Capital Markets Insight has been focusing on familiarizing readers with the terminology and mechanics of the CMBS market as well as the reason for its current demise and attempts to revive it. George Smith Partners closely follows developments in the financial markets and reforms proposed by the leading regulatory bodies overseeing the restoration of the financial markets. The reforms serve as a roadmap for the private sector to revive the commercial real estate capital markets as well as laying a foundation for the new rules by which industry professionals will have to live. To read the full series of articles by Mr. Silbergeld, please use the following link:
Capital Markets Insight.
Introduction
In mid-June the Treasury Department published a ninety page White Paper outlining major overhauls to the regulatory framework that guides nearly all financial markets with a great deal of focus on securitized instruments and real estate capital markets. This update summarizes reforms with the most significant impact on the commercial real estate capital markets including the changes that affect the CMBS market. While a new framework from the Treasury and Federal Reserve was expected, no one was quite sure what it would entail and how far the reforms would go.
Most analysts and participants in the CMBS market recognize that reforms are needed and many of the proposals have been applauded as a step in the right direction for stabilizing financial markets. However, the proposal is only a first step as the market has overwhelmingly demanded more clarity in how these proposals will be implemented and greater differentiation between product types and institutions in order to avoid ineffective blanket reforms. The need for clarity and careful implementation along with long timeframes given to proposals set for committee review means a sense of normalcy will be a long way away. The future for CMBS is uncertain and if it does return, both the market for outstanding CMBS and new issuances will undoubtedly function and look fundamentally different.
Capital Requirements and Accounting Rule Changes
The Treasury White Paper puts a major emphasis on the need for an increase in adequate capital reserve requirements, highlighting the point that capital held by large financial institutions did not account for off-balance sheet assets, mainly asset-backed securities including CMBS. The White Paper puts the biggest spotlight on institutions that pose systemic risks, Tier 1 Financial Holding Companies or firms that are currently “too big to fail”, recommending that these institutions be subject to higher capital reserve requirements and more intense monitoring. In addition, the White Paper proposes that institutions should retain excess capital in good economic times in order to buffer losses during downturns.
By itself, the full extent of the effects created by these two proposals is not easy to determine. The reason it raises some concern is that the effect of higher capital requirements could be magnified by other regulatory reforms, including an accounting rule change set to take place in November of this year. The introduction of FAS 166 revises the interpretation of the qualified special purpose entities concept which was the vehicle that CMBS issuers used to treat securitized assets as off-balance sheet in order to avoid reserving capital typically required for loans and other receivables.
The exact manner in which this accounting rule change will be implemented is unclear, but it seems likely that a considerable percentage of outstanding securitized assets will be brought back onto the balance sheet of issuers while future securitizations will require accounting for a portion, if not all, of the assets as on balance sheet. Just how much is unclear as there is no clarification for what type of regulatory treatment these assets will receive, the capital ratios required for securitized assets, and ways in which the assets can still qualify as off-balance sheet. This uncertainty has market analysts anxious to get more definitive details on the application and implementation of the accounting rule change. Considering that according to Citigroup’s Global Markets, the outstanding CMBS balance is approximately $722 Billion and the entire securitized market has over $8 Trillion in outstanding assets, the potential implications of the changes are significant.
The higher capital reserve levels and accounting rule change will likely serve as an effective limit on the volume of the securitization markets moving forward. Before the financial meltdown, issuers of CMBS and other asset-backed products had to reserve minimal capital throughout the entire securitization process, and certainly had little capital constraints once the transaction was completed. This is how institutions became leveraged to astronomical levels as debt was created with no equity held against it. The accounting rule change, higher capital requirements, and massive amount of off-balance sheet assets will eat up free capital and constrain the supply of new securitized debt if the market does comes back.
The White Paper supports another accounting rule change which reinterprets the gain-on sale concept whereby the full profits from a securitization transaction can be realized immediately upon completion of the securitization. The White Paper supports the move to strike this accounting notion and force issuers to recognize proceeds over time while potentially having the banker’s compensation for the transaction tied to its long-term performance. The effect of this would be delayed, and potentially reduced, profits over time which would change securitization from a quick profit engine to a much slower and less economical process. Assuming the CMBS market returns, the pace of securitizations will slow and a number of transactions that have tight profit margins will be ruled out.
Potential Market-Wide and Macro Effects
The effects of a highly constrained supply of debt and slower pace of transactions will continue to have a sobering effect on commercial real estate. The basic theory driving monetary policy is that the Price and Output level is determined by the Money Supply and Velocity of Money. The higher capital requirements and return of securitized assets back on-balance sheet effectively lowers the Money Supply for assets relying on securitized debt including commercial real estate. At the same time the riddance of gain-on sale accounting effectively decreases the Velocity of Money.
If one uses the money supply formula to interpret the effects on Price and Output levels, this logic leads to a deflationary pressure on values for commercial real estate and other assets that relied on securitized financing. While the TALF program has effectively increased the supply of money providing some of the missing leverage in the securitized debt world, these reforms could counteract TALF and deter future CMBS originations keeping commercial real estate values subdued for a prolonged period of time. The positive viewpoint is that it is not yet clear exactly how the accounting rule changes and White Paper proposals will be implemented meaning the magnitude of the effects may be less harmful.
Even if the accounting rule is applied to only a percentage of the CMBS financed assets, coupling the number of outstanding assets with the push for more stringent capital reserve levels means the recent capital raising efforts of the “too big to fail” institutions could be severely inadequate. Capital insufficiency of the largest financial institutions that drive not only the CMBS market, but most major credit markets, could result in a prolonged recovery for all financial markets.
Along with the obstacles presented by the structural changes proposed in the White Paper, the individual institutions in the CMBS market and their mode of operations will be transformed. While the structural changes to the CMBS framework raise many concerns, the key institutions in the CMBS origination process will face more hurdles even if they are able to restore health to their balance sheets.
The next article in this series will focus on the White Paper’s proposals aiming to reform the origination platform for securitized debt and the methods used by institutions in the market including issuers and rating agencies.
