As time goes by we start to get close to the first of two risk retention effective dates; December 24, 2015 for residential product and everything else looming December 24, 2016 (does anyone really think a Christmas Eve Effective Date was unintentional? Bah, Humbug!). More and more attention is now beginning to focus on the Risk Retention. We are grappling with the Rule right now in our resi market, in the CLO space where reissuance is a common deal feature (bringing forward 2017 concerns to today’s deals) and in the Single Family Rental (SFR) space which, much like the coupling of a donkey and a horse, is an oddly structured mule of a deal where no one is certain when risk retention will apply.
But the feds said what they will say on Risk Retention over a year ago and we are in the “Phony War” period when we know it’s coming, are not quite sure what it is, but are pretty darn sure will be unpleasant. So, wassup? Has anything happened?
Well, in the CLO space technology developed by Dechert lawyers has essentially swept the field. Most CLO managers are looking at either using a Capitalized Manager Vehicle (CMV) or a Majority-Owned Affiliate vehicle (MOA). Both modalities meet the punctilio of the Rule and at least, in the CLO space provide an opportunity for managers to properly align their capital with additional fresh capital with the returns available for the risk retention dollars.
Do SFRs Need to Comply with Risk Retention?
In the SFR space, the players still want to know whether the commercial or residential rules with apply. Trade organizations and market participants have recently lobbed such a seemingly simple question into the SEC. Not much comfort has been forthcoming. However, having reread the Rule for the hundredth time (yes, I need a life), the following seems absolutely true: SFR does not meet the technical precepts of a residential securitization under the Rule and SFR does not meet the technical precepts of a commercial transaction under the Rule. So what do I do with that? Well, the first thing I do is conclude that while I don’t know what it is, I know by God that it’s not residential. The way the Rule works is that anything that is not residential is subject to the effective date of December 24, 2015. So I am confident that the SFR space will not need to comply with Risk Retention come next January. How it will be treated in 2017 is simply not clear. If it is not “commercial,” the CRE “B piece” fix will not apply and the basic rule of sponsor retained risk will pertain. This is the rule the CLO industry is having to adjust to.
Maybe, in the year and a half between now and 2017 the industry, working with the SEC and others, may actually get clarity that indeed it is commercial. According to those famous knowledgeable sources however, such an outcome is looking unlikely. First, several regulators have expressed the view SFR is indeed neither commercial nor residential as those terms are used in the Rule and SFR is actually an entirely new class of asset for which the base rule and 2017 effective date is the right answer. Further, even if there was support to treat this like commercial, that would require a Rule change, so all five agencies will have adopted the Rule will need to act collectively. How long is that going to take?
Finally to the Broader CRE Securitization Space
For those who will meet Risk Retention because as a business matter they expect to hold more than 5% of the capital stack by value (and who are generally complying with European risk retention already), this is a bit of a non-issue. For the rest, there seems to be little consensus about what to do about when December 24, 2016 finally rolls around. While the industry seems to have a “that’s then, and this is now” view of the problem, absent the intervention of a benign supreme being, Risk Retention is certain to happen. So what will we do? Many market participants see the market coalescing around an L structure and that seems, in a Occam’s Razor sort of way, to be right. Some issuers may be able to fob off some of the retention obligation to originators who originated at least 20% of the loans for a deal, but that doesn’t really fix anything.
So What About the Trumpeted B piece fix? Will this Be Broadly Embraced?
With great fanfare the industry celebrated its success in getting the B piece exception added to Dodd Frank and, seen on its face, it seems like a pretty terrific idea… Except for two things: First, the B piece buyers are in this game for returns associated with the unrated and BB parts of the capital stack and holding enough bonds to meet Risk Retention seems entirely inconsistent with that business plan. Second, and certainly as important, will anyone actually use a B piece for this purpose? The obligation to meet Risk Retention is the sponsor’s obligation and stays with the sponsor even if the sponsor satisfies its Risk Retention obligation through a B piece buyer. If the B piece buyer were to sell or otherwise dispose of the bonds voluntarily or involuntarily (think bankruptcy sale), the sponsor is in violation of the statue and Rule. What’s that mean? The Rule itself never mentions remedies. How curious is that? In brief, we think that failure to meet Risk Retention could result in the following bad things:
- Fines and penalties;
- Termination of access to shelf registration;
- Penalties assessed against individual officers of the sponsor including possible exclusion from the securities industry.
Here’s a link to our OnPoint reflecting our research on the remedies question.
How About Them Apples?
So if I’m a sponsor and I’m looking at those remedies, how anxious am I going to be to use a B buyer? This is an issue that hasn’t really been explored in detail and there’s certainly no consensus around it, but we are beginning to run out of time to engage and to embrace on an industry wide basis responses to the inevitable approach of Risk Retention.
If not the B buyer Hail Mary, what do we got? Can we get around the adverse economic consequences of the long term hold of inappropriately priced investment grade bonds through holding these retained bonds in an SPE and levering them with recourse debt? Non-recourse debt is verboten under the Rule, but recourse debt is just fine, thank you. The Rule does not require that recourse be to a creditworthy party (Huh?) Others think that the solution is to hold the Risk Retention piece in a single juridical entity and tranche the equity to allow some investors to achieve a higher return and others to accept a lower return with structural protection inside the equity vehicle. Again, at least a technical reading of the Rule suggests that is okay. Are these loopholes, or is this just good business? Maybe we’ll find out but I suspect that when we do, it might be a tad late to embrace Plan B.
We will talk about this more.