Page 24 —
COLORADO REAL ESTATE JOURNAL
— March 16-April 5, 2016
Finance
T
he recent box-office
hit “The Big Short”
makes the complexities
of asset-backed securities and
credit-default swaps accessible
to the masses. Adam McKay
brilliantly uses the game Jenga
as a metaphor to explain how
subprime loans brought down
the U.S. housing market. As a
result of the financial crisis of
2008, numerous government
agencies have been work-
ing to improve transparency,
fix underwriting pitfalls and
restore confidence in the ABS
markets.
As part of the Dodd-Frank
Wall Street Reform and Con-
sumer Protection Act of 2010,
two regulatory changes go into
effect at the end of this year.
Regulation AB II and Rule 15G
of the Securities Exchange Act
of 1934 are intended to improve
transparency and encourage
better underwriting standards.
The new requirements apply to
commercial mortgage-backed
securities, a significant source
of capital for commercial real
estate and there is concern
regarding the negative effect
they might have on the com-
mercial lending environment.
An asset-backed security is a
financial security collateralized
by assets like commercial mort-
gages, residential mortgages,
credit card debt, auto loans and
leases, etc. With an ABS issu-
ance, there is one issuing com-
pany (sponsor) that bundles a
number of loans backed by sim-
ilar asset types and sells them
as part of a public offering. The
sponsor contributes anywhere
from 100 percent to 0 percent of
the loans included in the offer-
ing, with a handful of other
loan originators selling loans
into the securitization. The
sponsor divides the issuance
into different levels of repay-
ment risk called tranches. In
“The Big Short,” Ryan Gosling's
character compares residen-
tial mortgage-backed security
tranches to different layers of
a Jenga stack. The safest of the
risk tranche is the AAA. This is
at the top of the Jenga stack and
represents the security holders
paid first. The riskiest tranche
is the B tranche, also known in
the industry as the “B-Piece.”
B-Piece investors are the last to
receive payment, not receiving
it until all of the tranches above
them have been paid. This is
the very bottom row of Jenga
blocks. Historically the B-Piece
has made up 5 to 10 percent of
a pool.
Significant losses by ABS
holders during the 2008 finan-
cial crisis exposed concerns with
transparency and oversight of
the ABS securitization process.
Regulation AB was originally
created in 2004 to better address
the needs of the ABS market.
Prior to Reg AB, ABS issuances
were solely governed by the
Securities Act of 1933 and the
Exchange Act of 1934. Reg AB
II is the revision of Reg AB,
and standardizes and improves
asset-level data in ABS issuanc-
es. I won't dive into Reg AB II
as it is mainly administrative
and although it will be a huge
pain for issuers, originators and
servicers, it is not expected to
have as big
an impact on
the
CMBS
market
as
Rule 15G is.
Rule
15G,
also known
as the Rules
for
Credit
Risk Reten-
tion, requires
sponsors of
asset-backed
securities to
retain credit
risk associ-
ated with the issuance of those
securities. The belief is that
requiring the sponsor to have
skin in the game will incentiv-
ize the sponsor to monitor and
control the underwriting and
will help align the interest of the
sponsor with that of the bond
buyers. Regulation AB II goes
into effect Nov. 23, 2016, and
the risk retention requirements
go into effect Dec. 23, 2016 ...
happy holidays to everyone.
Rule 15G requires sponsors of
ABS issuances to retain at least
5 percent of the credit risk asso-
ciated with the assets under-
lying the securities. Sponsors
are restricted from hedging any
interest in the credit risk of the
securitized assets or transfer-
ring the interest for five years,
both of which were determined
would undermine the intent of
the risk retention requirement.
A sponsor is allowed to allocate
a portion of the risk to an origi-
nator that contributed at least 20
percent of the pool’s underlying
assets. The risk must be pari
passu and relate to the entire
pool and not just the assets the
second originator originated.
Sponsors can retain the risk ver-
tically, horizontally or through
a combination of vertically and
horizontally. With the vertical
retention, a sponsor must retain
5 percent of each class of ABS
interests issued as part of the
securitization transaction. With
horizontal risk retention, the
sponsor retains interest in the
first loss position, or the riski-
est 5 percent. In the event that
the first loss position represents
less than the required 5 percent,
the sponsor would be required
to hold securities in the tranche
immediately above the first loss
position. Finally, the sponsor
can hold a combination of verti-
cal and horizontal risk so long
as it equates to 5 percent of the
total securitization and the ver-
tical exposure component has
equal risk to every tranche.
Although the agencies’ main
goal with risk retention has been
to promote good underwriting,
they are concerned with poten-
tial disruption to liquidity in
the CMBS market. The ability to
sell off the B-Piece has been an
important factor determining
the liquidity of the market. With
the dangers of potential market
disruption in mind, Rule 15G
allows the sponsor to sell off
the 5 percent horizontal risk to
a third-party purchaser. The dif-
ference with selling the B-Piece
in the context of the new risk
retention rules compared to
how it’s been done in the past is
the third-party purchaser must
follow the same rules the secu-
ritization sponsor would have
been required to follow, includ-
ing holding the securities for at
least five years, as well as not
hedging the risk. The agencies
believe the new rules instead
encourage improved due dili-
gence by the B-Piece buyers, in
turn incentivizing securitizers
to better scrutinize the assets
they include in the securitiza-
tions – without disrupting the
market entirely.
The question is what premi-
um will the B-Piece investor
charge to hold the investment
for five years? One CMBS origi-
nator with whom I spoke said
his discussions with B-Piece
investors indicated a premium
of 5 to 10 percent. For every 1
percent increase in the B-Piece
price, CMBS spreads increase 2
basis points, so using this math,
borrowers can anticipate a 10 to
20 bps increase in rate. A differ-
ent CMBS originator was not
as confident in predicting the
cost. To him the five-year hold
requirement was very concern-
ing as groups typically investing
in the first loss position require
liquidity and will be uncomfort-
able entering into trades they
can't get out of for five years. In
his mind, the number of B-Piece
buyers will shrink, driving up
pricing even more. One thing
both originators agreed on was
that vertical retention is unlike-
ly. Issuers won’t want to hold
the securities on their balance
sheet for an extended period of
time, so selling the horizontal
risk to a third-party purchaser
is the likely scenario to satisfy
the new requirements.
There is concern surrounding
CMBS loans maturing in the
second half of 2016 and begin-
ning of 2017. Those borrowers
might want to consider refi-
nancing early or looking into
alternative financing options. It
is to be seen what effect the
new regulations will have on
the market; however, like the
characters in “The Big Short,”
Wall Street will work diligently
to figure out how to get through
– or around – the new regula-
tions. In the meantime, if you
haven't seen or read “The Big
Short,” I highly recommend it.
Seventy-seven pages into his
book, Michael Lewis gives his
readers a gold star for getting
that far. If you’re reading this
last sentence, I feel I too should
offer you congratulations.
s
Dan Konecny
Vice president of loan
production, Essex
Financial Group,
Denver
The belief is
that requiring
the sponsor to
have skin in
the game will
incentivize the
sponsor to
monitor and
control the
underwriting and
will help align
the interest of the
sponsor with that of
the bond buyers.
