By Todd McNeill
The early signals of Risk Retention are reverberating through the commercial real estate capital markets. Several conduit shops, including MC Five Mile BNY Mellon, Redwood have exited the CMBS market. Other prominent shops include Freedom Commercial Real Estate, GE Capital, KGS-Alpha Real Estate and Liberty Island all of whom cited changing regulations and market volatility as the reason for their exit. On Dec 24th, the Dodd-Frank Risk Retention Act will be in full effect. Every CMBS securitization shall now contain a 5% risk retention piece. As is the norm on Wall Street, certain traders are attempting to make the best out of a turbulent situation.
The first securitization that had a risk retention piece was in August 2016. It was well received by investors. Three banks, Wells Fargo, Bank of America and Morgan Stanley, chose to retain the risk piece in this offering. The spreads on all classes of bonds in this securitization traded well below expectations compared to those securitizations that did not comply with risk retention rules. It appears that CMBS participants with the largest balance sheets (or access to the largest balance sheets) will be the survivors of the new era. According to Trepp, between November 2016 to June 2017, $12 billion of securitized mortgages will be coming due. If the CMBS lending sector faces a disruption during this period, the consequences could be immense. The industry is keenly watching these securitizations and working on integrating “best practices” to maximize profits and ensure market stability.
Large balance sheets isn’t all that the survivors of the Dodd-Frank Risk Retention Rules will possess. They will also demonstrate the willingness and patience of investors and lenders as they will have to hold these risk retention strips for a minimum of 5 years with no hedging or ability to liquidate. Currently, there are four different ways to satisfy the Risk Retention:
- a bank retains a vertical slice of the capital stack,
- a bank retains a horizontal slice of the debt,
- a L shaped slice where a bank takes a combined horizontal & vertical slice of the debt and,
- Sell to a B-piece investor that retains a horizontal slice.
A new question arises. Will there be a difference in credit quality of deals where risk retention is retained by a bank or sold to a third party B-piece investor? The general consensus is that banks may be more willing to retain risk retention on higher quality pools while selling the risk retention on lower quality pools. This would be similar to the recent securities completed by Wells, B of A, and Morgan.
For the surviving players in the CMBS market, this may unfairly benefit the giants while harming the smaller contenders. Walker & Dunlap, Ellington Management, Jefferies LoanCore, Ladder Capital, Rialto Capital and Starwood Mortgage are all exploring how to maximize the risk retention piece of the securitizations. This gives us insight into who will be prominent entities in the CMBS market in the near future. By February 2017, we predict the market will have better understood who will emerge unscathed. Coincidentally, February 2017 will herald the Mortgage Bankers Association’s annual CREF (Commercial Real Estate Finance) conference. The conference in San Diego, has traditionally been used to announce new lending programs and production goals for the forthcoming year. Till then, the end of the year 2016 has us holding our breath. What will the new year bring? That’s the question on our minds.
The author, Todd McNeill, is a Principal/Director at Metropolitan Capital Advisors in Dallas. Todd can be reached at firstname.lastname@example.org.