CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

Notwithstanding, the overall tenor of the conference seemed to be a determined optimism projected against the overarching blanket of volatility.  European instability, a jobless recovery, a newly normalized, lumbering pace of economic growth and a constantly evolving regulatory framework continue to make uncertainty the only sure bet.  As one might expect, a number of clients we spoke with last week are adopting a cautiously optimistic demeanor for 2012 and plan to tread the market’s murky waters slowly.

Will CMBS rebound (or continue to rebound)?  Will the life co's and other non CMBS lenders be able to fill the void?  How will regulatory reform be implemented?  These questions are so 2010, and yet they stay with us.  Depending on who you believe, CMBS output in 2012 is estimated to be anywhere from $25 billion to $45 billion (compared to approximately $28 billion in 2011).  And even if the portfolio lenders have a gangbuster 2012 (which is, in fact, likely), they won't be able to bridge the void left by $360 billion of maturing debt this year.  As for Washington, we can’t even determine a cogent agenda for regulatory reform at this point, much less predict what the rules of the game will look like.

Perhaps we’ll have answers (or at least a lessened degree of uncertainty) by the mid-year in June.  

By:  Matthew Clark and Stewart McQueen

The seminar consisted of a panel of industry specialists representing issuer, investor and legal perspectives: Paul Vanderslice, Managing Director, Citigroup; our own Rick Jones, Partner, Dechert LLP; Tom Doherty, Executive Director, JP Morgan; Ken Cohen, Managing Director, UBS Investment Bank; Brian Furlong, Managing Director, New York Life; and Bruce Martin, Research Analyst, Fidelity. 

The group considered investor motivations related to the public/private distinction, including whether the appetite of some investors in registered securities is driven by limitations on the amount of private paper that they can soak up or driven by a particular desire to diligence the additional information that is available in a private context.  In addition, the panel emphasized the industry’s (thus far unsuccessful) effort to demonstrate to regulators that the CMBS space, in comparison to other asset classes, has traditionally provided voluminous (and adequate) disclosure with respect to underlying assets and deal structure, whether in a public or private context.  So maybe the line in the CMBS sand is not so bright when it comes to a) disclosure -  because public and private books are not that different; and b) investor satisfaction - because some investors just want and can handle more information, while others have limited capabilities to buy private deals. 

With respect to CMBS 2.0, the panel noted some trends across the board for public and private deals: among other things, the inclusion of (1) mortgage loan seller representations and warranties and related exceptions, (2) enhanced (e.g., Reg AB-compliant) asset-specific and party-specific information, (3) investor Q&A forums and (4) the role of the operating trust advisor (which we at CrunchedCredit.com have previously discussed). 

Unsurprisingly, the group could not avoid discussions of risk retention and premium recapture - hot topics that CrunchedCredit.com has also addressed before.  Additionally, the presentation provided timely regulatory updates, including life with (1) Rule 17g-5 (i.e., no talking to, and instead posting of materials for, the rating agencies), (2) Rule 17g-7 (i.e., comparing a deal’s reps to rating agency benchmarks), (3) Rule 15Ga-1 (i.e., reporting and disclosing repurchase demands) and (4) Rule 193 (i.e., requiring issuers to know their assets).

More generally, the panel expressed a common industry sentiment regarding the many regulatory efforts currently on the table:  just make the rules and we will figure it out from there.

If you missed this after-work episode and the related installment of updates, the instant replay is available here on CREFC’s website.  And one thing you can count on is that there is plenty more to come!

By Devin Swaney. 

In the August 2 letter to the regulators, the representatives stated that the proposed PCCRA was never discussed during Dodd-Frank Act deliberations and urged the agencies to “perform a rigorous cost-benefit analysis to determine the effect of the PCCRA requirement on economic growth and the vitality of the U.S. securitization market before finalizing the risk retention rule.”

Stay tuned for a future post by me on this if such rigorous analysis is actually performed. My analysis sans the rigor:

• Cost of keeping the PCCRA in the rules: Big fat hindrance to the economic growth and vitality of the U.S. securitization market
• Benefit of keeping the PCCRA in the rules: Zilch

By: Laurie Nelson
 

On its face, and we absolutely have to start here, it says a securitizer who monetizes either an IO or earns a premium on the sale of P&I bonds, has to put that money in a box. That box serves as a first loss reserve for any losses on the loans for the life of the deal. The authors muse (they almost seem to chuckle) in the commentary that it’s unlikely that anyone will ever do this because it is onerous and therefore securitizations will be done without premium. Huh? Why, in Heaven, would a bank hire an origination team, build out technology, make loans, warehouse and hedge loans and assemble a pool for sale if it was not going to make a profit? I mean, we all know greed has a bad odor these days, but, good heavens, this is still a capitalistic economy, isn’t it?

Now, about the actual text of premium capture. In conversations following publication of the NPR, the regulators have told anyone who asks that the premium capture provisions were not properly drafted, and that what it really is all about is ensuring that the securitizer, who elects to satisfy risk retention with a horizontal first loss piece, retains 5% of the value of the underlying loans (the NPR curiously uses the term “par” to mean value). Regulators have gone on to say this is easy to achieve if securitizers would just stop their nefarious practice of stripping coupon and attach that interest to the first loss piece where it should always have been in the first place. Then, the bottom 5% would equal 5% of the value of the loans in the pool.

Disturbing, huh? And on so many levels.

First, this suggests that the regulators think that originators and securitizers can and should be responsible for stopping the business cycle and consequently loan losses are mostly attributable to bad underwriting which can be fixed by a strong regulatory whip hand. Regrettably, in the real world credit cycles are, well, cyclical. Securitizations, which typically have a term in excess of ten years, will see a full cycle. There is no way to make loans that are so good that they will all perform for ten years. The NPR suggests that the regulators think that’s tough nuggies and that if the originators and securitizers are sufficiently cowed by regulation, they will insulate investors from the cycle. Can not happen.

Second, the NPR suggests the regulators think if you put enough coupon on the B piece, it will trade at par and not at the deep discount common today. Wrong. This paper trades at a deep discount because of the likelihood of principal losses, not an inadequate coupon. See cycles, above. I cannot imagine how much coupon would need to be attached to the first loss bond to get a par bid, but it’s sure to God more than the excess coupons floating around your typical securitization.

In the real world, to get 5% of value in the B piece, the B piece would have to represent more than 10% of the total deal, probably penetrating into the investment grade certificates. What would this accomplish, that is, besides vastly increasing the cost of funds to the borrowers and materially impairing capital formation? We’re a touch light on B piece buyers right now. How many would we have if they need to buy 10% of the Pool? Buying that mezzanine paper is not the business model of the B piece investors and they will not want this paper. I simply don’t get it. To make this scheme work, both originators and investors would have to do things for regulatory reasons they would not do when following their economic best interest. Anytime both counterparties to a trade are doing things for purely regulatory reasons, something is deeply wrong.

Let’s put aside for the moment the whole notion of whether skin in the game has any science behind it (that train has regrettably left the station). Let’s also put aside that the CMBS market has functioned relatively efficiently. The losses in CMBS are not vastly disproportionate to the underlying performance value of the real estate markets. (It’s not resi, it’s not resi, it’s not resi.) We’ve got Dodd Frank and we’re stuck with it. Yet Dodd Frank leaves enough wiggle room for the regulators to craft regulations that are fundamentally aligned with how business is really done, and which, in fact, will improve investor protections and facilitate the successful and efficient operation of capital markets.

Dodd Frank gave the regulators the tools. The Congress recognized the need for flexibility with respect to CMBS. The statute included the concept of a qualified commercial mortgage which because of its relative conservatism would require no risk retention. The regulators gave us a box that’s so small that less than ½ of 1% of all deals done in the past ten years, would qualify. That’s silly. The legislation gave the regulators the opportunity to use high quality reps and warrants as an ameliorative factor for risk retention. This opportunity was completely ignored. That’s inexcusable.

Within the context of this law, the regulators should be using their regulatory power to improve the alignment of the interest of investors and securitizers. Look, investors are happy to take the risk of mortgage loans. That’s the business they’re in. What they cannot underwrite and where regulations can be useful is to protect against loans which are poorly underwritten, poorly documented and not properly and transparently disclosed. Now that’s a doable and estimable goal for regulation. That’s in the tradition of the Securities Act and the Exchange Act. Good regulation improving markets. This will not.

I think it’s fair to say what Congress intended was a regulatory regime that encouraged good underwriting of mortgages, an embrace of industry best practices, support for strong representations and warranties, and good disclosure. That would improve the efficacy and sustainable operation of the capital monies. That’s not premium capture.

Now, I kind of get how a retained interest by a sponsor or by a party whose business it is to take the enhanced risk of a first loss piece is a sort of short-hand for the protections promised by good reps, good underwriting and good disclosure. But risk retention ought to make sense in the context of how markets really function. If we’re going to honor Dodd Frank’s embrace of the B buyer as a risk retention modality, risk retention by B buyers has to make sense for the business plan of the buyer. That means the holder of the B piece should not be obligated to hold it forever, should be able to hedge and lever the paper. First, an investor will know if the originator and securitizer assembled a “good” pool within a couple of years at the outside. By that time, you know whether the loans were well-originated, well-structured and supported by good disclosure. Making the holder hold longer than that is to stick a B buyer with the consequences of the credit cycle. Second, why shouldn’t a holder hedge? Hedges represent investment and reflect competent management. Finally, the B buyer needs to lever to make its business model work. That market is non recourse. They need to volunteer for recourse to satisfy risk retention? That’s insane.

I am not sanguine about how we take the Risk Retention NPR forward and get to an outcome that enhances the alignment of interest between bankers and investors, and that improves the safe and efficient operation of capital markets. There’s just so many bad ideas and so many missed opportunities in the NPR and it just seems unlikely that the authors will be prepared to walk back on some of the more startlingly bad choices made.

But we don’t have much choice, right? We’ll do our best to engage and provide constructive comments before the (completely unrealistic) June 10th deadline. Once a final rule is issued, we’ll remain engaged and keep the conversation going until implementation confronts us sometime in the middle of 2013. What else is there to do?
 

By: Rick Jones

I was thinking back to the client event like this that we held in late September of last year in connection with an American Securitization Forum Sunset Seminar.  The theme at the time was largely the unintended consequences of the Dodd-Frank Act (which, at the time, we were all still trying to fully digest).  We've since commented on proposed regulations related to Section 943 (related to disclosure of breaches of securitization representations and warranties) and Section 945 (related to due diligence requirements) and have seen final regulations promulgated by the SEC on those rules.  More importantly, we have finally seen the multi-agency collaborative effort on proposed rules related to risk retention.  We spent weeks last fall agonizing over what the risk retention proposed rules might look like.  We then spent many more weeks early this year waiting for the proposal to finally come out.  Better late than never.  The proposal is far from perfect but at least it has finally arrived and we can get on with trying to fix it as best we can.

We hope to soon have some certainty on what the ground rules are so we can get the securitization business back in full swing.  There will be a lot of long industry-wide conference calls hosted by CREFC, MBS, SIFMA and ASF as we all come up with our wish lists of fixes to risk retention before final comments are due in early June.  I'm looking forward to our next client event when we all look back and congratulate ourselves for laying the groundwork for a market recovery.

By Ralph Mazzeo.

Nonetheless, the model reps are very instructive as to those issues that are weighing mostly heavily on the minds of CMBS investors as they look to allocate risk in CMBS 2.0 structures. And – while certainly not an investors’ wish-list by any means – the model reps do, in some ways, represent significant risk-shifting on many issues – particularly as it relates to underwriting practices. A game changer? Maybe, maybe not – but it will be interesting to see how investors (B-piece buyers in particular) use this set of reps and warrants to lever increased reps and warrants on a going-forward basis.

I’m in the process of comparing the model reps to the deals that have populated the 2.0 market thus far and will be preparing a more detailed review of the final rep package once it’s released. The following, however, is an (unscientific) preview of the features contained in the CREFC model that could been seen as new additions to traditional CMBS loan seller reps:

• Representations that the origination, due diligence and underwriting performed by the loan seller materially complied with its internal origination, due diligence, underwriting procedures, guidelines and standards for similar loans, as well as a representation that interim servicing was conducted in accordance with industry standards;
   
• Representation that the loan seller obtained a certified rent roll and operating history within 180 days of the date of origination of the loan;

• Representation that the loan seller obtained an organizational chart reflecting all equity owners of 10% or more of the equity in the property, as well as representations regarding know-your-client processes and credit-checks;

• Significantly expanded representations regarding lease estoppels for retail, office and industrial properties, including requirements that lease estoppels be requested of all commercial tenants and requirements that estoppels be received from tenants representing 65% of in-place rental within 90 days of the origination of the loan;

• Expanded representations regarding site visits, including representations that the property was inspected within 4 months of origination and 12 months of securitization, and that an engineering report was obtained within 12 months of securitization;

• New reps for hotel properties, including representations regarding the enforceability of franchise comfort letters;

• Substantial revision and clarification to common MLPA insurance reps that reflect the input from several CMBS-industry insurance consultants;

• Increased scrutiny of originator due-diligence with respect to the adequacy of licenses and permits required to operate the property; and

• Representation requiring recourse liability to guarantors that are natural persons or entities that have assets independent of equity in the property.

Many of the reps obviously represent a significant departure from the reps and warrants we were accustomed to, and, inevitably, many could become susceptible to litigation abuse. But in light of what was being pushed by investor groups last summer, it’s clearly a heavily-negotiated product. Perhaps perfectly so – a set of reps and warrants that makes everyone unhappy.

After the seminar, we had dinner with a client (from one of the larger CMBS investors) in TriBeCa – the place where if you don’t call De Niro “Bobby” they’ll know you’re from Boston. Over appetizers, I asked him whether, after having attended the seminar, he’d push to stretch issuers on reps going forward. But as Jimmy Conway would say, “never rat on your friends and keep your mouth shut” .

By Matt Clark.

Congressman Garrett noted in his remarks that the portfolios of the GSEs are a combined $1.5 trillion-- a book with a lot of interest rate risk and a lot of unrealized gain. He said this portfolio needs to be unwound sooner rather than later. He wants to see the GSEs on the federal budget-- on the books of the U.S. government-- and he noted that in private industry, there has been a movement toward on-balance sheet and questioned why this wasn't so in Washington.

Knowing his audience, he stressed that securitization has to play a huge, vital, integral part in the resurrection of the mortgage market, and he said that securitization is vital to the movement of capital around the country. He noted the unsustainability of FHA insuring 50% of new originations and the government underwriting 95% of the mortgage market. The Congressman stated he is firmly committed to a purely private U.S. mortgage market over time, free of government subsidies or guarantees. He acknowledged concerns associated with a purely private market but also said there are competing concerns with models that include government support.

Addressing assertions from critics, the Congressman asked whether home price increases and higher down payments would be so bad (possible results of the 30-yr fixed rate mortgage not surviving without a government guarantee). He questioned whether the government is able to price catastrophic credit risk and pointed to a shoddy track record. He posited that there are other ways to keep a TBA market viable aside from a government guarantee and noted that the government steps in at the end of the day perhaps because it is allowed to, and that allowing it to increases the chances the government will do so. He noted that a discussion of servicing standards in connection with QRM never came up in crafting Dodd-Frank and suggests regulators not take the servicing issue into account. In the Risk Retention breakout session later in the morning, Tom Boemio (Sr. Project Manager, Policy, Board of Governors of the Federal Reserve System) concurred and asked: Why have servicing standards in connection with the highest quality loans only-- and not the rest?

The Congressman said there is no role for government assistance except in connection with first-time home buyers, and such assistance should be on-budget and transparent. Finally, he said that the government has to play a big role because the private sector isn't-- the old chicken-egg thing. [His prepared remarks can be found here].

At the February 7 General Session that followed, Martin Hughes of Redwood Trust further addressed the chicken and the egg issue noting that "uber government support is stifling the return of private securitization." He acknowledged that government bids are attractive and there's been no incentive for banks to sell to non-agency, and that reducing the government's role would be a game changer. Addressing the circular problem, he did note that if the government backs out before the private sector is up and running, there are sure to be problems but he suggested the status quo needs to be tested. Stating that "issuance velocity leads to issuance velocity," he also noted there are too few prime loans to get real issuance velocity. Hughes agreed that, yes, investors are mad, and investors have demands and opinions with respect to servicing practices but he believes those demands can be met and that prime jumbo can have safe attractive yields.

Hughes summarized the general sentiment by stating we need the new rules of the road-- final rules so that market participants can adapt and move ahead-- because uncertainty has been an enormous headwind. And we have uncertainty as to what the rules are and, in addition, how those rules are to be interpreted. Stay tuned for more from ASF.

By Laurie Nelson.

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.

No seminar can be complete without a discussion of "skin in the game" and the goal of improved underwriting. Only time will tell on whether we will see a horizontal or vertical slice requirement or a variety of alternatives. There was also talk about the residential mortgage reform provisions in Dodd-Frank. In a nutshell, no loan can be made unless, in a reasonable and good faith determination, the borrower has the ability to pay. At first glace it makes pretty darn good sense. In practice, however, it’s difficult for a lender to predict whether a borrower can in fact repay a loan. Will a lender be penalized for failing to accurately assess a borrower’s earning potential? Applicable Dodd-Frank criteria includes the borrower's credit history, current income, financial obligations, DTI, LTV and other factors including expected income. A lender needs to focus on regularity of income but can consider irregularity…. It was noted that no member of Congress could get a loan today when, even though the above-mentioned criteria aren't weighted, expected future income needs to be taken into account.

The safe harbor for qualified mortgages basically means non-traditional mortgages are out. Thirty year fixed is the new black. If a loan doesn't meet the definition of a qualified mortgage and it's in foreclosure, a claim can be asserted against the assignee (for any claim the borrower could have made against the original lender). The likely result is that lenders will originate only qualified mortgages.

Of course, if you originate a "qualified residential mortgage" under Dodd-Frank you can be exempted from the related risk retention requirements. Since historical performance data is required for any “qualified residential mortgage,” no new loan product type will ever be exempt from Dodd-Frank risk retention requirements. Expect more thirty year fixed. Consumers will certainly have more protection but they will also have access to much less credit as the markets struggle to reconcile competing regulations and deal with unintended consequences.

The usual themes were reiterated – disclosure, transparency, skin-in-the-game — as was the likely consequence — that there won’t be as many loans to securitize. There’s a lot of rulemaking going on in the District and will be for the next 6 months to a year. We can expect changes— and pain.

By Ralph Mazzeo and Laurie Nelson.
 

The heart of Rule 17g-5 is the simultaneous sharing of information. Again, sounds good but here’s what’s happening. Bankers legitimately concerned with liability are insisting that there be only one conduit of information from the issuer’s side to the rating agency. So no lawyers and no third parties are having direct contact with the rating agencies and, more importantly, the rating agencies can’t have contact with them. Moreover, the rule treats oral and written communication alike and requires all to be simultaneously transmitted to all rating agencies through the website. No one is quite sure how to deliver oral communication to all the rating agencies simultaneously through the web-based delivery system. Are transcripts needed? Can summaries be provided? How simultaneous is simultaneous? Bottom line: oral communication is being suppressed.

The consequence? The rating agencies have a much poorer picture of what they’re rating than they had before. Just think of conducting a business transaction in mime. Documents are never entirely clear. Documents describing highly complex structured finance transactions are REALLY not clear. How often do you call up someone in a transaction and say, I don’t get it, what are you trying to do here? So rating agencies have been left to try to discern what’s going on from the bare documentation and take a view without the benefit of the normal give and take of the conference call. Rating by charades!

Rating agencies are going to get it wrong. They may get it wrong in ways that results in lower subordination levels or higher. It’s inevitable, and not their fault. If you actually had to do a deal, any deal, without talking to the other side, can you imagine how wrong that deal might come out? So that’s what we’ve got. In an effort to level the playing field and create competition, we are degrading the quality of ratings. At a time when it’s clearly vital that the marketplace gain renewed confidence in the rating exercise, we’re creating reasons for lack of confidence. Explain to me exactly how that’s a good thing.
 

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.