We may be approaching a tipping point where the burden of the new federal regulatory state, purportedly designed to make our economy stronger by making the banking system safer, will begin to demonstrably become a cure that’s worse than the disease. To my eye, much of the new regulatory apparatus feels like political theatre designed to impress the financial illiterate. Random chest thumping for populist cred on the cynical assumption that the system is big enough and robust enough to tolerate all this tampering. Of course, I could be wrong and our policy elites could really be doing all this fiddling from an honest embrace of a simplistic, jejune analysis of extremely complex systems which they largely do not understand. I’m not sure which explanation scares me more.
We’ve written a lot about the new rules themselves and further excoriation of these policies and their enablers probably doesn’t do anyone much good (well, it would make me feel better, and oh, by the way, sorry George). It’s now time to just focus on the impact of this new regulatory edifice in the real world.
As they say on Fox News, “What’s all this mean to the folks?” As I am writing this, I’m just back from the MBA/CREF conference for yet another panel on regulatory change and here, contrasted with CREFC in Miami, the mood was notably more cheerful. Of course, that may have been only because there were a bunch of mortgage bankers there. Okay, that was mean. Net/net, both the pessimists at CREFC and the optimists at MBA may be right in their way, but I think the pessimists are closer to the mark. Here’s why:
- There will be an interruption in capital formation because of risk retention in late Q3 into Q4. There is no industrialized solution to the risk retention problem in place today or on the horizon that the broker-dealer sponsors are comfortable with. Continued access to a securitization exit is in doubt in 2017. If there is not clarity around the exit, securitization lenders will slow or stop loan production. The folks in that space have a moving company business plan: loans are originated to be sold. They are not originated to be held. If you can’t sell ‘em, you can’t make ‘em. The B-piece buyer fix is not going to work, at least not at the scale needed to run our industry. Sponsors who remain on the hook will not trust B buyers without an indemnity, a strong balance sheet, and a simple, straight down the fairway capital structure. Many sponsors will likely hold vertical risk, at least at the outset, and that’s expensive and may constrain appetites for loan volume. It is not at all clear to me whether all the principal sponsors in the CMBS space will still be here in 2017.
- Risk retention should have caused a rush to the altar for CMBS borrowers in 2016 attempting to escape the uncertainty of a damaged securitization market in 2017 – should have. So far, however, no panicky crowds of borrowers around the CMBS window. Perhaps its general concern about an economic slowdown (fear funk) or maybe borrowers, ambivalent toward CMBS triggered by sticker shock over ballooning spreads, but something is surely keeping them away. For whatever reason, CMBS volume is notably unimpressive in the early days of 2016. The really good first half that we were anticipating for CMBS to be balanced by a bad second half may be gone away. By the time the spreads stabilize and the system begins to self-repair, it’ll be time for the anxiety over risk retention to begin to suppress production in the second half. Assuming no recession really shows up, we’ll get out of the woods, but find the woods end at a cliff (credit to Mr. Joseph Franzetti).
- The very likely to be implemented Fundamental Review of the Trading Book Rule (FRTB) and the already rocking our world Volcker restriction on proprietary trading are causing a severe diminution in liquidity around commercial real estate finance. It doesn’t take a genius to figure out that lack of liquidity is bad. Market making is imperiled. Add to this the soon-to-be-effective Liquidity Coverage Rule (LCR), and the very new proposed Basel Step-In Rule which will require more and more capital to be held against financing vehicles and holding financial assets is becoming increasingly expensive. Together, the loss of liquidity and increased cost of holding positions will ultimately force spreads to go out, which will increase the cost of money to the borrower community, which will impair the market’s ability to refinance the Wall of Maturities and in general hurt capital formation. For the want of a nail…
- In December, the prudential regulators fired a shot across the bow of the entire commercial banking industry with the publication of the Statement on Prudential Risk Management for Commercial Real Estate Lending. This very clearly conveyed the regulators’ growing concern about the sheer size of the commercial real estate portfolios on bank balance sheets, particularly, the regional and sub-regional players. We recently heard some talk, and it was just talk, about some new, potential regulation around these concerns which would further restrain bank CRE lending. This, on top of the remarkably inscrutable HVCRE Rule, has or will crimp the supply of bank credit to CRE. Bank lending may get scarce and more expensive. (Silver lining for CMBS: the spread gap between portfolio lending and CMBS may close a bit.)
- Reg AB II is full of nifty notions to make the market safer for investors. I frankly don’t think any of it really moves the risk mitigation needle, but boy oh boy, its costs are clear and demonstrable. One “cost” is an increasing diminution of sponsors’ appetite to eat other peoples’ cooking. The CEO certification in Reg AB II focuses the mind most wonderfully, doesn’t it? Result? Many and perhaps most non-sponsor bank mortgage sellers will not be able to securitize. They will be out of the business.
- All in all, the financial sector is becoming less profitable and this is not just a problem for CMBS. Each regulatory initiative costs money, a lot of money, a fact to which our regulatory and political establishment appears to be obdurately insensitive. One wonders whether our banking edifice will survive when there are more people in compliance than capital formation. And each rule builds on the existing compliance edifice like a growing maleficent infection. No one regulatory initiative, designed of course to be in some way helpful, is fatal, but the continued doubling and re-doubling of the regulatory burden can be. Think of the chap who sadly decides to take one last madeleine in Monty Python’s The Meaning of Life. Messy end, that. When it costs more to run these businesses than they can earn in profits, banks may simply leave. It is not shocking to speculate that one or more major securitization houses may leave the space this year. Between that, the fact that many a mortgage loan seller and B buyers will find that it has been kicked to the curb in the new risk retention game, the business will diminish.
- Here’s one that is not the regulators’ bad, but yet unfortunate given the timing. The life companies are getting full. After a deep credit interregnum from 2007 to 2010, life company CRE portfolios diminished substantially and now have been growing back towards the customary historical mean. As the life companies get close to that historical mean, their appetite for growing the book will diminish accordingly. Who will fill that gap?
- And finally, don’t forget the general environment of animus towards banks and bankers that pervades the US polity today, on both the left and the right. No one can be unaware that there is a general sense across the financial industry, writ large, that it’s easy to become a target, a target of regulators, a target of politicians eager to pile on, and a target in the market of public opinion. It’s better to keep your head down, don’t get out in front. Don’t become a nail with all these fellows hanging around with hammers. That miasma of risk aversion reduces innovation, reduces energy, reduces excellence and will further impair capital formation this year.
Let’s face it, the fundamental rules of the game are being changed by our regulatory apparatus. Business models that have worked for quite some time are now broken. Cost structures are upset, expectations are confounded and the legal guardrails have moved. Waiting for all of this to go away and for it all to get better is not a strategy. The regulators have proven to be intransigently resistant to any recognition of adverse consequences and while we are in a political campaign sometimes bodes substantial change, there’s not much love out there across either the left or the right for the finance industry and Wall Street. It’s hard to see any positive change coming from the election.
So, strap it on and let’s figure out how to do business in this new world. Change always bodes well for the creative, innovative and brave and that’s probably where we are right now.
Dechert’s Risk Retention Resource Center