Two and a half years after Dodd-Frank and almost two years after the first hurriedly issued proposed rules, the six agencies (Department of Housing and Urban Development, Federal Deposit Insurance Corp., Federal Housing Finance Agency, Federal Reserve, Office of the Comptroller of the Currency, and the U.S. Securities and Exchange Commission) charged with creating risk retention architecture for commercial mortgage securitization have yet to issue a final rule, interim final rule or even a new proposed rule. Since Dodd-Frank provides a two year transition period after publication of a final Rule (or perhaps interim final rules), we might think, no Rule, no risk retention; all is good, no worries. Bad way to think about this. Something is coming out soon. It will be important. It may start affecting our business now. I don’t think we can or should be complacent. More on this later.

What we’re hearing from the panjandrums of the regulatory community is that the horrific concept known as premium capture cash reserve account (PCCRA) is finally cold and dead (although until I see sunlight shining in its grave and a stake in its heart, I won’t be sure), and that the regulation writing committee is settling on an alternative, focusing on risk retention to be satisfied through a B-piece buyer holding a horizontal 5% first-loss strip (the B piece fix was, of course, added to the statute by amendment by Senator Crapo, bless his heart). On this topic the statute said:

The regulations prescribed under the risk retention requirement shall (B) require a securitizer to retain (i) not less than 5 percent of the credit risk for any asset (I) that is not a qualified residential mortgage that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer, and …(E) with respect to a commercial mortgage, … (ii) retention of the first-loss position by a third-party purchaser that specifically negotiates for the purchase of such first loss position, holds adequate financial resources to back losses, provides due diligence on all individual assets in the pool before the issuance of the asset-backed securities, and meets the same standards for risk retention as … the securitizer. (Dodd-Frank Section 941)

After having vigorously and stubbornly embraced premium capture, having to walk it back in the face of compelling objections from the regulated community (structurally, it would have entirely ended securitization as a viable business) the agencies have, as a consolation prize, embraced a new version as the 5% retention rule. Under this provision, the B buyer, in order meet the risk retention obligation of the issuer, would have to buy 5% by value of the underlying assets, and hold that position for five years.

As those in the securitization world know, the current architecture of the business is that a B buyer buys roughly the bottom 5% of the face amount of the certificates at a significant discount to par or face to reflect the risk of owning the bottom of the capital stack. Broadly, this is the non-investment grade portion of the capital stack. It is also free to sell or hypothecate that position at any time. If compelled to buy 5% by value, it will virtually double the size of the B piece and significantly torque the business model. Bottom line: does the B buyer buy investment grade bonds at the yields that such bonds would attract in the open market, therefore, radically reducing the value of the investment to the B buyer, or does the B buyer buy the entire position up through the investment grade bonds at the same yield at which it buys the non-investment grade, thereby, significantly increasing the cost to the issuer? One side of the trade or the other is going to get gored by this regulatory change. Free market outcomes will be frustrated. Consequently, as the business is torqued to meet regulatory goals, securitization will get less efficient, the cost of capital to the end user will go up and the availability of capital will diminish. That’s what we call unintended consequences.

Well, that’s the headline bad news. But we’re not here today to rehash all the arguments that the rule is intellectually fraudulent and horribly ill-designed to serve its intended purposes of improving the function of the capital markets. Water over the dam. Today, let’s focus on all the second tier questions such a rule, when drafted, needs to address.

Imagine an exposure draft (or, worse, a final or interim final rule) comes out tomorrow (and it might come out tomorrow). What will it say? We don’t know and the tea leaves have been few and far between on this. Here are some of the things that really need to be addressed to make this Rule operational:

• Who will qualify as a B piece buyer? Will there be criteria for minimum net worth, minimum liquidity, capabilities, track record, etc.? Must it be a QIB? A QIL? Or something new?
• Can the position be levered? The statute says that if the Issuer holds the 5% horizontal strip, it cannot lever the position with non-recourse debt. What will be the rule as to the B piece market? The realities of the business model are that yield needs to be quite high to pay for the assumed risk of holding first loss paper. Will there be no more non-recourse lever? Is recourse to an entity that just owns the bonds OK? Must there be a guarantor or sort of net worth liquidity or AUM requirements applicable to it?
• What happens when appraisal reduction eliminates the B piece buyer control (as it does under CMBS 2.0 deal structures)? Must the B buyer continue to hold yet have no control? It would certainly make no sense to anyone entering the B piece business. Does this even carry out the Congressional intent?
• How about when realized losses eat the B piece away? Is the vehicle still in compliance? Must a new B piece holder be designated and agree to hold its bonds in accordance with the obligations of the original B buyer? That seems absurd, not to mention hard to implement and would certainly be the end of liquidity in junior investment grade bonds.
• What happens when the B buyer breaches its covenant regarding leverage, assignment, hypothecation or the like? Remember the retention obligations attached to the issuer, or in some cases the originator. The B buyer undertook its retention obligations under the pooling and servicing agreement. Who gets to enforce it? What happens if the enforcement effort fails? How about during the period in which the enforcement effort continues? We know that litigation of complex commercial matters in the U.S. courts is not a quick or easy process. Remember that if the issuer fails its B piece obligation it faces civil penalties including three tiers of fines. (Dodd-Frank Section 929P)
• What happens if the B piece buyer becomes insolvent and its assets are transferred by operation of law? Same issue?

What do we do with deals with only investment grade bonds? Shouldn’t there be another exception, maybe based on Section 943 of Dodd-Frank dealing with high quality representations and warranties or the qualified commercial loans or qualified commercial real estate ("CRE") loans (§__.18 to §__.20 of the proposed rules) that might alleviate the need of a B piece in deals tranched only to investment grade? Wouldn’t it be silly to create a B piece in that case just to meet the requirements of the statute? When one thinks of the underlying policy purpose of the statute, a low leverage deal without a B piece should meet it. The proposed rules contain the concepts of qualified commercial loans and qualified CRE loans which could easily fix this. The qualified loan in the proposed rules was insanely narrow and industry research indicated that virtually no loans ever originated for securitization would have met it. The chatter is that it will be designed to be unavailable, forcing issuers to some other form of risk retention. It’s silly when prescriptive rules conflict with sensible policy descriptions and this seems to be the case here.

Finally, in just the musings of a paranoid lawyer, it’s been two and a half years since Dodd-Frank and these regulations were supposed to be effective two years after implementation which, I suspect, Congress thought would happen tout suite after publication of Dodd-Frank. Now, if the regulations come out in final or interim final form (which, the regulatory types tell me, an interim final rule will begin the two year tolling on effectiveness), the industry will have almost five years since Dodd-Frank. Might some regulatory agency try to shorten that time by adopting this Rule or the substance of this Rule in another context where there would be no two year transition rule? It seems to me the temptation is there and we need to be diligent for any hint that such a bad surprise is being cooked up. OK. So I’m paranoid. But in this political environment I worry about ill-thought through regulations that have more to do with the ideology than the practical delivery of the risk mediation the rules were designed to provide.