Well, Halloween has come and gone and with the annual bacchanal of faux frisson over zombies, vampires and the like behind us, can we also put away risk retention anxieties like one of those annoying and morally disturbing Miley Cyrus costumes? Unfortunately not. The industry’s comments have all been neatly bundled and delivered to the multi-headed hydra which is the ad hoc joint rulemaking committee of the Office of the Comptroller of the Currency, HUD, the Board of Governors of the Federal Reserve System, the Federal Housing Finance Agency, the Securities Exchange Commission and the FDIC and the leading lights of the regulatory apparatchik are presumably cuddled up before the fireplace this holiday season with a glass of Bordeaux diligently reading comment letters.

It will all now be okay, right? What’s wrong will be made right and someday a beautifully and carefully crafted regulatory scheme will come forth which will balance the statutory goals of lender and investor alignment with the realities of the marketplace, right? Right?

When they read over our letters, they will learn that:

• We are all deeply, deeply grateful for the hard work and intellectual rigor which the regulatory community has brought to the risk retention regulation development process;

• We simply love risk retention, really we do; we’re so over carping about how silly and destructive it is. All we want to do is just make it better; and

• We’ve got a few tiny little fixes and tweaks that need to be made.

• But, and we so hate to be a downer, if our tweaks and little bitty fixes are not made, capital formation will be doomed.

Hopefully, our glowing gestures of bon ami suffusing our first two points will put the regulatory community in a holiday season mood when they actually see what industry finds problematic; which, frankly, is a lot.

We worked on a number of comment letters and I’ve looked at several more. I thought it would be useful to review what indeed it is that the regulators are curling up with as light reading thus far.

Here is quick impressionist summary of the principal voices in the commercial real estate finance industry:


• Provide a meaningful Closing Date Cash Flow Test, as most CMBS B-Piece retention investments will fail the test as written.

• Add an exemption for single borrower/single credit loans, as these loans are easier for investors to evaluate the credit of the transaction and they historically perform better than conduit CMBS.

• Modify the definition and parameters for QCRE to remove maturity term restrictions (in place of the minimum 10-year term requirement), to allow for 30-year instead of 25-year amortization schedules, to allow interest-only loans with an LTV ratio of 50% or less to qualify as QCRE, and to remove the lower LTV cap for loans that were appraised utilizing a lower capitalization rate.

• Provide the ability to create a senior/subordinate structure for B-piece retention so that these positions could be held in a wider variety of structures beyond pari passu.

• Make the appraisal reduction amount for Operating Advisor consultation attach when the EHRI has a principal balance of 25% of less of its initial principal balance.

• Increase the voting quorum to replace the special servicer from 5% to at least 20%, with a minimum of at least 3 investors participating in the vote.

• Permit B-Piece Buyers to be affiliated with originators, given that their incentives are aligned.

• Require additional disclosures by Operating Advisors.


• Warned of unintended consequences, including a shift of focus to return on assets, which could lead institutions to be disproportionately drawn towards riskier and unsecured asset classes, putting U.S. banks at a competitive disadvantage, introducing capacity constraints during a recovery, increasing the costs of financial products (and decreasing their availability to consumers), magnified economic cycles due to how the incentives for repo financing, warehouse lines, and loans to high quality investment counterparties will line up with economics at different phases of the cycle, and a decrease in liquidity.

• Picked out many of the same specific points which became the focus of the CREFC letter.


• Rethink switch to fair value calculation.

• Rethink the Closing Date Project Cash Flow Rate/Closing Date Projected Principal Payment Rate Calculation; several proposals were included.

• Increase the number of structural options for holding risk retention and additional exemptions to maintain flexibility.

• Permit B-Piece Buyers to hold their interests on a senior/subordinate basis in addition to pari passu.

• Adjust the definition of QCRE so that a larger percentage of CRE loans could qualify.

• Clarify that certain subordinate or pari passu interests held in “loan” form would qualify as an acceptable form of risk retention.

• Adjust the definition of CRE to include certain “land loans”.

• Provide that a sponsor’s risk retention obligation would terminate with respect to a CMBS transaction in which all loans have defeased.

• Clarify that multiple sponsors in a CMBS transaction can divide up the risk retention obligation among themselves pro rata based on their contribution to the deal.


• Eliminate or revise restrictions on payment of residuals for an eligible horizontal interest.

• Do use fair value calculation for horizontal risk retention, but the related disclosure should not be required to be provided to investors, and the timing of the calculation should be rethought.

• Do not require the use of fair value for vertical risk retention.

• The amount of vertical risk retention should not be required to exceed the amount that would be required under the horizontal option.

• Provide a streamlined and consistent procedure to obtain interpretation and guidance.

• Allow risk retention to be held as participation interests and through representative sampling.

• Eliminate the minimum risk retention requirement for blended pools.

• Exempt legacy assets from risk retention.

• Permit unfunded forms of risk retention, such as letters of credit, surety bonds and guarantees.

• Exempt asset-level and pool-level insurance s from the restrictions on transfer and hedging.

• Permit multiple sponsors to allocate risk retention among themselves.

• Permit sponsors to allocate risk retention to originals without any minimum permitted restriction.

• Exclude non-economic REMIC residual interests from the definition of “ABS interest”.

• General statement of support for CREFC’s letter.

• Do not require multiple B-pieces to be pari passu.

• Exempt single creditor/single borrower transactions from risk retention.

Real Estate Roundtable

• Make sure an appropriate alignment of incentives is created to keep sponsor and investor incentives aligned.

• Conduct a more thorough cost benefit analysis of the proposed rules.

• Rethink the effect a switch to fair value from par value will have on the size of the risk retention piece to be held.

• Rethink the effect that the five year retention requirement will have on incentives.

• Revise QCRE guidelines to make them more realistic.

• Exempt single creditor/single borrower transactions from risk retention.

There is enormous commonality among and across the comment letters; all are respectful, reflect a recognition that the law is the law and are, I think in a very transparent and constructive way, proposing modifications to the proposed regulation to make risk retention really work in a commercial setting. All focus is on ensuring the baby does not get thrown out with the bathwater.  That’s a good and hopeful sign.

Essentially, the Roundtable and the other organizations primarily representing the users of capital are focusing on the risk that the regulations may constrain capital formation at a time when non-bank capital formation might be increasingly important to sustain the growth of commercial real estate markets. The trade organizations of the securitization marketplace show a certain amount of tension between the investor community and other constituencies, but in large measure were able to get substantial consensus bridging the gap between investor and banker concerns.

The uber-marquee issue raised throughout: If the mechanic which limits cash flow going to the junior bonds to the rate of principal repayment to the pool as a whole is not fixed, the horizontal solution risk will have been eliminated for much of CMBS. That doesn’t seem what the regulation should have been out to achieve. This is the one provision of the proposed regulation that is simply and entirely inconsistent with the continued viability of the CMBS marketplace. Perhaps it was inserted without a full understanding of how it would interplay with the conduct of structured finance. Otherwise it would be hard to conclude it had any purpose other than being a poison pill.

Secondly, there is no conceivable policy reason nor statutory restriction prohibiting a carve out for single obligor, very low loan to value loans (tranched to investment grade) nor for a reasonable CRE Qualified Mortgage safe harbor. Such a CRE "safe harbor" would be entirely consistent with the spirit of the law. It just seems terribly mean spirited to the commercial mortgage industry to deny us such. What did we do to deserve that?

There are another dozen really important and necessary fixes of relatively singular import in all of these comment letters, incorporation of which into the final rule would make it a better rule, make it a more commercial rule, and make it a rule that better achieves the purposes of the legislation without throttling the patient.

What will we hear from the panjandrums of the regulatory heights, and when will we hear it? I don’t think anyone knows, although there has been a strong push by the White House to get all Dodd-Frank rules final before 2014 and I am filled with anxiety about the consequences of such a hurley burley rush to judgment; the Obamacare October 1st coming out party sort of leaps to mind.

Let’s face it, we have a fundamentally flawed process for development of complex regulations. The regulatory community first takes a disorderly amount of input from the market. It then sequesters itself from industry input and produces a Proposed Rule. Shockingly, such a rule often displays a material lack of understanding about the processes the regulators are out to regulate. What follows is a series of one-way conversations through a Kabuki like formal comment letters and meeting process at which regulators will only listen but not really engage. Then the regulators go back and beaver away at producing a Final Rule in another very solitary process. Why can’t there be an ongoing dialogue? Why can’t language be proposed, discussed and incorporated into a rule in a dynamic give and take where industry specialist and the regulators can carry on a real dialogue? What are we scared of in that process? In a world where the communication tools we have are fantastically flexible and allow a very real dialogue around critical issues, why are we sending each other the technological equivalent of telegraph messages?

But I digress. I get the process will not change. But all the flaws in this damaged process will be magnified considerably by artificial deadlines and politically motivated time pressures. From the industry’s point of view, there is an awful lot of wood to chop, simply to address technical questions and take steps to avoid the more obvious unintended consequences. We are certainly all more than happy to help the regulators get it right, but the structure of the rule making process, and the inevitable tension between the regulated and the regulator suggests that we may well end up with a Rule that will be an incredibly blunt instrument to achieve congressional intent, where capital formation is impaired without a concomitant improvement in risk reward outcomes.

Sad, really. But that’s how all this works. I still have some hope that we will have another bite at this apple. Maybe we’ll see some limited amount of re-proposal of portions of the rule – that would be fantastic and it is certainly within the power of the regulators. But the calendar, the politics and the dynamics of this relationship all conspire against us. The only good news here is the transition period is 2 years and a lot of water will pass over the regulatory dam before Dodd-Frank risk retention becomes a reality in our marketplace.

By: Rick Jones