimate rules may be wrong-headed and damaging to entrepreneurship and enterprise, but at least we’ll know what we have. The Rule, as written is so theoretical, so remote from the hurley-burley of everyday business, that it’s chilly penumbra impacts deals and structures that, perhaps, with real regulations, might (might) be seen as OK. This endless limbo of yet to be finalized rules is infinitely worse.

There are no detailed regulations yet, though, for good reason. The regulatory community cannot, for its life, figure out what the implementing regulation should actually say. The statute sets a lot of fundamentally quixotic standards which are more classroom than boardroom. The rationale for the Rule, sensible on its face, is that banks shouldn’t be making risky private bets with publicly guaranteed deposits. But it’s not easy in the real world to distinguish, in many cases, the conduct which inspired the Rule (bad) from legitimate business deals (good)

More in a moment about why Volcker has graduated from merely inexplicably annoying to a bona fide pants-on-fire problem for me, but let’s detour for a moment on the idiocy of wasting time on proprietary trading and PE fund investment right now in the first instance. This law was given birth and justified by the credit crisis and the recession which started in 2007 and, in some material way, continues today. If memory serves, the credit crisis was brought to us by the bubbles in housing and commodities and the riptide when it collapsed. Anyone hear prop trading or PE funds in that pithy summary? That’s because it had little or nothing to do with the credit crisis and attendant recession. So here’s Volcker, in a nutshell: A wildfire almost burned down the village and, after long deliberation and much chest thumping, the City Fathers decided that the clear and obvious thing to do was to put a new Stop sign on Main Street. Come again? Reducing the risk of running down Granny is, to be sure, something of a public good. But, excuse me, the town just burnt down; shouldn’t we be a scooch more focused on fire safety? Okay, I don’t want to push this analogy too far, but no credible member of the economic chattering class has said that the prop trading was anywhere near the epicenter of the financial meltdown. At a time when we have plenty else to worry about, why in the world are we tying ourselves into knots about prop trading?

Ah, it’s the populism, stupid. The political calculus was compelling: the financial sector caused the recession. The financial sector is full of banks run by, ugh, bankers. If we punish banks and bankers, virtue will ensue.

Enough. Back to why I’m now really annoyed by the Volcker Rule. The Rule purports to limit a bank’s ability to invest in a hedge fund or private equity fund. Now, as I said at the outset, there’s a core of sensibility to the rule. There is certainly an argument that banks, with the benefit of the government guaranty of the deposit base, shouldn’t be playing private equity investors with customer deposits. But with an atom bomb to kill a mosquito sensibility, our elected leaders carpet bombed all bank investments in private equity vehicles and funds. Consequently, the Rule greatly impairs a bank's ability to do legitimate, bank-like things with private equity vehicles and funds. Just a few examples: Can a bank take an equity kicker to compensate it for risk? Probably not. Is an elevated interest rate or a higher fee structure good debt architecture or impermissible bad investment? What happens when the bank exercises remedies? My Lord, the bank may end up with more than the maximum allowable 3% interest! The statute sort of addresses this but creates artificially hard deadlines for disposing of the collateral, which is often inherently illiquid, chilling the willingness to fund these enterprises in the first instance. Moreover, why can't a bank invest funds in private vehicles, which are structured like funds but which are, in actuality, specialty finance companies providing financing to meet needs unmet by the conventional bank market? If we can structure these as operating companies, they are OK, but maybe that's not the deal. Why shouldn't a fund vehicle be used for lending? This is basic banking. This is the stuff that makes the economy work. Here we see the big flat foot of a Volcker giant stomping on customary non-nefarious banking, all to honor a narrative that, if tested, would be found wanting.

Oddly, the law excludes from the restrictions on investments in PE funds, funds exempt from registration under the ’40 Act under Section §3(c)(5). §3(c)(5) is the real estate fund exception. Not that I’m complaining, but why is investing in a real estate fund OK whereas investing in others is not? Moreover, investing in an operating company is also OK. What’s the difference between an operating company and a fund? Mighty fine stuff when you get down to it.

And so, like much in Dodd-Frank, we have a statute hurriedly put together, some proposed regulations that everyone agrees don’t work, no clarity and a lot of energy being spent figuring out what is and what is not permissible, at a time when time could be much better spent on entrepreneurship and enterprise. And all in the name of a populist conceit that prop trading and PE fund investment caused the financial crises. We should have better things to do.

By Rick Jones

Quick background for those with a life. The covered bond business has been extant in Europe since the 18th century, with the leading participants being the Germans, whose program is known as the Pfandbrief program. Generally, covered bond programs exist in most EU countries and all have roughly the same configuration. A bank legally isolates a pool of low-leverage mortgage loans (and in some cases governmental loans, maritime-based loans, and other more quirky assets but, for our purposes, we’ll focus on mortgage loans). Typically, low leverage means 60% loan-to-value or less. The bank issues bonds which are both the obligation of the issuing bank and have a priority claim on the economics of the isolated pool of mortgage loans. By virtue of statute, if the bank were to become insolvent, the creditors of the bank would not have a claim on the assets isolated in the covered bond structure until the related bonds were repaid. Bonds get the benefits of both the banks’ unsecured promise to pay and the pool of isolated mortgage loans and, hence, trade very tight to risk-free sovereign paper. The bonds are highly rated even though the credit rating of the bank is several ticks below terrific. Whereas in the United States, we’re used to the notion of a co-dependent rating structure where if there are multiple credit inputs into a transaction, the lowest rated input will tend to drive the rating of the ultimate product, the covered bond business has not been so burdened.

Like Generalissimo Franco, the U.S. covered bond structure is still dead and is likely to stay that way for the foreseeable future. The FDIC loathes this idea. And now the Euro Zone covered bond business is in peril. While not likely to ever actually die, the business in the EU is likely to shrink precipitously. And that has consequences.

The European covered bond business is going to shrink because the banks are in terrible shape, and regulators and the equity markets are increasingly intolerant of high quality assets plucked from the balance sheets and hived away from bank creditors to support these bonds. When no one dared to think the thought that a European bank could be insolvent, anxiety over asset allocation resulting from the covered bond business was low. That’s not where we are at now. Moreover, as European banks continue to retreat from traditional banking, gorging on sovereign debt, shedding “non-core assets” (e.g. anything not in our back yard – a reverse NIMBY), shrinking balance sheets to meet Basil III and parking liquidity at the ECB, there is going to be less and less to cover.

When a cycle is long enough, it’s indistinguishable from a secular change. EC bank balance sheets will repair but, for many, they will not fully repair for so long, it will be essentially a secular change in the European banking environment. The covered bond business is going to shrink, and shrink rapidly, and shrink, for all intents and purposes, indefinitely. This is going to massively disrupt capital formation for commercial real estate businesses across Europe. It will significantly increase the cost of funds to support commercial real estate lending by European banks and eliminate the cost advantage that the European banks have had both in Europe and in North America. No more will U.S. banks grouse that German banks swooped in to take low LTV, high-quality assets far inside the best the U.S. banks could do because they had Pfandbrief execution.

The shrinking of the Pfandbrief business, together with Europe’s new fascination with core (e.g., domestic) assets, and the dedication of large hunks of the European banks’ balances sheets to sovereign debt (least they can do for the pols, right?) means that the U.S. markets will not see Pfandbrief financed European bank lending anytime soon. Moreover, the needs of the commercial real estate markets in Europe will now far exceed the capacity of the European domestic banks to provide that capital. The Wall Street Journal reported on August 29 that Euro Zone lending was down 43% from a year ago and a whopping 68% from 5 years ago. Therein lies a whopping funding gap, estimated by some at €250 billion, for 2013 alone. It is real and is here for a long time.

Non-EC banks have recently been moving into the European market place to provide credit. Well, to be honest, tiptoeing into a market is closer to the mark. European markets continue to look rather fraught with recession, but as the Pfandbrief trade unwinds, the case for jumping in with both feet will become more and more compelling. So pack your bags, U.S. banks desperately seeking assets, looking for spread and fee income. Join your high yield and distressed fund clients in the EC pool. The Pfandbrief barricades are coming down around Europe and markets are open.
 

By: Rick Jones

Oh, don’t get me wrong, I’m a serious fan. Representing issuers on this product will be fun. While this has been a booming business in Europe for a while (like, the last 300 years), it does not translate well in the US. In Europe, broadly, every mortgage loan is originated with the expectation that all or a part of it will be financed in the covered bond market (in German parlance, the Pfandbrief market), that reflects the capital markets environment in Europe where covered bonds are a critical part of every financial institution’s capital structure.

That’s not what we’ve got here. US banks have the benefit of robust deposits, of deep equity markets and unsecured borrowing to provide needed capital. The fundamental economic problem for this product here in the United States is that, if an institution is sufficiently highly rated so that the co-dependency problem when the institution issues covered bonds will not be overwhelming, it could raise money more efficiently in the unsecured debt market. Consequently, covered bonds are negatively accretive to the cost of funds. On the other hand, if the covered bond economics are accretive, the bank’s unsecured ratings are probably insufficiently high to support the structure. So we have a Goldilocks problem. One issuer is too good and one issuer is too bad, is there one in the middle? Maybe, but it can’t be a big market. Compounding this problem is the hostility of the equity analysts who don’t cotton to ring-walling assets away from the general creditors of the institution, and of the FDIC, which broadly hates the whole thing. From the FDIC’s viewpoint, covered bonds dip into its pocket to steal assets from the rainy day fund. There’s been some potential compromise discussed with the FDIC, but it will remain a daunting roadblock to getting something done.

Net, net, I’m not holding my breath for birth of a real covered bond market here in the United States. But if anyone can explain to me the compelling need to which this is a compelling answer, I would love to hear it. In the meantime, maybe it’s simply worth enjoying the fact that our elected representatives have found an issue on which they can just get along.

By: Rick Jones

Again, the crux of the legislation is certainty on the treatment of covered bonds in the insolvency or receivership of the covered bond issuer. The bill seeks to provide this certainty through a framework that, at certain points in default or insolvency, isolates covered bond programs’ cover pool assets and liabilities into separate estates by the operation of law. Generally, the issuer (or receiver) retains a claim to the residual interest in the cover pool and the bondholders retain claims (contingent in receivership) for deficiencies on their bonds.

Before receivership, if an issuer defaults on a covered bond program, a separate estate is created. If appointed receiver before an issuer default, the FDIC has the option to transfer a covered bond program to an eligible issuer within 180 days or to elect to cease performance. If the FDIC (i) fails to transfer the program within the 180 days, (ii) elects to cease performance or (iii) fails to perform, or cure any arising issuer default, on the program, a separate estate is created. A separate estate is also created for a covered bond program if anyone other than the FDIC is appointed as receiver, trustee, conservator, etc. for the issuer.

The new bill will of course be the big theme at today’s covered bonds hearing before the House Capital Markets Subcommittee, chaired by Representative Garrett. You can find the witness list and access to their testimonies and the webcast (as posted) here. We will be looking for clues in how it is received as to how far it will go or whether, in the end, it will be just another bill on Capitol Hill.

By Stewart McQueen and John Bumgarner.

As Professor Kenneth Snowden noted in his testimony before the Senate (available here), the U.S. has made several abortive attempts to create covered bonds markets, from the 1870s to the 1930s.  These past attempts either failed to find the right formula to attract investors or ran afoul of established regulatory authorities and market participants.  We have investor demand, which is currently serviced by “Yankee issuances” from foreign issuers; U.S. investors reportedly sent $22 billion last year abroad in search of these safe assets. This time around the push for covered bonds is foundering on the FDIC’s concerns about adequate collateralization and access to the cover pool in the resolution of failed issuer banks.

The FDIC is concerned to preserve its current authority in resolving failed banks’ contracts.  Currently, just as with any other issuer, when covered bond issuers are placed in receivership, the FDIC has the authority either (i) to perform and make payments on the bonds, (ii) to repudiate and pay par plus accrued interest through the date of insolvency, and reclaim the collateral, or (iii) to do nothing and let the covered bonds default.  The FDIC, speaking for depositors and other creditors (also before the Senate Committee on Banking, Housing and Urban Affairs, available here), argues that it must have the option to access cover pools in receivership.  So the argument goes, absent the FDIC’s current flexibility to repudiate covered bond programs and access the cover pool to maximize recoveries, recoveries will be suboptimal and losses will be transferred to the Deposit Insurance Fund and the taxpayer, and the moral hazard abounds.  However, without legislation giving certainty on the FDIC’s treatment in issuer receivership, U.S. issuers cannot offer covered bonds on terms competitive with other forms of financing, including those so called Yankee issuances. 

With the continued lobbying efforts of certain industry groups and the shift in the balance of power in Congress, we do not expect the push for covered bond legislation to die any time soon.  We understand that Representative Garrett plans to reintroduce legislation in the House (which must first travel back through committee) and has already circulated a discussion draft to members of Congress and securitization market participants (please see this Dechert OnPoint (pdf) for a more in depth discussion).  The House Capital Markets Subcommittee is keeping the ball rolling with another hearing scheduled for the 11th, and covered bonds remain on the radar of the Senate Banking, Housing and Urban Affairs Committee.  Even the Obama Administration (pdf) has given a nod to working with Congress to explore covered bond legislation in the context of GSE reform.  We will be looking for signs of bigger and better things to come.

If our legislators and regulators can make haste, slowly of course, toward integrating covered bonds into our financial system, U.S. issuers may have an opportunity to tap into investor demand and give the European issuers a run for those Yankee dollars, and I may have the opportunity (or privilege) to visit my in-laws and watch college basketball and NASCAR without interruption… unless, of course, I'm working on a covered bond transaction.

By Stewart McQueen and John Bumgarner

Section 942

Generally, the disclosure requirements of Dodd-Frank Section 942 overlap significantly with the SEC’s proposed rules to revise Reg AB.

Causing a recent stir is Section 942(a) of Dodd-Frank which amended Section 15(d) of the Securities Exchange Act (the “Exchange Act”) to exclude ABS, as defined in the Exchange Act (a definition that is more broad than the Regulation AB definition), from the automatic suspension provisions of 15(d). Prior to enactment of Dodd-Frank, Section 15(d) automatically suspended the duty to file ongoing Exchange Act reports after any fiscal year other than the fiscal year in which the related registration statement became effective - if the securities of each class to which the registration statement relates are held of record by fewer than 300 persons. As a result, for most issuers of ABS, Exchange Act reporting obligations suspended after the filing of one annual report on Form 10-K. Dodd-Frank Section 942(a) further authorizes the SEC to suspend or terminate Section 15(d) reporting requirements for any class of ABS on such terms and conditions and for such periods as the SEC deems appropriate.

The SEC is proposing in new Exchange Act Rule 15d-22(b) to permit suspension of the reporting obligations for a given class of ABS pursuant to Exchange Act Section 15(d) for any fiscal year, other than the fiscal year within which the registration statement became effective, if, at the beginning of the fiscal year, there are no longer ABS of the class that were sold in a registered transaction held by non-affiliates of the depositor. The SEC is also proposing to update Exchange Act Rule 15d-22 to indicate when annual and other reports need to be filed and when starting and suspension dates are determined with respect to a shelf takedown, and is proposing to amend Exchange Act Rule 12h-3(b)(1) to exclude ABS from the classes of securities eligible for suspension since Rule 12h-3 tracks the language of the Exchange Act. Comments to the SEC pertaining to the proposed rules are due on or before February 7, 2011.

Note that on January 6, 2011, the SEC issued a “no-action” letter to the American Securitization Forum (“ASF”) confirming that the SEC staff would not recommend enforcement action if an ABS issuer continues to determine whether its reporting requirements for existing transactions are suspended based on the standards of Section 15(d) prior to the enactment of Dodd-Frank. The “no-action” relief is subject to certain conditions.

Dodd-Frank imposes no rulemaking deadline in connection with Section 942.

TITLE II – Orderly Liquidation Authority

You may have happened upon my December 13, 2010 blog entry addressing concerns about FDIC treatment of preferential transfers under the Orderly Liquidation Authority (“OLA”). Since then, on December 29, 2010, the FDIC issued a letter from the FDIC General Counsel addressed to the ASF concluding that the treatment of preferential and fraudulent transfers under the Dodd-Frank OLA provisions was intended to be consistent with the related provisions under the Bankruptcy Code, and indicating that a formal regulatory resolution to the issue will be addressed by the FDIC Board of Directors. The FDIC published an NPR on October 19, 2010, with a deadline of November 18, 2010 for comments addressing the proposed rule and January 18, 2011 for comments on additional questions. Final rules are expected to be released by the FDIC in March 2011.

Coming any day now…

Section 945

Here’s a hot button topic. Section 945 of Dodd-Frank (amending Section 7 of the Securities Act of 1933) states that the SEC shall issue rules relating to the registration statement required to be filed by any issuer of an ABS (as defined in the Exchange Act) that require such issuer to perform a review of the assets underlying the ABS and to disclose the nature of such review.

On October 19, 2010, the SEC published an NPR and comments were due November 15, 2010. In addition, the SEC proposed a new rule and form to implement Section 15E(s)(4)(A) of the Exchange Act, added by Section 932 of Dodd-Frank, which requires an ABS issuer or underwriter to make publicly available the findings and conclusions of any third-party due diligence report.

The SEC final rule is due by January 17, 2011 (within 180 days after the date of Dodd-Frank enactment).

Section 943

Another hot button topic and another SEC final rule due by January 17, 2011 has to do with representations, warranties and repurchases in connection with ABS. In accordance with the requirements of Dodd-Frank Section 943, the SEC’s proposed rules would require ABS issuers to disclose fulfilled and unfulfilled repurchase requests across all transactions. In addition, they would require nationally recognized statistical rating organizations to include information regarding the representations, warranties and enforcement mechanisms available to ABS investors in any report accompanying a related credit rating, including a preliminary rating. The SEC’s NPR was published on October 13, 2010 with a comment deadline of November 15, 2010.
Dechert LLP worked with the Securities Industry and Financial Markets Association’s Securitization Group drafting two comment letters to the SEC in connection with Dodd-Frank Section 943 and Section 945 (the two comment letters can be found at: http://www.sec.gov/comments/s7-24-10/s72410-33.pdf and http://www.sec.gov/comments/s7-26-10/s72610-30.pdf).

Section 941

Credit risk retention. Speaking of hot button, even my mother called me to ask about this one, and I sensed she was somewhat zoned out listening to my explanation until I mentioned “skin in the game” at which point she perked up and said, “That’s what I read-- that phrase.” We can pretty much count on skin covering at least 1/3 of the torso. (Is that a horribly inaccurate 5% estimate?) Here’s where we’re at insofar as risk retention rulemaking is concerned. Numerous acronyms are on this one, including the SEC, OCC, FDIC, HUD, FHFA and OTS to name a few. The SEC plans to propose rules (jointly with others) regarding risk retention by securitizers of ABS as well as implement the exemption of qualified residential mortgages from the risk retention requirements between January and March 2011 (see SEC rulemaking timetable at: http://www.sec.gov/spotlight/dodd-frank/dfactivity-upcoming.shtml#0910). The final rule is due by April 17, 2011 (within 270 days after the date of Dodd-Frank enactment). However, the buzz is that risk retention rulemaking will be delayed.

Section 621

I’ll leave the Volcker Rule for another day (because, frankly, I’m hungry) and conclude with Dodd-Frank Section 621, the intent of which is to eliminate incentives for securitization market participants to intentionally design ABS to fail or default. Section 621 adds a new Section 27B to the Securities Act of 1933 entitled “Conflicts of Interest Relating to Certain Securitizations.” Section 27B(a) states that “[a]n underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security . . . which for the purposes of this section shall include a synthetic asset-backed security, shall not, at any time for a period ending on the date that is one year after the date of the first closing of the sale of the asset-backed security, engage in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.” An NPR is expected to be released by the SEC any day now. Final rules are due by April 17, 2011. Recognizing that many potential and actual conflicts of interest are inherent in the ordinary course of securitization transactions, comment letters were submitted to the SEC by industry trade groups specifying conflicts of interest that should not be expressly prohibited under Section 621.

As the Muppets have sung, things are Movin’ Right Along.
 

By Laurie Nelson.

WHAT? The Reform Act’s “Orderly Liquidation Authority” (“OLA”) provides that if the FDIC is appointed as receiver of a “covered financial company,” the FDIC has the power to void transfers, preferential as well as fraudulent, such that security holders end up left with an unsecured claim in the FDIC receivership if the security interest in the assets was perfected solely via UCC filing (and not, for example, by possession or by filing plus stamping)-- a different result than under either the Bankruptcy Code or, in the case of a bank, the Federal Deposit Insurance Act.

WHERE? Here.

WHEN? Now.

WHY? It has been noted by industry trade groups that the above-described outcome is most likely the result of an unintentional drafting error caused by trying to combine into the OLA section of the Reform Act both Section 547 and Section 548 of the Bankruptcy Code. Industry trade groups plan to meet with the Senate Banking Committee and the House Financial Services Committee, speak with the FDIC, and submit a comment letter under the October 19, 2010 FDIC NPR which asks for comments on the FDIC’s avoidance powers under Section 210 of the Reform Act.

HOW does this affect ABS transactions? Affected securitizations would, for the most part, include auto or equipment loan/lease (and certain student loan) securitizations. The underlying assets in these types of securitizations are generally characterized as “chattel paper” or “instruments” under the UCC and therefore the security interest may have initially been perfected solely by filing a Form UCC1. The problem arises when ultimately, under the UCC, a “bona fide purchaser” of the collateral trumps earlier perfection that was accomplished via UCC filing. This would not be the result under the Bankruptcy Code.

The legislative history and the FDIC’s October 19, 2010 NPR suggest that creditors should be similarly treated under the Bankruptcy Code and the OLA provisions. Further, no public policy supports such a distinction. Still, without further guidance, legal counsel will not be in a position to give a legal opinion as to whether a transfer could be avoided as a preference under the OLA or whether any given financial company could be determined to be a “covered financial company.”

As the musical group Bowling for Soup has sung, there will be No Opinion.

By Laurie Nelson.
 

The Golden Turkey Award for the Idea Which Launched a Thousand Ships: Risk Retention

Yes, we have to make mention of the 2010’s fiscal cure-all - risk retention. Risk retention has earned a place of just south of gravity and just north of evolution (with some notable exceptions) as received wisdom in this country. It is at the core of a vast amount of regulatory change which will sweep financial markets when turbo charged by FASB's views on consolidation of securitization vehicles literally changing the fundamental rules of the securitization game in a way to diminish capital formation at a time when capital formation is critical to the recovery of our economy. A base for received wisdom? Pretty dodgy. Lehman, Bear, Merrill, AIG, et. al. didn't fail because it laid off the risk of ownership of financial assets. It was because they retained it. The worst performing sector of the entire commercial real estate debt capital markets was the land loan and construction lending sectors. Sectors notably bereft of the ability to sell off the risk. While reasonable people might differ on the behavioral impact of retaining a 5% strip of a financial asset, the data simply do not support the religious fervor with which this notion has been embraced. Hockey stick, anyone?

The Golden Turkey Award for the Most Opaque Regulation: 17g-5

This was a highly competitive category this year – but the winner is Rule 17g-5!

Rule 17g-5 provides that rating agencies must require a party retaining a rating agency to rate an asset backed security (including CMBS), to establish and maintain a password-protected website for all other rating agencies. The website must contain all information provided to the rating agency in connection with the rating. Both written and oral information must be loaded into the website simultaneous with its delivery to the retained rating agency. While the idea behind Rule 17g-5, the simultaneous sharing of information is good – the end result has been murky at best.

Bankers legitimately concerned with liability are insisting that there be only one conduit of information from the issuer’s side to the rating agency. No one is quite sure how to deliver oral communication to all the rating agencies simultaneously through the web-based delivery system. Credit rating agencies are likely to make mistakes due to the fact that they no longer have access to as much information. Accordingly, we find the revisions to Rule 17g-5 thoroughly deserving of a Golden Turkey.

The Golden Turkey Award for the Scapegoat of the Moment: MERS

In an upset, Mortgage Electronic Systems unseats Wall Street Fats Cats, winner of this category since 2007.

Until recently, Mortgage Electronic Systems (“MERS”)  was ubiquitous but relatively unknown. MERS has two roles. First, it acts as record title holder of the mortgage (as nominee for the noteholder) and keeps track of the owner of the beneficial interests in the note. Second, in states where it is permitted, MERS will appear in court to execute the foreclosure process.

MERS was born of necessity, created to address the inability of local recorders to keep pace with the number of assignments, providing a more modern approach to tracking the ownership of mortgage loan. As we mentioned before, ubiquitous, but relatively unknown until recently. However, in early October, a judge in Oregon stopped a foreclosure of a securitized sub-prime residential mortgage loan on the grounds that the assignment of a mortgage to MERS was ineffective because MERS didn’t hold the note – leading the judge to find that MERS lacked a cognizable interest in the property. Did MERS cause foreclosures, or even contribute to the current mortgage crisis – no. Yet, we anticipate that this will be an issue we are sure to hear more about in the future.

The Golden Turkey Award for the Worst Sequel : Basel III

Basel III wins the award for worst sequel.  Basel III is the most recent effort by the Basel Committee on Banking Supervision to fix the worldwide financial system. To provide some background, 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, 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.

Unfortunately, now everyone agrees that something must be done, and that something is to jack up capital. Additionally, politics suggest that whatever comes out of Basel III will, this time, be implemented in the United States. Some have estimated that Basel III will require banks to raise as much as a trillion dollars in equity and obtain over $5 trillion in committed facilities to meet new capital and liquidity requirements.

We’ve heard suggestions that, under Basel III, in order for commercial real estate to be a competitive asset class for the banks, the risk spread would have to increase over 200 basis points. This may simply drive commercial real estate out of the banks. That’s why we call it the worst sequel.

The Golden Turkey “Ironman Award”: Our Readers

This is our recognition of you, the commercial real estate industry and your continued, determined efforts to right the ship during the past 12 months. There can be no doubt that 2010, with properties trading, loans being made and securitizations being printed, was a significant improvement over 2009 (which, in turn, was better than its particularly ugly predecessor). Of the many lessons that may be gleaned from the credit crisis, one is that, in boom times and bust, the CRE market lies in a state of constant innovation and requires professionals with unending creativity and unceasing motivation. We stand at a critical point in the real estate cycle as you – the architects of the future of this industry - lay the foundation for CMBS 2.0.

By the Crunched Credit Team.
 

But now, while both political and policy waters remain roiled by the recession and credit crisis, the FDIC has chosen to recast its Safe Harbor and impose a host of additional restrictions on access to the Safe Harbor. The new Safe Harbor Rule not only purports to protect securitizations from being unwound even if the transaction does not qualify for GAAP sale accounting, but in addition, and this is very important, it also limits access to the Safe Harbor even for transactions which DO qualify for sale accounting. The FDIC does say a transaction that fails to meet the Safe Harbor conditions, but nonetheless is a GAAP sale is not subject to repudiation and seizure, yet the regulatory missive seems to suggest that any prudent party better hustle its regulated rump into the Safe Harbor. In what seems, to me, a beautiful expression of Brave New World speak, the FDIC says, in describing its rule, “The FDIC recognizes that, as a practical matter, the scope of the comfort that is provided by the rule is more limited than that provided in the Securitization Rule. However, the FDIC believes that the requirements are necessary to support sustainable securitizations.” Come again?

These additional conditions on the Safe Harbor are a grab bag of policy and populist nostrums that have been current among the chattering class for the past year or so. First, we’ve got a simplistic 5% risk retention. (And banks can’t hedge it. Seems a weird provision to be imposed by a regulator charged with the safety and soundness of the banking community.) Second, it incorporates the SEC’s new proposed Reg AB and offering reform rules (at a minimum). Finally, for RMBS, which lives in a separate circle of Hell, specific additional provisions have been included, which limit the number of tranches of securities that can be issued, require additional disclosure (including disclosure of compensation of various parties to the transaction), enhance representations and warranties and the like.

What is troublesome here is the assertion that an additional agency will be making dual track ad hoc decisions on issues which are more centrally the purview of other agencies.

Is it enough that the disclosure meets the SEC’s disclosure requirements, or might the FDIC have a different view of compliance? I noticed in the preamble that the FDIC does suggest that it reserves the right to require added disclosure. Maybe the FDIC will want something else, something different? That’s efficient, right?

What in the world is the FDIC doing regulating the tranching structure of securities? Don’t we have the SEC for that?

Finally, what’s the FDIC doing out in front on risk retention when Dodd-Frank specifically directed all applicable Federal agencies to engage in joint rulemaking (which, by the way, started last week and, badly I hear), leading to a one year transition period for RMBS and 2 years for CMBS. Oh, I know the FDIC rule contains an auto conform provision but the preface to the rule suggests the FDIC reserves its right to further regulate if the joint rule making does not fully meet its needs. One is left with the inescapable sense that this Safe Harbor is more about regulatory turf than good policy.

This Safe Harbor will not achieve the goal of making the world safe for securitization. It will make securitizations more difficult, more complex and more costly.

Oh well, as a lawyer perhaps I shouldn’t complain. But I can’t help be concerned that, once again, we’re losing track of the notion that before we can whack up a pie, we have to bake a pie. In order to refine securitization to better serve policy goals, we first have to have securitization. This is not helpful. This creates a duplicate regulatory regime and, with the prospect of many regulatory constituencies fighting over the rules of the game, fires of uncertainty will be stoked. We need rules and we need certainty. This really is not hard. Can’t we just get it done?

By Rick Jones.
 

And that’s just for commercial real estate.  Our duly elected representatives have tied themselves into knots trying to square an ideological commitment to risk retention with the dawning realization that a private residential securitization market may be critically needed and is on life support and may not tolerate any risk retention.  This broad rush to regulate will almost inevitably result in an overly intrusive and complex set of rules, burdening an already weakened capital formation process far in excess of the benefits conferred.

The second bit of good news may be that the effective dates of these rules have been pushed out into the dim recesses of the middling long term.  Courtesy of Senator Crapo and others, the Fed, FDIC, SEC, and Office of Thrift Supervision (why in the world is the Office of Thrift Supervision still involved? It’s done, isn’t it?) have been, first, directed to study all of this, particularly its impact in light of FAS 166 and 167, before beginning to develop regulations.  So, if my math is right, the study is going to take at least 90 days (with luck a little longer) to complete, then Congress is supposed to react and presumably give further direction to the Regulators.  That’s got to take some real time, right?  Then the rules have to be crafted, which almost certainly will take a very substantial amount of time.  Finally, the effective date for CMBS is 2 years after that.  In a world where we see more game changing news in a week than we used to see in a year, three plus years to implementation sounds a lot like forever.  A lot can happen before forever.  A lot can change.

More on this later, but let me spend a moment on the proprietary trading ban.  A couple of weeks ago, I got myself into a lather worrying that the prohibition on proprietary trading, as written in the framework Senate bill, banned securitization.  The bill said that a depository institution (and affiliates) could not buy or acquire a financial asset with the intention of selling it.  Okay, I’m paraphrasing a bit there, but that’s the gist.  Lo and behold, the final bill contains a specific carveout for securitization.  It’s buried in 13(g) Rules of Construction and it’s worth quoting in its entirety: 

"Nothing in this Section shall be construed to limit or restrict the ability of a banking entity or non-bank financial company supervised by the Board to sell or securitize loans in a manner otherwise permitted by law."  

A nugget of good news, indeed.  I almost cried.

So, what’s it all mean?  Just that the regulations contemplated by these four Sections of the Bill may give us a tome to rival the Internal Revenue Code.  But that won’t happen for a couple of years, and, as I said, a lot can happen in that time.  Does this stop the SEC or the FDIC from pushing forward with their own skin in the game rules?  One might think that the provisions requiring a study to be completed by the applicable regulatory agencies before rule-making commences, a directive to all applicable agencies to coordinate rule-making and a two year effective date might strongly argue for a deferral of the current rule-making process (and note the current comment period for the FDIC version expired July 1, and for the SEC, it expires in early August).  Such a deferral would be consistent with the spirit of the Act.  We should strongly argue that current rule-making efforts be suspended.

It’s important for the industry to remain engaged on this and on all the major regulatory initiatives that will flow from FinReg.  We need to continue a robust educational effort with the regulatory constituencies about how our business can be improved in an efficient manner that doesn’t impair capital formation.  Get ready for a long slog.  We need to get this right.  Otherwise, we’re looking at a choking fog of incredibly complex regulations that will make only the lawyers happy.  Hey, what am I saying?  Is that so bad?

The FDIC is also pressing for the ability to immediately take control of collateral assets to the extent of any over-collateralization, and to extend the period of time allowed for the FDIC to find a purchaser for the failed-issuer’s covered-bond program. Nonetheless, the FDIC appears very open to getting some sort of deal done. Industry groups – including the American Securitization Forum and the Securities Industry and Financial Markets Association – are watching these developments closely and appear encouraged by the ongoing discussions.

For my part, the desire by the industry and regulators alike for a robust domestic covered bond market has reached a critical mass, and we can expect legislation (in some form) to arrive before fourth quarter.
 

As reported by the Wall Street Journal, the FDIC is contemplating selling just 11% of the assets of the more than 200 banks that have fallen into receivership in recent years.  The reason?  Likely a reaction to the outsized gains on failed institutions enjoyed by the RTC bank buyers during the late 80's. For those assets emerging for auction, investors face an unnecessarily secretive and costly diligence process – a process identified by most investors as the singular key to successful distressed investment.

Want to perform a site inspection?  Not permitted under the bidding procedures.  Want to discuss the status of the loan with the asset managers involved in the workout?  Sorry, no-can-do.  Want to talk to the borrowers about their plans for a potential work-out?  No way.  And the loan documents (which, fortunately, you are permitted to review) often appear to have been negotiated, signed and syndicated during a particularly boozy afternoon at the country club.  Documentation is missing or unexecuted.  Servicing files are woefully incomplete.  Syndication documents are unintelligible.

Each inconsistency and inadequacy, of course, presumably leads to lower bids for the asset and for the successful bidder, the spectre of the winner’s curse.  The result is a continuing dilemma for investors.

On the deals we’ve seen play out, there’s been a rabbit who blew away the competition and left the also-rans scratching their heads:  "How'd they get to that number?"  But someone keeps seeing value in these auctions.  I suspect it’s based on a view about the underlying value of the properties and a conviction that, regardless of the static emanating from bad docs, liens and other property-specific problems, the bidder will get to the dirt at a price per square foot that will work.  The learning from all this is that you’re not going to enjoy the comfort of the hard diligence you'd want if you were buying privately, but if you like the real estate, be prepared to take a deep breath, dig deep for a winning price and gear up for an ugly war to get to the dirt.

Photo:  Flickr user chispita_666

Representative Garrett indicated last week at the CREFC conference in New York that he intended to introduce a covered bond proposal.  The proposed amendment directs the Treasury Department to establish a covered bond regulatory oversight program. (NOTE:  A link to the text of the proposed covered bond amendment is contained in this article from the Atlantic).  Under the proposed amendment, eligible issuers (which include FDIC insured depository institutions and bank holding companies) would be permitted to issue covered bonds pursuant to a covered bond program approved by the Treasury.  The issuance would be required to have an original term to maturity of at least 1 year and to be secured by a "cover pool" of eligible assets (and certain substitute or ancillary assets) from a single eligible asset class.  The eligible asset classes include, among others, residential mortgage loans, commercial mortgage loans, student loans, credit card receivables and car loans.

Although far from a done deal, the amendment seems to have some support, and we are optimistic that a regulatory framework for a covered bond market will be part of the final financial reform legislation.  A vibrant covered bond market could provide additional liquidity and financing sources to financial institutions which can only help to spur the recovery of the capital markets.  In addition, the structure of covered bonds seem to accomplish a lot of the stated goals of the financial reform legislation - particularly Congress's desire for "skin in the game", as all of the assets in the "cover pool" will remain on the financial institution's balance sheet.

We will continue to monitor the proposed legislation as it works its way through the reconciliation process.

Stay tuned ... 
 

I’m reminded of that scene in Ghostbusters where that wonky EPA bureaucrat (you can tell he’s a wonky bureaucrat, cause he’s got a beard) orders the boys to shut down the containment grid.  Funny in the movies.  Sucks in real life.

This will impair credit formation.  Full stop.  We’ve seen what happens when unmediated fair value accounting takes corporate balance sheets on a pro-cyclical ride.  We can’t do it to ourselves a second time, can we?  Can we?

OK, here’s what we need to do.  Comment on the Exposure Draft.  The comment period is open until September.  FASB will hold a hearing.  Talk to the SEC, FDIC and Fed.  Fire up Congressman Paul Kanjorsky again.  It’s our bad luck it’s election time and our elected representatives’ attention spans are at cyclical lows, but we need to try.  This requires action, or we may get to ride this economy down for the double dip.

The FDIC couldn’t even get its own Board to approve this as a proposed rule and, hence, we get this Rube Goldberg request for comment on something that looked an awful lot like a rule, but wasn’t (“We’re fixing to think about it”). 

Virtually nothing in the end seemed to have much to do with the safety and soundness of our bank institutions which, last I checked, was the FDIC’s principal responsibility, but it did have a lot to do with stuff more customarily the beat of the SEC and the part of Congressional initiatives towards financial reform.

The usual suspects showed up to comment. The banks and the trade organizations said the obvious thing. This has nothing to do with safety and soundness, this is the purview of other regulatory agencies and other potential legislative reform and the FDIC should stick to the knitting. Shockingly, the consumer advocacy cohorts praised the initiative in large measure, it seem to me, on the theory that, if it was bad for the banks, it must be good for the consumers, therefore have at it, Ms. Bair.

The good news, this is probably not going anywhere, but we must be vigilant. There will be rulemaking around the securitization safe harbor, because in light of recent accounting changes (FAS 167), the bank securitization rules have to change. This cannot possibly be good for the economy as a whole, or for the banking sector if FDIC rulemaking makes it hard or, indeed, impossible, for banks to securitize assets. From a safety and soundness, securitization remains hugely important as a risk management tool for the banks. As to the broader, economy, we simply don’t have enough lending capacity in the bank portfolios to support the needs of the capital markets.

            Keep your eyes open.

Photo:  Flickr user jclarson