Three of Wall Street’s biggest banks are preparing a CMBS bond that will test new regulations on risk and could mark a fork in the road for the financing of US commercial real estate.
The bond is expected to be backed by a pool of roughly US$1.1bn in commercial mortgages from Wells Fargo, Bank of America and Morgan Stanley, three people with knowledge of the trade said.
Like all such offerings, it will have to win the confidence of wary investors who are skittish about buying bonds in a sector feared to be in another bubble at the moment.
But the true measure of the deal’s success will be whether it can pass muster with US regulators tasked with overseeing rules on risky assets that come into effect at the end of 2016.
Success means cash will keep being available for malls, hotels, office towers and other properties funded by the US$600bn commercial mortgage bond industry. A failure, however, could slam the brakes on what has long been the industry’s key source of capital – cash provided by investors who buy bundles of mortgages turned into bonds.
“It is a test case for the industry,” said one source. “The industry wants an answer.”
Sea change
So far, however, answers have been hard to come by.
In the wake of the financial crisis, tougher rules were drafted that require originating banks to hold at least 5% of any new CMBS deal on their own balance sheets – or find investors who will hold it instead.
The so-called risk-retention rules force banks to keep “skin in the game” when selling new mortgage bonds – and avoid the fast-and-loose attitude that helped spur the last crash.
The people with knowledge of the new deal said that it would be roughly US$1bn in size, meaning that banks selling the securities would have to retain around a US$50m piece of the bond.
They said the banks planned to keep a “vertical” strip of the deal – that is, a sliver of each class of the bond, from Triple A all the way down to the unrated bottom. The banks, they said, plan to argue that the strip – which must be retained for the life of the bond, which in the CMBS market is typically 10 years – constitutes a loan.
If regulators agree, the capital charge incurred by the banks could be 8% of face value, or US$4m, said two of the people, who have both been consulting banks on the strategy. If the strip is not counted as a loan, the capital charge for banks holding that risk on balance sheet could be four times higher, the sources said.
In the event that the regulators reject the loan idea, the vertical strip would constitute a bundle of securities that require a much more expensive capital buffer – which would be compounded by each new strip the banks would be required to keep.
“What our friends at the banks are trying to do is run this up the flagpole and see if regulators will react before the end of the year,” one of the sources said. “I hope regulators give their okay. But I think we are still very much at sea.”
Not smooth sailing
During the comment period when risk retention rules were first discussed in 2010, regulators said several times that loan participations would not qualify under the rule.
For the banks to get their way, six different regulatory bodies – including Securities and Exchange Commission and the Federal Reserve – would have to weigh in. Representatives of the agencies who could be reached declined to comment on whether the proposed vertical strip structure would fit their criteria.
But while there are clearly regulatory risks to be considered, the main issue for the banks is how much extra capital they would have to hold – how expensive it will be – to issue new CMBS deals under the new regulations.
Wells Fargo and other banks planning to keep a vertical strip want regulators to agree to them holding just 8% of additional capital against their retained position, people familiar with their efforts said. That would mean earmarking about US$4m of additional capital on a US$50m retained position, but up to US$15m if regulators take a more aggressive approach, they said.
If regulators do not agree with the banks, the future of the CMBS industry looks to be very much up in the air.
Regulators have already agreed to let so-called B-piece buyers take on the 5% stake if the banks do not want to, but they would also have to retain their holdings for longer. And those investors – named for the bottom, riskiest parts of bonds that they buy – make much of their money by quickly recycling their purchases.
Market participants say those buyers – typically firms backed by hedge funds and private equity – have been unable to raise enough capital under the new regulations to buy bonds that anchor new issuance.
That means this new test of the vertical strip may be one of the last ways of keeping the CMBS industry afloat.
“These are large and significant problems with real costs,” said Paul Forrester, a partner at law firm Mayer Brown focused on risk retention. “There has been no clear regulatory response – and we are running out of rope.”
