CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

And then you’ve got to recharge the shelves. Most registered shelves are out of date and there are material time commitments and costs associated with getting a shelf ready for prime time. One could also reasonably be leery about knocking on the door of the SEC to approve a new shelf based on existing rules in the lee of a gigantic pile of someday-to-be-effective legislative and regulatory change that the SEC, understandably, is likely to be itching to implement.

Remember Reg A/B and Offering Reform 2.0? It’s still all out there. The comment period ended on August 2, 2010 and it’s been crickets ever since. One theory has it that the SEC is waiting for joint rule making on risk retention, the comment period for which has just begun, while others say that the sheer project fatigue at the SEC, short on budget and personnel and long on projects, is responsible for the delay. In any event, not a terrific environment to paste a shelf back together under old rules.

If Reg A/B comes out, what would it look like? The industry had significant and systemic issues with the proposed regulation. What happens if the worst of the ideas floated last spring make it into the final rule? Will our CEOs face new responsibilities and liabilities? Will there be some interim form of risk retention imposed prior to the FSOL pending joint rule making initiatives effective sometime in 2013? Will static disclosure return to CMBS? How about the broadly loathed Python program?

Similarly, we have the new FinReg Section 945 regulations effective next January. Rule 193, which is (for the moment) limited to registered deals, implements new due diligence requirements. Issuers will be obligated to develop diligence schemes “designed and effected to provide reasonable assurance that the disclosure…is accurate in all material respects.”  So we have a new liability standard and a new obligation to disclose not only outcomes but processes. (Note that Rule15Ga-1, which was published at the same time as Rule 193 early this year, and which requires disclosure of both fulfilled and unfulfilled repurchase requests, regrettably applies both to registered and un-registered deals).

Finally, there remains the on-and-off again problem of expertizing the rating agencies' rating information. Under FinReg. Section 939G, rating agencies were striped of their exclusion from expert status where ratings were included in registration statements. The SEC responded with a no action letter suspending 939G but who knows when that letter will be withdrawn and whether the problem will be front and center again.

That’s a lot to dislike and, frankly, one could be forgiven for having limited enthusiasm about ramping up a public initiative to run smack dab into a wall of a new and burdensome regulatory requirements.

When all is said and done, you need a pretty darn good reason right now to return to the public market and wade into the regulatory swamp burdening the registered deal. As our business continues to thrive (more or less) in the private markets we can both continue to reassess a return to the public market and hope the SEC will not become sufficiently miffed to further condition access to 144A on some of the provisions currently applicable only in the public arena. (I probably shouldn’t have even thought that thought out loud, should I?)

For the moment, the 144A market is open and robust. Net, net, I don’t see a return of the registered deal any time soon.

By Rick Jones.
 

The proposed Rule, some 370 pages long, is an impressive, albeit deeply flawed, attempt to implement a law that we all knew at the time could not be implemented without a massive rule making lift. It is absolutely critical that the industry comment robustly and thoughtfully, and the regulators engage thoughtfully and with an open mind to make this complex and comprehensive set of regulations do the job intended by Congress while not fundamentally impairing the function of the capital markets.

Let’s go back for a bit of history. Risk retention was one of the hallmarks of the Dodd-Frank legislation. With the industry’s thanks, Senator Crapo was successful in ensuring some asset specific flexibility was baked into the statute regarding CMBS, particularly, the notion of the B piece buyer as an alternative to the simplistic vertical sponsor slice. (We, here at Dechert, have commented on this repeatedly in the past, including here, here and here.) There’s not much point on rehashing what was in the statute (and I promise not to give in to my strong impulse to again cry: “What were you thinking?!?”). We have 5% risk retention required by statute and, unless the statute is amended or repealed, we’ll have to live with that. What I want to do here is focus on how the regulators took that statutory guidance and are proposing flawed specific rules.

So here’s the takeaway:

• The 5% risk retention can be achieved in a number of ways, including a vertical, horizontal or L-shaped slice retained by the sponsor.
• This retained risk cannot be sold, levered on a non-recourse basis or, in many material respects, hedged.
• The 5% sponsor retained risk requirement can be reduced (at the discretion of the regulators) if the securitized loans meet prescriptive underwriting standards and adequate controls required by the proposed Rule. These underwriting standards and controls are very rigorous, and it’s fair to say that many loans that typically would be securitized in a conduit operation would not meet these standards. While the guidelines of a qualified commercial real estate mortgage meanders on for several pages, just look at some of the high points here: DSCR of at least 1.7 (for most properties), LTV of 65%, no subordinate liens on the property, borrowers who have not defaulted during a two year lookback period, etc., etc.
• The sponsor can share a portion of that risk retention with an originator who contributes at least 20% of the loans in the related securitization up to that originator’s percentage contribution (but remain “responsible” for the transferees’ compliance with the proposed Rule).
• The retention obligation can be met by a qualified B piece buyer in a qualified transaction. Here, the corset’s been tugged pretty tight. To qualify for the B piece buyer risk retention alternative, a number of criteria must be met, the most important is that the B piece buyer must retain the 5% on the same basis applicable to the sponsor.
• Curiously, the proposed Rule is silent on what happens if an Originator or B piece buyer fails to hold its position as required by the Rule. The sponsor must monitor and “tell” if its sees a violation. What then?
• An Operating Advisor will be required if the Special Servicer for the transaction is an affiliate of the B piece buyer, or, for that matter, to any other party to the transaction (curious that). Moreover, and I missed this in my first reading, an Operating Advisor must be appointed even if the Special Servicer is not affiliated with the B piece buyer if the B piece buyer has customary CCR removal rights over the Special Servicer.
• This version of an Operating Advisor is, compared to current 2011 practice, a Super Operating Advisor. The Operating Advisor can “recommend” removal of the Special Servicer if it concludes the Special Servicer is not doing an adequate job. I put “recommend” in quotation marks as that recommendation must be implemented unless each class of bond holders affirmatively votes to reject that advice. That’s a vote that will never happen (see here also for discussion on bondholder voting).

We’ll return to many of these points in more detail in subsequent commentaries, but fundamentally, two good questions here. First, does the Operating Advisor’s Special Servicer termination right really improve pool performance and is it really desperately wanted and needed by investors? Second, can you sell enough B pieces if the B piece buyer cannot be an affiliate of or control the Special Servicer? Good questions. The answer to the first is maybe. Unfortunately, the answer to the second is no.

Moreover, there are no rules to mediate how a regulator (or which regulator) can agree to a reduction of the 5% threshold based on these mitigants. How does one plan, absent some fairly mechanical relationship between the delivery of mitigants and the reduction of the risk retention?

Two last words on risk retention. First, if 5% risk retention is required across the board, borrowing costs are simply going to go up. Particularly in light of the complete absence of any compelling evidentiary basis for the assertion that risk retention means better loans, it’s sad to see us pour sand in the saddlebags of the commercial real estate industry just when an expansion of credit is so critically important. (I said I wasn’t going here, but, oh well). Second, none of this applies to the GSEs, at least in their conservatorship. Now there’s a shocker.

Finally, even though this commentary is CMBS specific, I cannot talk about the new proposed Rule without mentioning the Premium Capture Provision. Yikes! They can’t possibly be saying that one may not earn a profit in securitizing loans, can they? Capitalism anyone? This is the ultimate above-the-fold headline for this regulatory Nantucket Sleigh Ride. This provision actually says that securitization cannot occur at a price above the outstanding principal balance of the loan plus costs.

I get where this came from. The regulators were concerned that somehow the 5% retention would be subverted through the unseemly earning of a profit. In this through-the-looking-glass world view, profit and capital are conflated and somehow banks will still do business for free! There is also a notion, current in regulatory circles, that securitizers don’t make conservative loans at low coupons because the securitization of those loans produces diminished profits, whereas securitization of really bad loans with high coupons produces high profits. That is clearly not true, but an ideological commitment to that notion is the underlying genetic material from which these provisions were birthed. The headline, of course, is that: “Government Ends Securitization Business, Capital Markets Starve for Capital”.

Certainly, this notion will be mediated as the comment period progresses, although I am very fearful that conversations will be captured in a price control dialogue where the regulators’ response to said headline is OK, we’re not offended by profits, just by excessive profits. Let’s discuss how much profit is acceptable. That path leads to damnation. Price controls never work, but their appeal never seems to fade away.

Enough. We have 60 or 70 days to comment, and then 2 years before implementation. A lot of deals and a lot of palaver (not to mention a Presidential election) will pass over the dam between now and then. The industry has to act, make its case, engage honestly, openly and transparently, and move this regulatory framework to a place that delivers on the promises made in the law in a way that permits capital formation to continue to flourish. It can be done.

By Rick Jones.

An issuer has strict liability for misstatements and omissions in a public deal. So what’s really added here?  An issuer can now be liable for bad disclosure about the nature of its diligence process or if its diligence failed to provide “reasonable assurance” that the disclosures were “correct”.  Now that’s new and different!  I don’t know what “reasonable assurance” means, but I suspect if we round up the usual suspects at the trial bar, they will tell us it means something, by God!  One more count in every complaint!

This only applies to registered deals and in the CMBS space registered deals are beginning to look like the dodo.  But the SEC staff mused in the preamble to the Rule that a similar regulatory regime for the 144A market might be appropriate and they’re a fixin’ to think about it.  Joy. 

Also one should not discount the argument that, as the SEC has concluded that this information needs to be provided to meet its standards for adequate disclosure, mischief could be concocted by our usual suspects right now.  If this disclosure is appropriate in 2012, why not now?

Another new rule, Rule 15Ga-1 (release here (pdf)), is more straightforwardly and more immediately problematic.  Rule 15Ga-1 requires an issuer to disclose, in a very complex and burdensome way, its past history of demands for the repurchase of assets -- successful, unsuccessful or otherwise -- for breaches of representations and warranties on pool assets.  The SEC is also requiring, in Rule 17g-7 (released with Rule 15Ga-1 above), that rating agencies include in their reports a description of the issuer's reps, the enforcement mechanisms to address breaches and how each differs from such provisions in "similar securities".

All this kicks in by the first quarter of 2012 as well, and it applies to all securitizations, public and private. SIFMA, in its comment letters on these rules (available here and here) stressed how burdensome this was, how little actual probative information it would deliver to investors, by giving investors data about unrelated asset classes and unsuccessful or even unpursued claims, and how, at least in CMBS, put-backs were really extraordinarily rare in any event.  And what in the world do rating agencies do with a "similar securities" standard?

All for naught.  We’re now going to have to learn to live with this.  Note how extraordinary it is that issuers of private 144A deals will now have to make public filings.  If that doesn’t blur the distinction between the public and private markets (which I sort of think is what the SEC has in mind), what does?

While Rule 15Ga-1 doesn’t kick in for a year, this will cause issuers a very substantial amount of work, starting now, to get ready for next year.  Below the Rule's headlines, a lot of detailed compliance and mechanics questions will need to be answered in the process.  How comforting that the Rule contains an analysis by the SEC of its expectations of the cost of compliance.  And here’s the headline: the compliance costs won’t be bad at all!  It makes risible reading.

Beyond the additional costs, extra work and potential liability imposed by these Rules, which are bad enough, this first batch of Dodd-Frank regulations tells us that complying with the fullness of Dodd-Frank is going to be a lot worse.  In a significant way, Dodd-Frank was built on the basis of unsupported conjecture, received wisdom and ideological certitudes.  Dodd-Frank booted much, if not most, of the actual sausage-making to the reconciliation and launched dozens of regulatory processes. 

The regulatory handcuffs will magnify the underlying subtext of Dodd-Frank - that we have insufficient regulatory restraints on the behavior of market participants and we need more to avoid a return to the edge of apocalypse.  Regulators will regulate.  Close calls and unclear, skeletal legislative direction will be settled in favor of more, not less. 

Consequently, the industry faces a daunting rear guard action in the 112th Congress to try to mediate what will likely be excessively burdensome and intrusive rules.  No matter how well this goes, capital formation will get harder and more expensive.  Will all of this really help investors and prevent irrational exuberance and excess?  

At least in CMBS, I think not. It’ll make some trial lawyers happy, though.

By Rick Jones.

First, while it’s doubtful the current administration has exhausted its populist impulses to reengineer the economic and social life of America, I can't envision any more historic, paradigm shifting legislation coming out of Washington (at least until 2013).  With the Republicans in charge of the House and a cloture-proof Senate with a righter right and a leftier left staring at each other across an empty middle, dramatic legislation seems practically impossible.  That in itself is significant. Count that as a Treat.

Maybe we get the Bush tax cuts extended in the lame duck. Treat 2, Trick 0.  Healthcare is not going away, FinReg is not being repealed, the trillions of stimulus money (and the whopping new debt) can't be taken back.  Treat 2, Trick 1.  Let’s not forget populist fervor.  Regrettably, it’s not the exclusive province of the left or the right, Democrat, Republican or Tea Party or whatever.  Free Trade is under assault, easy money is a near religion and God knows what else will fire the heaving middle.  Treat 2, Trick 2.

The tiebreaker is regulatory oversight.  This may sound like Washington small ball, but it’s huge in the here and now.

Just like to the man with a hammer everything looks like a nail, to a regulator, everything looks like an opportunity to regulate.  Even absent the jet fuel of a left of center Congress, the regulatory instinct is to regulate.  And that constituency tends to have a tin ear for unintended consequences and is broadly unimpressed by macro arguments of the impact of regulation on capital formation and business in general.

In short, the new Republican majority is likely to have a fairly significant moderating impact on the regulatory implementation of FinReg and any further regulatory shenanigans.  This is a benefit not to be lightly dismissed.  FinReg left so much to the imagining of the regulating community - it invites the regulators to exercise unprecedented power to shape the new lending and capital formation environment.  If that brief opportunity had been empowered by the left-leaning (oops, “progressive”) Congressional leadership of the last Congress, we’d without a doubt have seen a Congress encouraging, if not demanding, the broadest possible interpretations of government power and authority to constrain business behavior.  A right-leaning House leadership will likely do the contrary.

I hope those who say gridlock is good for business and the country are right, cause that’s what we’ve got.  Gridlock is pretty thin gruel to set the table for a return to prosperity.  But, as 2011 dawns, the regulatory burden should be materially lighter than would have been the case if Messrs. Dodd and Frank, Kanjorski and the like still held the whip hand.  So, we’re Treat 3, Trick 2.

We should, therefore, look to the fundamentals of the economy for our guidance as to what the next couple of years will look like with more confidence.  I said in this column a few weeks ago, why not be optimistic that, on the whole, the fundamentals for 2011 don't look bad.  So perhaps November 2nd this time around represents a little more treat and a little less trick and we can get on with the business of business.

By Rick Jones.

We’ve beaten to death the nexus of conflict between a B buyer with termination rights and a special servicer intent on doing its bidding. Done. Agreed. What we got in return may be a special servicer that is incredibly hard to replace and is perhaps insensitive to bondholder concerns. In the Goldman/Citi deal, seventy-five percent of the bondholders must vote to replace the special servicer. Seventy-five percent! While the deal created the infrastructure for a voluntary bondholder register, it is unclear whether it will work at all. My bet is it doesn’t. My bet is bondholder removal initiatives will make hen’s teeth seem common.

So we have a special servicer for life and a fairly toothless B buyer who will have substantially less tools at hand to hold the special servicers’ feet to the fire. Is that a reasonable price to avoid the conflict? For those around in the early days of the business, we saw a full and robust debate over whether the B buyer at the bottom of the capital stack with the unfettered right to remove the special servicer was good or bad and the conclusion was that it was good. To borrow from Mr. Churchill, it was the worst possible system for enforcing the rights of various bondholders as a collective whole, except for all of the others.

And then you have an ombudsman. An ombudsman is essentially limited to cajoling and jawboning. Will that really improve the performance of the servicer? I doubt it. Will it create more transactional friction in the system that is already not exactly a paradigm of German engineering? For sure. Will it generate emails and correspondence which will potentially be grist for the mill of aggrieved borrowers who don’t like any particular decision of the special servicer and are looking to attack it? Certainly. Will this really move the ball forward? I think the question is on the table.

Finally, at least finally for purposes of this brief piece, special servicing compensation has been suppressed. Competition is certainly a wonderful thing and it can generate efficiency and enhance performance. On the other hand, if you pay peanuts sometimes you get monkeys. Is there enough compensation here to motivate the special servicer throughout the term of this long term relationship? Is the compensation competitive enough here to attract a replacement in the event the bondholders somehow get to the point they wish to remove the special servicer. I don’t know the answer, but I think the debate on these issues have been short of full and robust.

Standby. I don’t think we’re at the end of the experimentation that will ultimately stabilize into a CMBS 2.0 – no one should jump to conclusions in these early days.

By Rick Jones

All that sets the table for a sustained recovery, albeit a slow one. Yes, there are real risks to this modest good news scenario including, notably, the levels of governmental debt, the exhaustion of the strategy of pushing growth with cheap money, the likelihood of higher taxes and ham-handed regulatory action and continued governmental-bred uncertainly. So prospects for low sustained growth could yet be transmogrified into stagflation.

So, what can be done to support the growth scenario? In large measure, we need to continue to engage in the political and regulatory process to try to mitigate any further potential damage from regulatory misfires or overreach. We cannot make up aggregate demand, rehire away all the unemployment (please hire where possible) or reverse the psychology of the bad news cycle, but we can still play an important role as FinReg and its philosophic regulatory and legislative siblings get implemented.

Beyond that, I plan to fully embrace a strategy of hope. As Labor Day looms and the can kicking of summer comes to an end, we see some data from our admittedly somewhat myopic perch as a capital markets law firm sustained by transactional activity that is consistent with the upbeat scenario. That’s enough to make me mildly optimistic. Could this be vacation induced bonhomie? Maybe. But for the moment, I’m sticking with it. There’s always time to embrace despair later.

By Rick Jones.

Moreover, the SEC’s AB Reg project now must be woven into the tapestry of FinReg (I’m just not gonna call it Dodd-Frank), and someone with way too much time on their hands has determined that something like 90 studies and new rulemaking initiatives are required by FinReg.  Estimates are that the FinReg regulatory product may amount to 25,000 pages in the Federal Register. I hope our little corner of the financial sector will only be graced with a small fraction of that rulemaking activity!

If only it didn’t matter so much. FinReg and its progeny is a broad invitation to the regulatory constituencies to regulate and, as they say: to a man with a hammer, everything looks like a nail.  If I’m a regulator, I want to regulate – and this is an extraordinary invitation to remake much of the structure and operation of U.S. financial markets, including our CMBS market. Oh, and let’s also not forget the Gnomes of Basel and what they and the G20 might do between now and the end of 2010.

There appears to be a drug in the Perrier served in Washington that gives legislators and regulators extraordinary confidence in their ability to get things right, and a certain blindness to the notion of the unintended adverse consequences of regulatory action.  Populism, political anxiety, unemployment, the conga line of failed financial institutions and the parade through various Congressional hearings of largely unlovable masters of the universe has created an environment in which the urge to regulate is terribly seductive, and even when they truly, truly try their best, they will often get it wrong.  We will need to continually remind the regulators that as the risks and rewards of the financial pie are whacked up by new rules, we need to make sure we still have a pie to whack up.  Moreover, the Treasury Secretary has been on a mission to convey Treasury’s commitment to getting to rules quickly. The instinct to do this massive regulatory overhaul quickly will not help. Complex and quick are a toxic brew.

Which is a long way of saying that the financial services industry and, in no small measure, the commercial mortgage securities industry, has to sustain and, indeed, redouble its effort to educate, engage and partner with the various regulatory agencies charged under FinReg to re-make our financial markets.  Perhaps a good first step was this week’s Wall Street speech by Secretary Geithner in which he makes it clear that the administration wants to work with industry to make regulations that work. We need to clasp that outstretched hand and hope that all players will work together in good faith to get this right.
 

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.