For the struggling CMBS industry, the medicine may be just as bad as the disease.
The latest hurdles for the struggling sector involve a series of regulatory reform proposals floated by the Obama administration that could, paradoxically, undermine its own efforts to revive the CMBS industry. As the administration continues to build out the TALF CMBS program, some of the proposed reforms could make conduit lenders less able to lend and investors less willing to buy CMBS bonds.
The reforms include a mandated 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 has momentum in Congress, and in broad 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 third-party investor that 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. “Like most B-piece buyers, we re-underwrite the entire pool of loans that are put into securitization,” says John D’Amico, a senior managing director at New York-based Centerline Capital Group.
The focus should be less on assigning that 5 percent to originators, more on improving how that risk is transferred, and ultimately about making sure that whoever has the risk knows exactly what they’re getting, D’Amico says. If originators were forced to take that 5 percent retention, it would ultimately make them less liquid and less able to lend.
A Losing Proposition
Having skin in the game hasn’t worked out that well for portfolio lenders like 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,” notes Rick Jones, a Philadelphia-based partner at international law firm Dechert, and a CMSA board member.
A separate proposal floated by the administration 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.
Another issue that has rankled the CMBS industry is proposed changes to Real Estate Mortgage Investment Conduits, the vehicle by which loans are pooled and securitized. The changes 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 the loan off.
But the reason investors are attracted to CMBS is the certainty of returns. Investors would be much less inclined to buy CMBS if the cash flows and duration of the loans underlying the bonds could be modified at any time, the CMSA says.
Who's to Blame?
Lenders and ratings agencies are often blamed for the CMBS industry’s meltdown. But some argue that ultimately it’s the investors that set the bar on what the market will bear.
“The only thing better than legislation is market forces that say, ‘If I don’t like the way you underwrote those loans, I’m not going to buy that bond’,” says Annemarie DiCola, CEO of New York-based Trepp, the New York Federal Reserve’s collateral monitor for the TALF CMBS program. “That’s a very powerful way of self-legislation and self-regulation. If investors remain informed and diligent, then issuers and underwriters will have to be mindful of that.”
While many in the CMBS industry agree that increased oversight is needed, the current Regulatory Reform Proposals could undercut the government’s own attempts at revitalizing the CMBS industry, notably through the TALF program. Hopes are high that TALF will indeed spur new CMBS issuances, possibly as soon as within the next 30 days, but many in the industry are now wondering whether the government’s right hand knows what the left hand is doing.