How Risk Retention Affects Lenders, Borrowers, & Bond Investors (Pt. 2)

Written by Fernando Martin| September 29, 2018

Since its inception, CMBS lending has been the go-to mortgage product for larger properties with sponsors that want non-recourse financing with high leverage, low interest rates, and lenient underwriting. However, since the market collapse in 2007 and the passage of the Dodd-Frank “Risk Retention”, things have changed. Although still more permissive than conventional or insurance products, CMBS underwriting standards have become more stringent, leverage points have been lowered, and interest rates can fluctuate greatly depending on treasury indexes and bond investor demands.

“Since its inception, CMBS lending has been the go-to mortgage product for larger properties with sponsors that want non-recourse financing with high leverage, low interest rates, and lenient underwriting.”

Historically, one of the biggest benefits to being a CMBS lender is having the money that is loaned to the real estate investors replenished once the bonds are sold to investors on the open market. Since these loans aren’t kept in the lender’s portfolio, the money that is paid for the bonds flows back through to the securitizers to replace the money that was originally lent to the borrowers. However, once the risk retention rule took effect on December 24^th, the CMBS lenders had to do one of two things: 1) keep the required 5% credit risk of each securitization or 2) find a qualified “B piece” investor to take on the credit risk. Neither of these options are ideal for CMBS securitizers because of the consequences that each option would have.

“…once the risk retention rule took effect on December 24^th, the CMBS lenders had to do one of two things: 1) keep the required 5% credit risk of each securitization or 2) find a qualified “B piece” investor to take on the credit risk.”

If the CMBS securitizer keeps the 5% risk retention themselves, their liquidity would be brought down with each pool of mortgages in the amount of bonds retained. Looking at the $100+ billion worth of CMBS loans maturing over the next 18 months, this could add up to billions of dollars fairly quickly. Because only the larger CMBS lenders that are backed by national or international banks would be able to keep pace with this type of volume, this structure would have the effect of knocking out all smaller and mid-sized CMBS shops because they wouldn’t have enough liquidity to continue lending. The only work-around for this would be for the pools to contain higher amounts of “qualified CRE loans,” which are the only loans that are not subject to the retention rule.

“If the CMBS securitizer keeps the 5% risk retention themselves, their liquidity would be brought down with each pool of mortgages in the amount of bonds retained.”

If the CMBS shops are able to find qualified “B-piece” buyers that are willing to take on the risk, the bond investors would most likely require a much higher yield than they do now because of the longer hold periods and higher yield requirements. If this happens, the spreads for CMBS mortgages would go up, making interest rates higher and less desirable for borrowers. However, there is also a high likelihood that there won’t be enough bond investors to both qualify and show an interest in taking the risk retention on, leaving a large gap in the marketplace if CMBS lenders are unable or unwilling to take the risk on themselves.

“If the CMBS shops are able to find qualified “B-piece” buyers that are willing to take on the risk, the bond investors would most likely require a much higher yield than they do now…”

Either way that CMBS lenders choose to deal with this new regulation will fundamentally change the securitization process and the lenders and the borrowers will feel the result.

Want to know more about Risk Retention? See the rest of the series here:

• What is Risk Retention under Dodd-Frank? (Part I)
• Proposed Changes and Where CMBS Lending Goes from Here (Part III)