Risk Retention Redux Illustrates Importance of Fact-Based Policy-Making

CRE Finance World, Winter 2014

Risk Retention Redux Illustrates Importance of Fact-Based Policy-Making he Dodd-Frank Act (DFA) includes 15 titles, mandates more than 300 rules be written, covers 2,300 pages, and codifies roughly 10,000 new requirements for the financial services industry. And yet, there are some focal points in the document. Capital and the Volcker rule are the subjects of conferences, public debate and a multitude of papers. Section 941, the piece of the DFA that requires credit risk retention for securitizations, follows close behind these topics in importance and impact. Risk retention, commonly referred to as the eat-your-own-cooking provision, requires that issuers and sponsors of securitizations hold 5% of their transactions at fair value for 5 years. The goal of these core provisions is to ensure that issuers / sponsors will share incentives with investors and refrain from poisoning the stew. At the Commercial Real Estate Finance Council, we have a diverse membership. Depending on where you sit, you may agree or disagree with the rule’s underlying premise. In policy circles, however, risk retention is considered to be a necessary feature of a stronger CMBS market, and other securitization markets in general. The original proposal that was issued in 2011 was so hotly debated that it was diverted from the normal course of rulemaking to reemerge as a half measure almost two years behind schedule. The Agencies had good reason for the delay as industry participants and others had filed over 10,000 comment letters in response to the first draft. Many of those letters focused on an exemption for residential mortgages embedded within the proposed rule. If a loan meets certain underwriting criteria, then it can be exempted from the retention requirement. For the public-at-large, the qualified residential mortgage (QRM) exemption harnessed considerable debate. While the QRM was relaxed to include 85% or more of residential loans, the qualifying commercial real estate (QCRE) loan requirement, moved only slightly capturing a range of 2–8% of CMBS loans historically. CRE Finance World Winter 2014 10 In the second round of comment writing, CRE Finance Council members found common ground on many subjects. However, the QCRE quickly bubbled into a heated debate across the four constituencies that were engaged in the feedback process — IG Investors, Issuers, B-Piece Investors, and Servicers. To resolve their differences, the membership turned to quantitative analyses of historical loan performance. Several members undertook the fairly weighty exercise of analyzing the correlation between a given QCRE parameter and credit quality factors. Many of the members compared their work and found that there was general consensus about the results. Contrary to our assumptions, we found that some of the loan characteristics considered by the regulators to be less safe, and that they in fact correlated with higher losses. Loans with 30-year amortization, interest only (IO) loans and shorter-term loans, that met all other QCRE characteristics, performed much better than the average conduit mortgage historically. In some cases, the non-exempt loans performed better than even QCRE-qualifying loans. From 1997 – 3Q13, loans that CREFC proposed be exempt incurred cumulative losses of .57% versus the .74% for Agencyproposed QCRE loans. If the QCRE definition were to incorporate CRE Finance Council recommendations, the proportion of qualifying loans would remain modestly-sized. When including these additional loan types in the analysis, QCRE-qualifying loans accounted for 15.6% of loans originated between 1997 and 3Q13, up from 3.6%, as per the re-proposal. Many of the members agreed that the real threat to loan quality was not necessarily easily circled with underwriting standards. For many members, “pro forma” practices, or aspirational growth assumptions used in the valuation of a property and the lack of transparency around them, pose the greatest threat to CMBS credit quality. Certain members took the view that there should be no relaxation of the QCRE standards in order to offset pro forma practices, which are difficult to observe and evade capture in risk-return modeling. T Christina Zausner VP, Industry and Policy Analysis CRE Finance Council


CRE Finance World, Winter 2014
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