We thought it would be useful to give a quick, interim update on the slow-motion train wreck that is our industry’s response to the upcoming effectiveness of the Risk Retention Rule. For those of you who have been blessedly snoozing under a rock these past couple of years, the Risk Retention Rule becomes effective on Christmas Eve and applies to all transactions closed (priced?) after that date. The Rule, to generalize a bit, requires the sponsor of a securitization to retain a 5% vertical or horizontal strip with the additional possibility of laying off some or all of that risk onto a qualified B piece buyer or a mortgage loan originator. For more detail, please see our OnPoints, our risk retention briefing white papers and many, many back issues of this CrunchedCredit.
Here’s the headline in Muddville in May of 2017:
We As An Industry Are In Trouble.
We as an industry don’t have a scalable solution to the problem. We as an industry do not know what this will cost, who will pay for it, and to what extent this is an existential risk to CRE capital formation as it has been conducted for the past twenty-five years.
Now there’s an above-the-fold headline if I ever saw one. Am I being hyperbolic? Well, I have occasionally been accused of so being but, remember, hyperbolic-ness in the pursuit of liberty is no vice. A certain amount of a “pants on fire meme” would not be wholly inappropriate right now.
Take a quick look at the balance of 2016. Given the time it takes to put a pool together—with a 60-day average delay from term sheet to closing and a little windage for the fact that nothing goes quite as planned—one must take into account the possibility of adverse credit conditions late in the year. We’ve seen that movie several times of late. What it really means is that a lender who is a card-carrying member of the Originate-to-Sell Club better have real clarity about how to execute a transaction under the Risk Retention Rule by about Labor Day. Last I checked that was roughly a hundred days from today.
Don’t get me wrong, there’s stuff happening. People are fixing to think about this. There are any number of players trying to build some conviction around a strategy to conduct business in the Post-Risk Retention world, but right now, conviction is in very short supply. Blame the Rule and the regulators. There are vast oceans of white space in this Rule. There are so, so many unanswered questions that are critical to sorting out how to comply. And the regulators themselves, they make the Oracle of Delphi look like a loquacious model of clarity. So, at best, we’ve got a Rule we can’t figure out how to implement. At worst, we’ve got a Rule that simply can’t be mapped onto the existing realities of the business model.
This is a little like those complex Christmas presents that you have to build for the little ones. With a snootful, you confidently start to build the thing around10 p.m. on Christmas Eve. How hard can this be, you think. And then you read the instructions, first written by a Korean engineer and then translated by a Mandarin speaker from Dutch to English. Page one: “With your hex handed screwdriver, now, flom the jabberoo.” Sure.
If there is a narrative out there, it runs along the lines of “I’m waiting for someone smart to figure out what to do and we’ll do that, too.” The problem is, said hypothetical smarty-pants hasn’t yet figured it out. There are asset managers out there trying to build compliant B piece purchasers, but what do you tell investors when the hold might be ten years (or even more) depending on what happens to the cycle? How do you deal with indemnity requests, particularly when investment advisory agreements are terminable at will? Can you offer liquidity to investors? How about some nifty “recourse leverage?” If you are an insured depository institution, what are the consequences of holding a vertical interest? Is an MOA structure helpful? Or not? Just how okay are you with holding other people’s cooking on a long-term basis?
There are many who have read the writing on the wall about risk retention and about the enormous panoply of regulatory intrusions into the life of the prudentially regulated banks and who see this whole business model at risk. Here’s a flash. There are many in the regulatory apparatus who just plain don’t like securitization and blame it, wrongly to be sure, for the Great Recession. They apparently don’t care if all this goes casters up. Might it be a good idea to do this in the unregulated market? How to raise the capital necessary? How much clarity do we have around the structure of an ownership in an MOA? How hard really is it to build a securitization business from scratch? (Hard!) And if you build it, will they come?
These are all terrific questions, but they are the same questions that we have been dealing with for the better part of a year and we are strikingly no closer to clarity today than when folks began to engage these issues last fall (it’s like Groundhog Day but no one gets the girl (or Bill Murray, depending upon your constitutionally protected orientation and bathroom usage)). The only difference is that, last fall, compliance was a year away and now it’s just a few short months until a real solution is needed.
It’s been reported that Wells, BofA and Morgan are going to float a trial balloon this summer by doing a risk compliant, registered deal on the theory (the hope?) that it will compel engagement by the regulators on structure and capital. Good idea, but it has more than a whiff of a Hail Mary about it. Maybe it will resolve enough of the uncertainty to allow this business to continue to thrive, but if not, it will be time out, game over, and we’ll confront Christmas Eve with continued uncertainty and with a considerable amount of trepidation.
Hey, this business will survive. The capital markets will continue to support commercial real estate. Without a robust CRE securitization business, one can’t solve the simple equation that the demand of capital borrowers must always equal the supply of capital. But who delivers those funds and how and in what structure remains strikingly uncertain. Uncertainty is inefficient. Uncertainty costs money. Uncertainty will be painful for the CRE capital markets and, at least in the short run, it will hurt capital formation and impair the efficient delivery of capital to commercial real estate. That hurts our economy. Atta boy, Mr. Government. That’s what you wanted, right?