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
The last installment of Capital Markets Insight covered just a sample of the sweeping regulations that the Treasury’s White Paper introduced in June. Market wide reforms focusing on capital reserve requirements of major financial institutions and accounting rules will have lasting effects on the securitization and CMBS markets moving forward. The White Paper also takes a strong approach to the rules individual institutions will have to abide by when originating CMBS with the ultimate goal of aligning incentives in order to improve underwriting standards and protect investors.
New Rules for CMBS Issuers
The White Paper focuses specifically on the mechanics of underwriting asset-backed securities and requirements to guide the way new issuances are underwritten with many implications for CMBS. Probably the most detailed topic the White Paper discussed was the idea of securitization issuers having a “skin in the game” for future issuances.
The White Paper proposes issuers would have to hold a 5% economic exposure to a securitization giving regulatory agencies the right to determine the appropriate portion of the securitization to be retained. As an example, the White Paper suggests issuers could either retain the first-loss tranche, or a “vertical slice” whereby they have a 5% interest in each bond class. The idea behind this is that exposing issuers to potential losses will make them more inclined to originate loans with higher underwriting standards and include collateral with lower credit risk characteristics. In addition, by exposing issuers to immediate losses many practices currently plaguing loans underwritten between 2006-2008 including rent trending and long periods of interest only debt service can be avoided in future issuances.
This is a case where the market has called for differentiation between product types as some CMBS professionals feel the market has an adequate platform. CMBS issuers typically marketed the first-loss tranche of the securitization to knowledgeable investors including special servicers and hedge funds who performed significant due diligence. Because selling the first-loss tranche was essential to completing the transaction, buyers of the first-loss tranche were typically provided the right to “kick out” loans from the CMBS pool if they felt a particular mortgage posed unwanted risk. Though the CMBS market has a process in place to address underwriting standards, it seems that regulators intend to apply these rules to all securitized product types.
The 5% retention rule should align CMBS issuers’ interests with those of bondholders making them more inclined to underwrite loans with strong credit characteristics and ensuring that the terms of the mortgages don’t increase payment and refinancing default risk. However, this will require CMBS issuers to retain more assets on book in which they have sole ownership forcing them to reserve more capital from their balance sheet. Transactions often have balances well in excess of $1 Billion meaning issuers would be retaining a nominal value of $50 Million or more. Once again the capital situation of the major investment banks that drive the CMBS and securitized markets may have to be strengthened to accommodate future bond issuances.
Hedging and How it Affects Securitization
Another rule that is understandable in its creation, but may prove difficult and unwise to implement is the “no-hedging” rule for issuers. The White Paper clearly states that issuers should not be able to hedge the securitization position they retain whereby they would transfer the risk to another party. It seems likely that this rule was created in response to the perception of issuers “pumping and dumping” by making sure they couldn’t complete a securitization transaction and simultaneously purchase credit-default swaps to hedge against the default risk associated with the transaction. Credit-default swaps provide the buyer of the instrument insurance against a credit event, which can be anything from a default on a CMBS bond to a default on a corporate bond, by paying a periodic premium to the seller of the swap in return for the guarantee of repayment for the amount they insure with the swap.
Again, the thinking is that by disallowing hedging in combination with retaining an economic exposure, issuers will be encouraged to underwrite and securitize higher quality loans as they are exposed to losses. While it does make sense to force issuers to retain exposure to the default risk of the collateral involved in a securitization, the generic language of the “no-hedging” proposal exposes the issuer to other risks which they typically hedge with derivatives other than credit-default swaps and additional strategies. This is a perfect example of where the White Paper needs far more clarification and differentiation, in this case between different hedging products.
When CMBS issuers originate mortgages they have to warehouse them on their balance sheet until there is a large enough pool to offer a securitization to the market. At the time of origination the interest rate charged on the mortgage is a spread over the yield demanded by bond investors at the time the mortgage is originated. The yield demanded by bond investors is a function of Treasury bond yields, which is considered risk-free return as U.S. sovereign debt is generally viewed as safe from default, and an additional credit spread to account for perceived risk associated with investing in commercial real estate. Since issuers may have to warehouse mortgages for long periods of time, even up to two years, they are exposed to movements in Treasury bond yields and increases in the credit spread demanded by CMBS buyers. If the yields demanded by CMBS investors exceed the weighted average fixed interest rate of the loans backing the CMBS issue, the CMBS issuer takes a loss on the securitization as they would have to discount the offering price of the bonds in order to boost the yield.
This warehousing period leaves issuers highly exposed to interest rate risk and changes in credit spreads as rises in Treasury bond yields and increases in the credit spread demanded could negate already tight profit margins on securitizations. To solve this problem, there are two main strategies used by issuers to hedge against both risks associated with warehousing CMBS loans. According to Jennifer Imler, of Custom Hedging, LLC, “To hedge against a rise in Treasury yields, issuers short sell Treasury bonds. Bond yields are inversely related to the price, which varies according to market demand. A drop in Treasury bond prices results in a higher yield, which could wipe out profits for CMBS issuers. By short selling Treasury bonds, issuers can make a profit from a drop in Treasury bond prices, thereby offsetting losses on the securitization attributable to the correlating rise in Treasury bond yields.”
While that strategy addresses an issuer’s exposure to interest rate risk, the issuer still needs to hedge against a rise in the credit spread demanded by CMBS buyers, which Imler says can be done through Total Return Swaps (“TRS”). Total Return Swaps allow for a synthetic purchasing or selling of the credit spreads on CMBS. CMBS issuers use TRS to synthetically short credit spreads and protect against a decrease in the offering price for a CMBS bond as a result of an increase in the credit spread demanded by CMBS buyers. Because the rates on the mortgages backing CMBS bonds are fixed, the only way to boost the yield on the bond is to discount the selling price and cause a loss to the issuer. By utilizing TRS hedging, an issuer is compensated for a credit spread driven decrease in the price of its bonds and thereby offset related losses from a securitization transaction.
By using multiple hedging strategies issuers were protected from the risk inherent with holding fixed rate mortgages for a period of time before completing the CMBS offering. If the White Paper’s proposal applies to all hedging products, CMBS issuers would be highly exposed to any moves in Treasury yields and credit spreads making securitization and CMBS a far less appealing lending platform.
The reforms focusing on the mechanics of securitization and strategies implemented during the process are more detailed than some of the other broad brush strokes presented in the White Paper. However, they still lack the clarity needed to know how the 5% retention rule will be applied and require more differentiation to determine what hedging strategies will be prohibited from use by CMBS issuers. Regulatory uncertainty is one of the biggest enemies of financial markets and the Treasury needs to make a swift effort if the markets are to undertake a significant recovery in the near future.
Rating Agencies
The White Paper also looks at the conflicts of interest and reforms necessary for the credit rating agencies to try and restore investor confidence in the ratings. CMBS analysts have loudly voiced the sentiment that there were inherent conflicts of interest in the ratings process as the rating agencies were compensated only once they had won rating assignments.
Because CMBS transactions only require ratings from two of the agencies, issuers would submit a transaction for initial rating to three or four of the rating agencies and select the two agencies providing the top ratings. Since the rating agencies competed to win the rating assignments, the process incentivized them to issue higher ratings in order to win. The Treasury proposal is not specific about the manner in which they will solve the conflicts of interest, but a clear mechanism to discourage issuers from shopping for ratings needs to be implemented to restore credibility in the rating agencies.
The proposal that has drawn the most ire from market participants and trade groups, such as the Commercial Mortgage Securities Association (“CMSA”), has been the proposal for the agencies to distinguish credit ratings for structured products, like CMBS, from unstructured corporate debt, municipal bonds, and government bonds. Analysts, issuers, and industry trade groups insist this proposal will cause investors to view asset-backed securities as a naturally riskier investment product regardless of the collateral quality backing the securities. They claim investors will no longer be able to draw a direct comparison between asset classes by assuming that a AAA corporate bond has the same repayment risk as a AAA CMBS bond. The Administration wants distinctly different credit ratings to clearly demonstrate to investors the risks that are inherent and unique to products with structuring intricacies and complex payment priorities.
Like the structural market changes and the proposed reforms to the securitization process, improving the framework for the credit rating agencies is a key step to reviving the commercial real estate capital markets. It is unclear just what effect the differentiation in credit ratings for products like CMBS will have on investors’ viewpoints, but re-establishing credit ratings as a reliable method of confirming due diligence and forecasting potential losses is essential for reviving CMBS.
The White Paper’s Effect
Reforms are unquestionably needed to improve practices of institutions active in the market and to protect against another credit bubble driven by overleveraging via securitized debt. While there is great uncertainty and a dire need for more extensive details on the proposals in the White Paper, it is quite clear that if the CMBS market returns it will never operate in the same way as it did in the “go-go” days. Some of the reforms could pose a threat to the revival of the securitized lending markets prolonging the drought of available financing for commercial real estate.
This financial crisis has shown that deterioration in the value of commercial real estate and other assets relying on securitized debt can cripple huge lending institutions, shut down entire financial markets, and disrupt the global economy. Reforms are needed to solve the crisis but it is not clear that securitized lending and CMBS will have the capacity needed to bring about the speedy recovery that so many are looking for. Clarification is needed immediately so that CMBS professionals can understand the new regulatory framework and get to work to revive the lending markets and stave off further pains in the commercial real estate industry.
