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CRE Finance World, Winter 2014

Brian Lancaster: Randy, on the topic of capital, talk about risk retention. In August, U.S. regulators came out with their revised 5% risk retention proposal for CMBS deals. They got rid of the premium capture account, which I think most people would agree is a good thing. However, the proposal is based on fair market value rather than the initial principal balance of the retained interest which means a lot more will have to be held. Commentary ended in October and the expectation is that the final version will come out in the next few months if not December as has been stated. Originators can hold a horizontal or vertical slice; B-piece buyers, up to a maximum of two, can hold a horizontal 5% slice. What are your thoughts in terms of how that is going to impact your business model as a B-piece buyer? Randy Wolpert: It is a bit of a “chicken and the egg” problem — you really have to question: what are these pools going to look like? The first thing is at a minimum, the investment amounts are going to have to be substantially greater. Again, assuming that they leave the rules as proposed, a B-piece buyer could split the investment with another buyer. But it would be pari passu, so then the question becomes, what risk are you actually buying? I don’t think there is any answer now. There is speculation that the pools are going to look the same and we will just buy higher rated, lower risk pieces. But it isn’t clear that really will happen. I tend to think it won’t, but no one really knows. It does mean in our minds that buyers will need to fundamentally change the capital raised. Right now, that capital seems to be separated. The higher-rated, lower-risk buyers don’t have the same type of characteristics that buyers of the bottom of the structure have. While there is some liquidity at the BB level for the most part, B-piece buyers assume we will hold our investments to maturity. When you start limiting liquidity higher in the structure, the question becomes, is that a reasonable thing to be asking buyers to do and what is the premium for asking them to do that. More importantly, is it really going to be less risky, or are the pools going to have more risk in them? Brian Lancaster: While the aim of risk retention is to improve credit quality, if you’re going to need more capital, someone has to pay for that extra capital. Isn’t there a danger that we perversely end up instead with lower quality loans that offer the higher yields necessary to pay for the extra capital? Randy Wolpert: It seems like that is certainly one possible outcome. I don’t think there will be any “free lunch,” where you’re going to be able to buy the less-risky pieces but get the same yield.. So the question is going to be, who gets stuck with that bill, or is it really a bill? Is it just a fundamental change in the way these pools look? Dan Bober: Do we have a sense as an industry as to whether the cost of risk-based capital drives up the borrower’s rate such that CRE Finance World Winter 2014 18 we get adverse selection in terms of borrower quality or property quality? Also, as a corollary, does it drive up borrower’s rates enough so that they take advantage of pre-risk based capital pricing and we get a bulge in production? Jon Strain: I think all these are questions which we can’t really answer. I think it is the unintended consequences of the rules that scare me the most. If we make bonds more illiquid then people will charge more for them. If we make the B-piece bigger then we will have to charge more. I think both of those two things make capital more expensive. But it could only be 25 BPS more. The bigger impact that Randy brings up is, if the quality goes down, I don’t think 25 BPS makes us noncompetitive. I think the banks and the life insurance companies will cherry-pick the borrowers, the markets, the assets that they like that are in their target range. But they don’t have an infinite amount of capital. So there is still a whole lot of product that needs to be financed through securitization, so I don’t think qualitatively we lose everything. I think on the margin, if CMBS is more expensive, we can lose the marginal quality loan to the life insurance company or bank. One of the reasons why the industry asked for the single-asset, single-borrower exemption is that the rules are somewhat vague about what happens to a single-borrower deal. But if you’re doing a loan on Aventura Mall and you now have to either hold 5% on your balance sheet, (5% of a billion three is still $65 million dollars) with no control since accountants would consolidate the entire loan, that you can’t sell, you can’t hedge. A broker dealer is going to charge more for that. Or, if you take advantage of the B-piece exemption and an investor has to hold that BBB bond that trades at something like swaps plus 300 over, and now you have to tell John Mulligan who bought it that he can’t hedge it, and he can’t sell if for 5 years. I don’t understand why that would be good for investors to have a single borrower deal become less liquid. That’s why it made perfect sense to ask for full exemption on all single-borrower transactions. Those are loans I am most worried about being less competitive on if we don’t come up with a solution to address it. Brian Lancaster: Jon, Randy, do you think that it will be most likely the B-piece buyers who will take the risk retention, or will it be the originators, since you have both options? Randy Wolpert: It seems hard to imagine that it wouldn’t be the B-piece buyers holding the retained amount. Jon Strain: I think it will be different for each of the investment banks and CMBS issuers. CMBS is the single structured product that was given in exemption because that’s the way our market works. Ten-year fixed-rate investments aren’t natural fits for banks’ balance sheets. I think the prospect of banks holding pari passu interests on 10 year fixed-rate loans on their balance sheets CRE Finance World Roundtable Discussion: 2014 Outlook


CRE Finance World, Winter 2014
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