CREFW-Fall2015

A publication of Autumn issue 2015 sponsored by

CRE Finance World Autumn 2015

Rule 17g-5 of the US Securities Exchange Act requires rated

transactions offered to U.S. investors to maintain electronic

archives of information provided to the rating agencies rating the

transaction. This information must be available to other rating

agencies to permit them to issue unsolicited ratings. Compliance

with this rule adds costs for rated transactions.

Further European regulation applies to transactions treated as

“securitisations” under the Capital Requirements Regulation

(“CRR”)

. This defines securitisations as transactions tranching an

“exposure” or pool of “exposures” (for CMBS, CRE loans) where

the subordination of tranches

determines the distribution of

losses during the ongoing life of the transaction. In other words, a

“securitisation” is a transaction where multiple classes of bonds are

issued on a senior-subordinated basis.

Under the Regulation for Credit Rating Agencies (“CRA III”)

, if a

structured finance transaction is rated, it must be rated by at least

two credit rating agencies. Obviously, such requirement will add

costs to a securitisation.

The regulatory capital treatment for regulated investors holding

unrated, untranched CMBS is unclear. As such transactions are

not tranched, they may not be “securitisations” under Basel III and

Solvency II rules. As such, there seems to be no guidance as to the

regulatory capital treatment of such transactions.

Commentators suggest

that regulated investors in unrated,

untranched CMBS applying the Internal Ratings Based (“IRB”)

Approach may “look through” the structure and treat CMBS as

a direct investment in the underlying CRE loan. This applies only

to “pass through” CMBS backed by a single CRE loan with no

credit enhancements as otherwise, the CMBS bonds would not be

effectively the same as the CRE loan. Depending on the terms of

the underlying CRE loan, particularly its loan to value (LTV), this

could result in regulated investors achieving favourable regulatory

capital treatment.

Some unrated European CMBS transactions involved the issue

of single tranches of bonds; Reni SPV, Pangaea Funding, Mint

Mezzanine and Midas Funding

. Reports suggest that the more

favourable regulatory treatment of unrated, untranched CMBS may

have motivated these transactions

For unrated, untranched CMBS to receive favourable regulatory

capital treatment would be inconsistent with other forms of CMBS.

It would also be illogical for the senior tranche of an unrated,

tranched CMBS to be treated less favourably than an unrated,

untranched transaction and as such, specific guidance may well

be issued to address this.

CMBS transactions are arranged to generate profits for the arranger

through the differential between capital markets pricing and

loan market pricing (conduit deals) or, to access efficient capital

markets funding for the related borrower (agency transactions).

In either case, the market pricing for the CMBS and its start-up

and on-going costs will affect the viability of the transaction. This

is particularly important for conduit CMBS where profit extraction

is sensitive to bond pricing and to recurring costs such as liquidity

facility and hedging costs.

Disadvantages of Issuing Unrated

Credit ratings provide assessments of the likelihood of payments

being made in full and on time. A wider range of investors will be

more interested in rated than unrated investments. This is even

more pronounced with complex assets such as CMBS where

an investor would need considerable resources and expertise

to undertake the level of analysis equivalent to that provided

by a credit rating. Certain investors (particularly funds) are also

constitutionally restricted from making unrated investments. Due

to this, unrated investments are less liquid than rated ones leading

investors to seek higher returns.

Recent regulatory changes have further reduced the liquidity of

unrated investments (particularly unrated tranched securitisations

including CMBS) by imposing punitive capital treatment for

regulated investors under Basel III.

In Europe, the Capital Requirements Directive (enacting Basle III)

provides for different treatment for regulated investors holding

unrated tranched CMBS depending on whether it is permitted to

use the Standardised Approach or the IRB.

Investments in unrated, tranched securitised bonds will, generally

under the Standardised Approach, either carry risk weightings

of 1250 percent or require the investor to make a full deduction

from capital for their investment

. Investors using IRB apply the

“supervisory formula approach” using a complex formula based on

the structure of the investment and the nature of the underlying

assets to calculate the capital requirements. A full analysis of

this is beyond the scope of this article but it is understood to be

very unfavourable.

Regulated investors holding unrated tranched CMBS bonds, will

generally not be able to finance their investment through the ECB’s

Long Term Refinancing Operation or the Bank of England’s Asset

Purchase Facility as these schemes require investments to be rated

Unrated CMBS: A New European Asset Class