As we begin to close in on the initial implementation of the Risk Retention Rule, we are looking beyond the headlines and trying to figure out how the Rule will actually work.  The result is troubling.

First, let me remind you that your hair is indeed on fire.  The Risk Retention Rule affects every single securitization in every single asset class subject to US law.  That is hundreds of billions of dollars in transactions a year.  It will compel industry participants to make or hold unnatural investment positions and undertake liabilities contrary to those supported by market forces.

For the nonce, however, the Rule is the law of the land and we have to figure out how to comply with it.  Except for the poor bastards in the private label resi world (staggering around after a cretaceous-like extinction event brought about largely because of wrong-headed regulatory dictate…but that’s another story), the effective date for most of us is December 24, 2016.  That sounds like a long way away.  It’s not.  The problem is today.  Originators that need to sell loans into a risk retention compliant structure but don’t know what that structure is, are likely to stop originating loans sometime late Q3 next year.  Well before then, structures need to be agreed to and capital needs to be raised.  December 2016 is tomorrow.

Now that I have everyone’s attention, here’s the bad news:  There are a lot of unanswered questions about how the Rule works and, right now, no one to answer them.  As we look beyond the headlines and try to actually use the Rule to build compliant securitization structures, you discover that the arc of the Rule is like a fractal.  The closer you get, the more ragged the shape of the Rule becomes and more unanswered questions reveal themselves.  As we actually try to apply the Rule in individual cases, we see it clearly.  We see the unanswered questions lurking in the interstices between little islands of certainty in this monstrously important Rule that, at the end of the day, is a mere 25 pages in length.  God knows I loath this type of intrusive regulation, but if the regulators are going to regulate, couldn’t you do it clearly, please?

It’s absolutely astonishing how much becomes unclear when you actually sit down to build a risk retention solution.

And let’s be real here, we’re not going to see any material changes to the Rule before this goes live.  We are not going to see “technical corrections.”  The Agencies exhausting themselves birthing the Final Rule over a year ago and reportedly, comity, let alone agreement, was hard to come by in this interagency scrum.  Bringing the band back together again to issue anything that would even look like a technical correction is not happening.

On the other hand, hope dies hard and there are questions that might be posed to the Agencies that are not likely to cause regulatory turtling.  If our asks are modest and targeted, we can perhaps get some informal guidance on what the Rule means and knowing even a little more could be very important.  Everyone leaks these days, all we’re looking for here is a little useful leakage.

A really good example of what I’m talking about is a question that has swirled around the single family residential business (SFR).  For those not playing in this sandbox, the SFR business is the business of acquiring single family residential properties and leasing them out.  It is a business in which there are some small fry owning a few houses to big players like Starwood, Colony and Progress Residential which own thousands of units.  It’s the business of managing deconstructed apartment buildings.  Both in the single borrower format and the multiple borrower format, these deals have been aggressively acquiring term financing through securitization.  This business hadn’t even existed when the rule making process around the Risk Retention Rule began and indeed wasn’t even a thing when the re-proposed Rule was last opened for public comment.  So what’s the problem?  From the text, it’s entirely unclear whether loans backed by these properties are residential or commercial loans.  You can see the potential regulatory urge to view lending against these properties as another species of residential lending.  But from a common sense perspective they surely are not.  This matters, because if they are residential loans, risk retention happens on December 24, 2015… that would be a little over 10 weeks from now.

The Mortgage Bankers Association took point on this issue and has had a dialogue with the Agencies saying:  Listen, we’re not telling you what it should be, but you ought to tell us what you think it is.  Very recently, the SEC staff indicated informally to industry constituencies that they don’t view SFR as residential.  That’s super helpful.  (Another question is whether it is actually commercial.  On that point, we don’t have an answer, but at least we know we don’t have to impose risk retention on SFR loans until Christmas Eve 2016.)

That type of input is helpful and where I don’t see big ticket regulatory change, this sort of clarity is a reasonable ask and where we may get productive input.  It is indeed essential if we are going to construct legal structures to meet the Risk Retention Rule when it becomes applicable in very late 2016.

Here are some examples of things that I don’t think are clear, and where we might, if we ask nicely, get some guidance:

• If a B-piece buyer sells its B-piece after 5 years, does the subsequent B-piece buyer have to hold for any particular period of time? The Rule says that the subsequent B-piece buyer has to satisfy the initial B-piece buyer’s hold period.  Well, that makes no sense since you cannot have a subsequent B-piece buyer until after the initial B-piece buyer’s hold period is over.  Because it makes no sense, one wonders what it actually means.  I hope it means that a subsequent B-piece buyer can sell its interest at any time and has no further hold period.  It would be nice to really know that.
• The Rule prohibits third party purchasers from using funds provided by a person who is a party to or an affiliate of a party to the securitization. Does this mean that even such non-sponsor parties as trustees and custodians, who are typically major banks, cannot provide banking services to the B-piece buyer market?  That would be unfair and would make no sense.  Some of the largest money center banks in the country play supporting roles in securitization and also provide substantial liquidity broadly across the markets.  I cannot see a reason why they should be prohibited from continuing to do so.  That would only hurt the operation of the markets broadly.  But the Rule’s prohibition is written in very broad language.
• The Rule says that there may be multiple sponsors to a securitization and the sponsors need to pick one to be the risk retention party. The Rule also says that a sponsor is defined by reference to Reg AB II.  But the Rule also says that the party which has the most control over the quality of the collateral and the Sponsor is a person “who organizes and initiates a securitization transaction BY (emphasis added) either selling or transferring assets to the issuing entity.”  So:
• Could any sponsor be the risk retention party? Under Reg AB anyone who contributes a loan into a securitization is a sponsor.
• Can a sponsor even with a de minimus amount of collateral in a pool be the risk retention party?
• While we are at it, if one sponsor elects to discharge the risk retention obligation and then fail to do so, are the other parties deemed sponsors with respect to that transaction liable?
• What’s the story on direct issuance deals? If the issuer is the lender, is there a Sponsor?
• Should we expect any further guidance on recourse, treatment of Memoranda of Agreements, the capital structure of parties that may hold the risk retention and the like?
• There are complicated affiliation rules around third party purchasers. Should the affiliation rules prohibit a party from being a third party purchaser because it is related to the trustee?  The custodian?  The operating advisor?  That all seems inconsistent with the purpose of the Rule.
• Could you give us a hint on penalties? The Rule has nary a word on penalties, and on things like that, I just hate to speculate.  It would be terrific to know that some notion of good faith effort could inoculate a sponsor from penalties.  If a sponsor sells a B-piece and does everything in its power to insure the B-piece buyer continues to meet the obligation of the Rule, shouldn’t that be enough?
• And finally, I can’t help myself here. While this admittedly doesn’t fall into the litany of minor clarifications, why in the world can we not get a qualified mortgage exemption for single asset, single borrower, and extraordinary low loan to leverage deals.  What’s the point of a vertical strip that’s all investment grade?  What’s the point of a horizontal strip that itself is investment grade?  It was just petty that the regulators didn’t give us some help on that.

In any event, there is some wood to chop and there is some hope that on some of these more technical issues we can get some guidance from the regulators.  As we get closer to actual implementation, and recognizing the devil is in the detail, more of these small ball issues will arise and become important.  It would be terrific if the Agencies would establish some form of Q&A or staff chat room where guidance on such technical issues that doesn’t change the import of the regulation could be resolved.  That, however, may be a bridge too far.  But, let’s be totally clear here, uncertainty doesn’t serve the purpose of the Dodd-Frank Act or the Risk Retention Rule.  It just burdens the process of getting deals done.

Guidance from the Old World anyone?  Our European friends are in the middle of a volte face and now are considering reducing red tape to lift investment.  This little bit of good news showed up in the Financial Times on October 1 and it cheered me considerably.  Late last week, the European Commission issued an open appeal for evidence of unnecessary regulatory burdens and other unintended consequences of its banking and marketing laws!  This is change of biblical proportion; I mean Old Testament, real wrath of God type stuff.  Fire and brimstone coming down from the skies!  Rivers and seas boiling!  Forty years of darkness!  Earthquakes, volcanoes, the dead rising from the graves!  Human sacrifice, dogs and cats living together (… with apologies to Ghostbusters).  That’s refreshing!

To my readers, let me know what questions you have that fall into this “Clarification, But Not Change” bucket.  I’d love to collect as many as I can and open a dialogue with our friends in government.

To my friends in the regulatory apparatchiki:  Come on, folks!  There’s no excuse not to give us a little help here so that we can at least effectively design the structures critical to actually doing what the Risk Retention Rule told us to do.