Risk Retention Re-proposal: The Good, Bad, Ugly And Unintended

by Dechert LLP
Contact

The new Risk Retention Rule published jointly by the FDIC, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System and the Securities Exchange Commission, with a little help from the Federal Housing Finance Agency and HUD slouched into the light of day on August 28, in the lee of the holiday weekend. Reportedly, it's been locked and loaded for months as the regulatory panjandrums wrestled over the politics of the Qualified Mortgage. Really? The day before the long weekend? Isn't that a tell that it is less than entirely estimable? Didn't Nixon resign on a Friday? It's like maybe no one would notice the delivery of a long-anticipated 550 page opus which has, in its gift, the continued vitality of structured finance at large?

Well, we're all reading it now. I have been mulling this edifice and talking about what it means with many, many people who are very invested in getting this right. Frankly, this thing is a very hard read. Its breadth is quite extensive and its clarity comes and goes. Given the witch's brew of a regulation drafted by a committee of committees, the conflicting goals and guideposts of those regulatory constituencies, the incredibly complex business on which this regulation scheme is overlaid, and the swirl of politics around the issues giving rise to this regulatory construct, figuring this out requires a literary deconstructionist's sensibility to figure out what's wrong and what might need to be fixed.

There is a half dozen trade organizations working on comment letters and Dechert is active on most of these undertakings. With an outside comment date of October 30th (and notwithstanding pleas for more time, little likelihood the regulators will brook any delay), we really have to hustle if we want to make an impact. Here is the lead: There is plenty in this Proposed Rule that strongly suggests to me that what it appears to require may not be what the regulators expect will be achieved as, in some measure, the assumptions about the structure and performance of the securitization industry on which it was constructed may not be entirely valid. Consequently, this is fertile ground for unintended consequences. When they come home to roost, it will not be a good outcome.

Well, we do have the balance of a 60-day comment period, and embracing my sunny optimism, perhaps some of our comments, if well made and convincingly substantiated with facts, may actually affect the form of the Final Rule. And, as we have observed before, this puppy has a two year transition rule which commences on the publication of the Final Rule in the Federal Register. Assuming that happens sometimes early in the new year, its effective date will see the passage of a congressional and a presidential election and God knows what else. In this mad world whether things deemed final in 2014 will still be final in 2016 is anyone's guess.

There will be plenty of room for many, many technical comments to just try to make all of this work better, indeed to work at all. But for cocktail party purposes, here are my preliminary cliff notes on the big issues of the Proposed Rule:

  • Resi got a pass. The Qualified Mortgage rules as proposed reflect a victory for the political and policy constituencies in favor of maximizing the ease of capital formation for the residential market place. In that wrestling match, safety and soundness got just plain thrown down. Estimates vary but between the exception for assets guaranteed by the GSEs (but there are going away eventually, right?, right?), and the relatively easy-to-meet underwriting criteria of the QM, perhaps as much as 85 to 90% of all residential mortgages will get a pass on risk retention. One might say that this is good policy for the restoration of our ownership society. One might wonder, however, how the epicenter of the last financial crisis gets a pass from the centerpiece of the regulatory construct designed to prevent a do-over.
  • Premium capture is dead. That is an unequivocal good, and we should take a moment to honor its death. Oh, by the way, you are still entitled to use premium capture as an alternate modality for risk retention; a special opportunity for the differently-abled.
  • 5% risk retention is now measured by fair value, not par. This means that for a straight, horizontal or first loss risk retention piece, the B buyer would be holding up into the investment grade bonds based on the current structure of publicly offered conduit CMBS product. That's a problem, as it is wildly inconsistent with a business plan of the B buyer community to hold spread product on an unlevered basis for a long period of time. Much is now made of the fact that risk retention can be both horizontal and vertical, the so-called L-shaped retention and that the relative elements of the horizontal and the vertical element can be agreed on by the parties. Terrific. Look, it's better than it was in the original proposal. A traditional B piece buyer can now buy a traditional B piece, which might get you to 2.5% or so on the required risk retention, and the sponsor can construct another 2.5% of risk retention through a vertical strip – that's a good thing. No, really, it's a good thing.
  • The document includes some seriously fancy-pants calculations of what 5% means, comparing projected cash flows and projected principal repayment rates, which may be a "gotcha" as drafted. Essentially, the B piece cannot get more cash than an amount in proportion to principal amortization. Apples and oranges – what's going on here? Given the sequential structure of most structured finance products and the securitization of no or slow amortizing loans, it seems many B pieces will fail this test. Maybe this is a mistake. Maybe. If this is an intended feature of the Rule, it is bad and we are in trouble. Could someone just ask the FRBNY and figure out if this is a typo or a gotcha?
  • Within this 550 page edifice, there is curiously little said about remedies. Oh, certainly, the relevant agencies will have broad enforcement remedies but the regulation says precious little about what actually to do when something goes awry. If the sponsor uses the B piece modality to meet its risk retention requirement and the B piece buyer either intentionally or unintentionally violates the conditions of risk retention, the document tells the sponsor in the sternest terms to tell the investors. Gotcha. That's it? How can a sponsor be responsible or really even monitor what a B piece does after closing?
  • If the sponsor elects to hold risk retention on a vertical or horizontal basis, the general rule is that it must hold it until the later of 2 years or when the pool has deleveraged to 33% of the original deal size. CRE gets a special rule that allows the sponsor or the B buyer to sell the position to another who will continue to meet the risk retention requirements of the Rule. The B buyer has to hold this paper without non-recourse leverage (and without risk specific hedging). As the successor B buyer has to continue to hold that paper on the same basis as the original holder, I am not sure how much good the 5 year exception to the hold period actually is. On the other hand, there's not a lot of rigor around the organization of the B buyer, how it is organized and the financial condition of the B buyer which certainly will provide some opportunities for recourse financing that might feel a bit less so.
  • The commercial side version of the Qualified Mortgage called the Qualified CRE Loan, is a very tiny place. Perhaps a few more loans would fit into it now than did when the original proposed Rule was promulgated, but not many. This would be good, as inclusion of such loans could reduce the 5% risk retention to as low as 2.5%. Clearly, the message is the only way you're meeting risk retention in commercial land, boys and girls, is by holding horizontal or vertical risk.
  • For reasons which only appear to be mean-spirited, the regulators willfully ignored the compelling arguments the industry made that a standalone which is tranched to investment grade should not have to have risk retention through either horizontal or vertical strips. Give me a break – tell me that a 35% LTV loan on a trophy property in Manhattan is somehow riskier than a pool of brand new minted QMs. With apologies to Evita; Politics, the art of the possible.
  • The Operating Advisor: Still with us. Joy. The role of the operating advisor is, on balance, slightly diminished from the original Rule but still greater than in the current version of CMBS 2.0. After the B buyer burns off (assuming there is one), the operating advisor can recommend the removal of the special servicer. While this requires an affirmative vote of certificate holders, it only requires such a vote of a quorum of 5%. As we know, it is almost impossible to get a lot of investors together, but a 5% quorum; that's doable.
  • There are some funky disclosure provisions in the new Rule that presumably, although not certainly, can be met as additions to the FWP or OC. One of these provisions requires an analysis of all of the reps, all of the exceptions, and an explanation of why loans that didn't meet the reps were included in the pool. I am sure there are trial lawyers cheering somewhere over that.

So what do we do? We need to focus on the existential issues and not fritter away any chance of credibly getting regulatory engagement which could lead to some important fixes by deluging them with a textual version of "we just don't like this at all." 

For my money, the priorities are: 

  • Fixing the cash flow to principal payment ratio test so that the B piece solution actually works. If we don't get this fixed, the B piece solution will largely go away. I do not believe that was the regulatory intent. I hope I'm not being Pollyanna-ish.
  • Insuring the sponsors do not get severely penalized for events outside their control when a B buyer does not meet the requirements of the reg. While an obligation to try would be acceptable, a broken B piece buyer cannot trigger draconian damages or loss of access to shelf eligibility or the like.
  • A bit of a more reasonable CRE qualified mortgage would be lovely.

Beyond this, we could certainly be helpful on a whole host of technical issues if the regulators will engage, but let's make sure that everyone understands wherein lies the main chance.

For a perhaps more balanced and scholarly analysis of the Proposed Rule, please take a look at our OnPoint. For a laser like look at how this applies to CLOs take a look at our other blog post on how the Proposed Rule applies to CLOs.

 

Written by:

Dechert LLP
Contact
more
less

Dechert LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.