We’re all just back from CREFC and the mood was broadly constructive.  (Don’t you love that word, “constructive”?  When did “constructive” become a fancy way to say “good”?)  We all went to South Beach this year wondering where the investors were, wondering whether the market was okay and wondering whether December was a blip or a coda. If the industry chatter captured the gestalt, and the gestalt is right, then while this recently strong market will surely expire at some point, this is not that point.

Amongst the frolicking in Goldilocks Land in SoBe, there were some actual issues discussed.  One of these that got some attention, at least by the wonkier members of the crowd, is the new risk retention rules out of Europe.

We’ve written about these before.  It is very much a moving target.  If you think the American rulemaking process is baroque, turgid and opaque, spend some time in Brussels.  Just to set the stage, for those of you who haven’t had to deal with the European risk retention regime.  It is similar but different from the Dodd-Frank version.  It requires an originator or sponsor (and the rules around exactly who must be the risk retention party are themselves complex and confusing) to hold 5% by value of the securitization, typically in a vertical or horizontal regime.  They don’t do Ls and they don’t do third-party purchasers.  As summarized in our OnPoint, as of January 1 of this year, a new, more robust set of risk retention rules for Europe took effect… kind of.  We say “kind of” because it appears that no one, including the Commission which promulgated the rules, can actually articulate what they say.  Perhaps we should count our blessings that this is all we have to deal with from the European Union, because until quite recently, the Europeans were considering increasing the retention obligation to 20%, which would have been, and let me be very technical here…bad.

Now, notwithstanding that the EU says it loves securitization (even if the Pope doesn’t), they have felt compelled to issue new and cranky rules which will make risk retention, from a sponsor’s or originator’s point of view, more onerous, while, at least in my judgment, doing very little for investors.  The new rules do two things.  The first is an extension of the risk retention obligation from the investors to the sponsor, which (in that regard) aligns Europe with the US approach.  Issuers subject to the jurisdiction of the European Union must comply with the risk retention rules in order to sell securities.  Prior to January 1, the onus of compliance in Europe was on the investors.  (Note that, in EU-speak, the obligation is on the originator, sponsor or original lender and not the issuer of the securities, but in the CRE context we’ll just say “issuer”).

Since risk retention became a thing here in the US, some deals have been structured to comply with European risk retention and therefore facilitate the investment by EU investors.  Some deals have not.  Essentially, in the CRE CLO market, where the sponsors were, for the most part, already obligated to hold a significant part of the bottom of the capital stack because of the REIT rules, compliance was easy and generally done.  The conduit CMBS marketplace, where the business model is that of the moving company with a REMIC tax structure, generally did not comply.  In the conduit world, the B-piece is typically sold off to a third-party purchaser, and that structure does not comply with the European risk retention rules.

What changed on January 1?  There has been a bit of a kerfuffle around the extension of the risk retention obligations to issuers this past year when some lawyers pointed out that the language of the rule left open the possibility of extraterritorial impact, in which case US issuers whose connection to Europe was only through the sale of securities to European investors would be subject to the rule.  That’s the type of thing that excites lawyers and otherwise causes eye-rolling in the business community.  It can’t be right, right?  Brussels’ coppers in Boise on the beat looking for the noncompliant issuer?  Really?  A consensus has developed, not without outlier voices, that extraterritoriality was never the intention of the Commission, and it is not asserting jurisdiction over non-EU issuers.  Indeed, there is some informal communication from the Commission and the European Banking Authority (EBA) confirming as much.  This all gets a tad more complex for affiliates of European institutions, but that’s another story for another day.

If all this new regulation had done was extend the risk retention obligation to EU issuers, then the new rule wouldn’t be that big a deal for the US market.  However, the new regulations refused to leave well enough alone, which brings us to the second important development: a complex bundle of new disclosure obligations on issuers and investors.  Apparently, these poor European investors, a notoriously clueless and naïve bunch, couldn’t possibly invest in structured products without the government mandating a new disclosure regime (in case this gets into the hands of my European clients and offends, that last bit was sarcasm, ok?).

There has always been an obligation under the European risk retention rule that investors thoughtfully and intelligently reviewed the risk profile of any securities in which they invest and concluded the investment was prudent.  At least when Europeans looked at US issuance, they had the benefit of the comprehensive and time-tested CREFC reporting package, and one could argue (and I would argue) that the CREFC package should be plenty for any investor anywhere in the world.   But now, the European Securities and Market Authority (ESMA) has proposed a new disclosure template including almost 500 fields of data.  Is it wildly at odds from the CREFC reporting package?  Not at all.  Do they ask questions that don’t perfectly line up with CREFC reporting?  Yep.  Do they ask some questions that at least US lawyers and servicers don’t understand?  Sure do.  Some of these data fields just simply don’t make any sense.

Doesn’t this feel a little juvenile?  A little “Nooo, it’s my turn!”  In the US, private parties working together under the auspices of CREFC built a wonderful disclosure regime for investors.  Investors, in collaboration with servicers, issuers and their counsel, came up with a terrific tool for investors to assess risk and reward.  But the Europeans didn’t think of it, and now they are going to impose their own data requirements.  So there.

During the summer, ESMA had floated proposals for what this disclosure would look like.  The Commission took their time reviewing it, and by the end of November, in the absence of any news (or likely upon receipt of negative feedback), ESMA and other European supervisory authorities announced that their disclosure rule would not be ready for January, and that a regime largely encapsulated in something called the Delegated Regulation (EU) 2015/3 (an old European rule providing disclosure templates for public structured finance transactions) was the best word on what was required to meet its view of required data disclosure and the market should do its best to apply it until the new legislation is finalized.  (ESMA was supposed to release their new proposal on Friday last, but missed the deadline….)

To be fair, the tone of the December missive was reasonable and practical.  But call me cynical if I worry about how a regulator will assess such reasonable and practical efforts with hindsight.  While I may indeed have fallen off the turnip truck, it didn’t happen last night, and if there are losses in structured products, pence to Euros, the bureaucrats will find fault with the issuer’s performance.  This is really bad news for European issuers and I feel sorry for them.  In a best-house-on-a-bad-street sort of way, the good news from a US issuer’s perspective is that a consensus is growing (again not without outlier opinions) that just as the new issuer retention obligations doesn’t apply directly to US issuers whose only connection to the European community is the sale of securities to European investors, the disclosure regime also does not apply.  Consequently, EU investors can buy US-issued securities without the template disclosure.  CREFC reporting is AOK.  That this reading of the law is correct seems pretty non-controversial at least to me, but it’s hard to say it’s true beyond peradventure (note that the above is CrunchedCredit’s musing and not to be confused with legal advice…please).

So, in several recent transactions, US issuers have taken the position that their deals are EU-compliant to the extent the US issuers can meet the 5%-by-value securitization risk retention in accordance with the pre-existing European rules.  In these deals, the risk factors include a discussion of the current confused state of play in Brussels on disclosure, indicate very clearly that there has not been an effort to map CREFC disclosure against the new template, and urge EU investors to discuss with their counsel as to whether the transaction is or is not compliant.

Frankly, that’s as good as it possibly can get right now, because US servicers are not yet prepared to map CREFC disclosure against this new disclosure template.  Generally, at a 50,000 foot level, the current CREFC reporting package and the new European template cover much the same ground.  In a fair assessment, it will be very difficult to say that one version provides better or more complete data than the other, but not shockingly, they don’t line up perfectly.

For US servicers, it’s going to be a lot of work to make that happen.  Moreover, as the Commission has rejected the current version of the template and a final real template might not be in place until mid-year, it’s hardly likely that a master servicer will do the massive amount of work required to remap our data to their template until that template stops moving.  A recent US SASB deal came to market which essentially told investors “you get what you get” in terms of US data, but that when the rules of the game in Europe are finalized, the issuer would endeavor to provide the data in the form provided by the European template.  But that’s a lot of endeavoring to do.  So far, we have seen that done but once.  In the meantime, sponsors that can meet the 5% fair value retention obligation will probably continue to indicate that their deals are intended to comply with EU risk retention, but the punctilio of the disclosure template will not be met.

We’ll see how that goes.

And just when you thought it was safe to go outside, the Japanese are beavering away at their own version of risk retention.  I guess their bureaucrats felt left out.  This matters because there are a lot of active Japanese investors in the US marketplace, and if these rules materially differ from existing US and EU risk retention criteria, this is going to turn into three-dimensional chess very rapidly.  Early indications are that the FAS proposal would require originators to retain a 5% first-loss piece, impose a new disclosure regime and, of course, impose capital penalties on investors who purchase securities where retention was not in place.

At this point, it seems clear to us that the new Japanese risk retention regime would apply to CRE securitizations (although all the early heat from the US is focused on the broadly syndicated CLO, which just recently got released from US risk retention jail).  In either event, the Japanese proposal is moving fast, with a final date for comment due today, January 28, 2019, and proposed initial applicability date of March 31, 2019.  Dechert has commented on the proposed rule, though at this point is still pursuing a clear English translation, so stand by to see where all this goes.

When asked on Jack Cohen’s industry leaders’ CREFC panel to describe 2019 in two or three words, one of the authors of this post responded: “A good year for lawyers.”  God bless the regulatory state.  They sure do keep us in business.