For the struggling CMBS industry, the medicine may be just as bad as the disease.

Since 2007, the CMBS industry has endured a roller coaster ride of dizzying highs and terrifying lows, finally grinding to a halt in mid-2008. But several public and private efforts at restarting and clarifying the CMBS market this summer have only made the outlook murkier for conduit lenders and borrowers—for every step forward, there's a corresponding step backward.

The government hopes to resuscitate conduit lending via a healthy dose of TALF, a program introduced in November 2008 and expanded in May 2009 to provide cheap loans to CMBS investors. And the earliest returns were positive: When the Federal Reserve announced that legacy CMBS would be eligible for TALF, spreads on conduit loans fell to around 550 basis points (bps) May 20, down from 924 bps April 1. But soon after, ratings agency Standard and Poor's (S&P) decided to toughen its methodology and downgrade many CMBS bonds, which instantly sent CMBS spreads soaring back toward 800 bps. S&P's new methodology also undercut TALF, since only AAArated securities are eligible for financing under the program.

A few weeks later in late July, S&P did a dramatic about-face, saying it would upgrade many of the bonds it initially downgraded, which only spread more confusion throughout the market. “S&P screwed up, and it's created more uncertainty,” says David Cardwell, vice president of capital markets at Washington, D.C.-based National Multi Housing Council. “This is a very reactive market that's still trying to respond to a number of variables that are changing on a very frequent basis.”

Like S&P's dramatic reversal, the government's own efforts to rein-in the CMBS industry have only increased uncertainty. A series of regulatory reform proposals floated by the Obama administration could, paradoxically, undermine its own efforts at rebuilding the industry by making conduit lenders less willing to lend—and CMBS investors less willing to invest.

In short, the market bleeds a little more every time a band-aid is applied. Can all the king's men put the industry back together again?

Competing Prescriptions

Maybe—but it's not going to be easy. When it comes to the government's efforts to restart the CMBS industry, it seems like the left hand doesn't know what the right hand is doing.

For one, the infusion of TARP funds— and the mark-to-market changes that allowed banks to adjust their capital holdings against real estate—undercut the Public Private Investment Program (PPIP), which was designed to clear toxic assets from a bank's books. Banks now have less of a need to sell their whole loans, leading the Treasury Department to first suspend and then restart the PPIP Legacy Loans Program in a diluted form.

What's more, a series of regulatory reform proposals floated by the Obama administration in late June threatened to undermine its own efforts in reviving the CMBS industry. Some of the proposed reforms include mandating a 5 percent retention of risk for conduit lenders; tying lender compensation with long-term loan performance; and giving servicers unprecedented ability to modify CMBS loans.

The 5 percent “skin in the game” proposal carries a great deal of political capital in Congress, and, in the broadest of strokes, it sounds like a good idea. Proponents of the reform argue that conduit lenders would adhere to tougher underwriting standards if they had a stake in that loan's performance.

But the retention of risk is already an important part of the CMBS industry. CMBS transactions always include a thirdparty investor who takes the first-loss position and negotiates to purchase the risk, argues the Commercial Mortgage Securities Association (CMSA). The onus is on the buyer to understand that risk. The focus should be less on assigning that 5 percent to originators, and more on improving how that risk is transferred and ensuring that whoever has the risk knows exactly what they're getting, the CMSA adds.

If originators were forced to take that 5 percent retention, it would ultimately make them less liquid, less able to lend. Besides, the approach hasn't worked out too well for portfolio lenders, such as banks and insurance companies, who hold loans on their books.

“If retained skin in the game was such a brilliant antidote to our problem, then builders' books and construction loans and condo conversion deals would've performed brilliantly over the past couple of years,” says Rick Jones, a Philadelphiabased partner at international law firm Dechert and a CMSA board member.

A separate proposal floated by the administration in June would tie lender compensation to the long-term performance of the loans' underlying CMBS. But the essence of the CMBS market is recycling capital: Lenders need to be able to sell loans to investors and use the proceeds to immediately make more new loans. Delaying compensation would give conduit lenders less capital to lend, the CMSA says.

Some industry watchers believe that CMBS investors are going to require a new level of accountability and transparency from the issuers, regardless of whether these proposals are made into law. “I don't think skin in the game should be required by law, but I think the investors will require it,” says Dan Fasulo, managing director of market research firm Real Capital Analytics. “For the first new CMBS issues coming, all the investors are going to want the issuer to have skin in the game.”

Another issue that has rankled the CMBS industry is proposed changes to Real Estate Mortgage Investment Conduits (REMICs), the vehicle by which loans are pooled and securitized. The changes, currently being mulled by the Senate Banking Committee, would allow servicers to modify loans well in advance (as much as 60 months) of maturity if the servicer has reasonable belief that the borrower would be unable to obtain refinancing to pay off the loan.

Proponents of REMIC reform claim that there must be some flexibility on the back end to help stave off defaults. “There should be a process that enables CMBS servicers and borrowers to be proactive in averting defaults while minimizing any negative impact to investors,” says John Cannon, an executive vice president at Horsham, Pa.-based Capmark Finance.

But investors are attracted to CMBS because of the certainty of returns. They would be much less inclined to buy if the cash flows and duration of the loans underlying the bonds could be modified at any time, the CMSA argues.

As if that wasn't enough, the Financial Accounting Standards Board created two new standards in June—FAS 166 and 167—which are causing concern throughout the CMBS industry. The new rules, which will go into effect come January, will change the way entities account for securitization and special-purpose entities.

The standards will have a big effect on companies, such as New York-based Centerline Capital Group, who are both a servicer and holder of subordinate bonds, as they will be forced to consolidate, “assets which it doesn't really own, and liabilities for which it has no contractual liability,” Jones says.

Race Against Time

While many in the CMBS industry are less than enthused about increased oversight, they do appreciate the government's most visible and viable prescription: TALF, a loan program where CMBS investors can get cheap debt—namely three- or five-year loans priced at 100 bps over the LIBOR swap rate—with which to buy CMBS.

On August 17, the Federal Reserve decided to extend TALF for newly issued CMBS until June 30, 2010. The announcement came nearly six months after the Fed announced that CMBS would be eligible for TALF. That's six months of inactivity for many conduit lenders.

The program has the potential to re-engage investors, which would lower spreads on conduit loans, thereby encouraging new originations. There's a catch, though: TALF was originally set to expire Dec. 31, 2009. The lead-time for originating, pooling, and securitizing a new issuance is at least 90 days, and given TALF's original, aggressive sunset date, many formerly active conduit lenders chose not to reopen their shops. “If we don't get an extension, we'll look back and say never have so many people worked so hard to accomplish so little,” said Jones of law firm Dechert in July. “The time frames involved are relatively ludicrous to build sustained programs.”

A number of formerly active conduit lenders, including Prudential Mortgage Capital Co. and Wells Fargo, did reopen their CMBS platforms with an eye on originating loans for a TALF execution. But many borrowers and lenders are sitting out the early days of TALF to see how the first few issuances will be received.

“Nobody wants to be the guinea pig,” says David Durning, senior managing director of originations at Newark, N.J.- based Prudential. “The issue is nobody is warehousing loans, so how are you going to coordinate a funding? It's like everyone has to learn to walk again.”

The first new deals under TALF will be single-borrower issuances, where a large REIT portfolio will create an instant pool. This move allows banks to undertake simultaneous issue or take very short warehouse positions to get the transaction funded. And it gives the Federal Reserve another chance to modify its own rules.

While the Fed has expressed a desire for a diverse pool, it also has the authority to change its mind at a moment's notice. “They recognize that particularly on the new issue side, achieving geographic diversity, asset type diversity, and borrower diversity immediately may be difficult,” says Thomas Fink, senior vice president and managing director of New York-based Trepp, which was selected as the CMBS advisor to the TALF program in mid-July.

Three subscription dates—in June, July, and August—passed without any requests for TALF funds to buy new issuances. That's no surprise, given that there were no new issuances to buy. But investors did ask for $2.28 billion of TALF loans against legacy CMBS—basically anything AAArated issued before 2009—in August, and the first new issuance is expected to be in the fall.

Slow Recovery

Multifamily REITs aren't likely to take part in the early going due to the availability of low-cost debt from Fannie and Freddie. Instead, retail and office REITs, including New York-based Vornado and Cleveland-based Developers Diversified Realty, are expected to be the first borrowers to take advantage of TALF.

CWCapital has been considering programs that would use TALF to help finance new originations, but the company keeps hitting roadblocks. First, many borrowers are still going through a painful de-leveraging process, making refinancing difficult. Second, the agencies and life insurance companies are offering prices that are well inside of what capital market lenders can offer.

“What you could originate is limited by the fact that most properties are encumbered and frequently overleveraged—and by the fact that anything relatively decent, a life insurance company will probably do,” says Hugh Hall, a managing director at Boston-based CWCapital Investments, a sister company to lender CWCapital.

Assuming a cost of funds of 600 bps above the benchmark, and a lender spread on top of that, a CMBS borrower couldn't really hope to get a loan with a rate below 10 percent. “While TALF is a good program in that it has stopped the utter free fall, it's really not a sufficient program to fundamentally contain cap rate expansion because the cost of funds is too high,” Hall says. “And there's a significant amount of uncertainty about its availability when it comes time to securitize.”

Still, industry insiders say that some conduit lenders have indeed been active this year, but quietly and on a select basis. “There are a couple of institutions that are actually close to having diversified pools available,” says Fink of Trepp. “But we have not seen any applications.”

The first real test of the program will come when some new issuances start emerging from the pipeline, likely in September. At that point, there will still be nine months left until the life support system of TALF disappears—unless of course, the program is extended again. Those nine months may provide enough time for TALF to gestate and give birth to a renewed CMBS industry, though if the process has proven anything so far, it has proven that good intentions don't always make for the best medicine.