Published on November 8, 2016 by Guest Blogger
The 2008 subprime crisis was very damaging for the financial industry and related sectors. Within the real estate sector, both the commercial and residential segments witnessed a downturn. Some key reasons for the crisis were:
Originators that were largely unregulated and had no skin in the game engaged in aggressive and loose underwriting practices
Many mortgage buyers relied only on rating agencies and did very little independent credit work
When the real estate market started to crumble and home prices began to soften, the default story of subprime borrowers began to unfold. With the overall contraction in the residential mortgage-backed security (RMBS) market, the commercial mortgage-backed securities (CMBS) segment began to feel the heat, as CMBS investors lost faith in the core assumption that property value would increase.
To revive the markets and regain investors’ confidence, several new regulations were brought in including the Dodd-Frank law, which was enacted in January 2010. It suggested changes across the financial sector, including improvements to the asset-based securitization process.
The new rules (which will come into effect on December 24, 2016) under the Dodd-Frank Wall Street Reform and Consumer Protection Act require CMBS issuers to keep 5% of a loan’s value on their balance sheet in the form of bonds unless the issuer meets the stringent underwriting requirements of a loan-to-value (LTV) ratio of 65% or lower, maximum amortization of 25 years, debt service coverage ratio of at least 1.70x, and no interest-only periods.
An issuer can meet the regulations by either retaining a “horizontal” strip (which encompasses holding 5% of the lowest-rated bonds) or a “vertical” strip (which calls for holding 5% of each tranche; or a combination thereof). The issuer can pass on this share to B-piece bondholders on the condition they agree not to sell the CMBS for at least five years. The rationale behind forcing issuers to hold a stake in the issuance is to ensure they have their skin in the game and to discourage them from engaging in the risky lending practices prevalent until 2007.
However, pushing issuers to infuse their own capital in bonds will negatively impact their profit margins. Moreover, the volume of loans an issuer can disburse would be curbed, thereby increasing the cost of lending. This would adversely impact smaller issuers.
B-piece buyers look for returns of 14-18%, and unless investors can reduce the cost of capital, the incremental B-piece slice will price significantly higher than current levels for that part of the CMBS capital pool. Banks may find it more expensive to keep CMBS loans on their balance sheet because of Basel III regulations, which stipulate lenders maintain higher capital for real estate loans. But given the rising price to compensate B-piece buyers, banks may agree to retain 5% of the loan themselves. In this regard, CMBS lenders are exploring different holding strategies, including an L-Shaped model in which banks would hold the 2.5% subordinate bond component and run the remaining 2.5% up to the most senior bonds.
The uncertainty triggered by regulations has negatively impacted the overall issuance of the CMBS loans; only USD 41 Bn of loans was disbursed as of September 2016 (vs. USD 101+ Bn in 2015).
CMBS loans of USD 99.47 Bn are set to mature in 2017. According to Morningstar, 47% of these advances have an LTV ratio of 80% or more. In all probability, the new rules will make refinancing these loans extremely difficult unless there is a significant improvement in operations and cash flows of the borrowers.
The risk retention rule, however, exempts Freddie Mac and Fannie Mae if an entity provides a guarantee that it would make timely payments of principal and interest on all asset-based securities transactions.
Having said that, the new regulations will be a positive step in ensuring the 2008 situation does not recur. The industry is resilient and would figure out a way through the new requirements.
Acuity Knowledge Partners has strong capabilities in structured finance, commercial banking and the entire spectrum of securitized products in particular. Through our deep product knowledge and industry expertise, we can help bankers/lenders meet their long-term objectives of cost-cutting and process standardization and also supporting them in meeting regulatory requirements.
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