Well, we now have our proposed risk retention rule. The regulator class has been incubating this egg for the better part of nine months and we’re all now well behind the, admittedly, magical thinking schedule proposed in the actual FinReg legislation. Now, I’m not complaining. Particularly having read this missive, I’m all into delay.

If you want to read the proposed rule, feel free to take your pick of announcements from the Department of Treasury, the Federal Reserve, the FDIC, the SEC or the FHFA: it’s here—the long-awaited Credit Risk Retention proposed Rule (large pdf). The Rule shows every evidence of having been written by a committee, in fact, by a committee of committees. We all know that the definition of a committee is something with more than two legs and less than one brain. A committee of committees? Need I say more?

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 We have 5% risk retention required by statute and, unless the statute is amended or repealed, we’ll have to live with that.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.