January 06, 2016
The CMBS market ended on a whimper to close out 2015 with approximately $100 billion of U.S. issuance, according to Commercial Mortgage Alert. Experts predicted approximately $125 billion for US origination, but it still outpaced last year’s total of $94 billion. The sector faced its fair share of headwinds during the second half of 2015, including pricing-in the Federal Reserve’s anticipated 0.25% – 0.50% hike to the Federal Funds Rate and recent volatility in the high-yield bond market partly due to a tumultuous energy sector, and the prospect of a muted Chinese economy. Stating the obvious, it shouldn’t be surprising that CMBS spreads blew out several months ago.
This volatility prompted issuers to postpone two securitizations to January in hopes of finding a more favorable pricing environment. As the industry hopes the bond market in 2016 is more receptive to these externalities, it must also cope with a stiffer breeze in terms of new regulations for the next year; specifically, two come to mind:
Regulation AB II
The Securities and Exchange Commission adopted sweeping regulations in 2014 geared towards CMBS and other asset backed securitizations. These regulations, commonly known as Reg AB, are designed to ensure lenders spend greater due diligence on the securitizations before they are offered to the secondary market. One of the aspects of Reg AB went into effect on November 25, which requires a senior executive from the CMBS issuer to attest that he or she is familiar with every material aspect of every loan in the securitization. More importantly, this executive can be personally liable for the certification, i.e. open to civil litigation, but not criminal proceedings.
This requirement has the potential to send shockwaves throughout the CMBS community since it not only will likely increase due diligence costs and delay time to market, but it may squeeze some lenders out of the sector completely. Specifically, specialty lenders that feed collateral into securitizations may be acutely affected since their due diligence resources are not as vast as their investment bank counterparts. The executive officer of the issuer may question whether smaller contributors have thoroughly vetted their collateral. This might be resolved with indemnification agreements, directors and officers insurance, or other credit enhancers, but it has the industry hurrying to address the situation.
Dodd-Frank Wall Street Reform and Consumer Protection Act
Another regulation aimed at changing how CMBS lenders do business comes from the Dodd Frank Act. There is a risk retention component that goes into effect December 2016. Risk retention requires the securitization sponsor to retain a 5% piece of the deal. In CMBS deals, this provision can be satisfied by a third-party buyer taking the bottom 5% of the transaction who must hold it for a minimum of five years. B-piece investors are thought to be likely buyers, but how this affects pricing and fees for the borrower is yet to be determined. The Commercial Observer states that industry experts speculate fees may increase 35 to 50 basis points when risk retention is implemented.
It can be argued that timing could be better to implement these regulations given the industry headwinds discussed earlier. Industry insiders will tell you the recent upward pressure on spreads have made them less competitive. However, the conduits are resilient enterprises and will adapt to change as quickly as possible, including implementing new regulatory requirements. I am hopeful early 2016 is characterized by a less volatile bond market and a new wave of industry ingenuity delivering pricing efficiencies. This might be the driver of a much-needed tailwind.
This blog post originally appeared in Transwestern's Structured Finance blog.