Financial Markets

Reversing The Risk Retention Rule For CMBS Could Improve Commercial Lending

By | Bond Market, Commercial mortgages, Financial Markets, Lenders, Regulation

There are several key bank regulations in the Dodd-Frank Act which if loosened could improve bank lending. One important one, is the risk retention rule for asset-backed securities including commercial mortgage-backed securities (CMBS). Reversing the risk retention rule, Section 941 of Dodd-Frank could help improve the CMBS market. The rule became effective December 24, 2015 and gave CMBS an additional year to comply which has caused lower CMBS loan origination volumes over the past year as CMBS lenders prepared to comply. It caused some smaller CMBS lenders to withdraw from CMBS lending altogether.

The risk retention rule problem

The main issue causing problems with the rule is that the CMBS issuers must have “skin in the game” by retaining 5% of the aggregate credit risk of the commercial mortgage loans that it adds to a securitization. Typically, a transaction goes like this. A lender originates a commercial mortgage and either holds on to it or sells it to a larger CMBS issuer. The CMBS issuer is an investment bank who pools other commercial mortgages from various lenders as collateral to support the CMBS. The CMBS issuer does its own homework on the loan before it purchases it.

So a lender will only sell loans that it feels would be accepted by the CMBS issuer. To do otherwise, risks the lender’s reputation with the CMBS issuer. There is already a lot of risk reduction going on before they get to the risk retention rule of holding 5%. That was not the case before the crisis for residential mortgages leading to the risk retention rule.

With the rule, the CMBS issuer, not originating lender has to hold a 5 percent interest in each mortgage they sell to a CMBS issuer. This causes issues both with the originating lender and with the CMBS issuer because the CMBS issuer must really know the lender’s origination and underwriting practices to have the assurance when purchasing loans from a lender. The bottom line is lower margins for all, higher interest rates and higher requirements for loans stemming from another rule that restricts lending. Loans that need to be refinanced and could be before the rule, now might struggle to get refinanced.

Additional issues occurring

A recent Wall Street Journal article expresses some of these issues.

“Pressures have been mounting on these firms for more than a year as volatility and risk have increased in the commercial mortgage-backed securities market.

Profit margins have narrowed in the past few months and are likely to be squeezed further as new rules take effect that require issuers of commercial mortgage-backed securities to keep at least 5% of the bonds they create.”

Some of the smaller lenders have left the business because of the new rules. Other lenders are having to increase their interest rates due to added cost of holding the 5 percent retention piece.

What to expect if you’re in the market for a commercial mortgage

CMBS lenders have, in the normal course of business, also been faced with increasing delinquency and default. As a result, according to another Wall Street Journal article more stress on CMBS lenders is causing additional requirements for commercial real estate borrowers. Some of the cautious steps lenders are taking to reduce their risk include the following. If you haven’t been in the market for a commercial mortgage recently, these are some things  you can expect.

  1. Lenders are keenly focused on their fundamentals of lending. Other than the top markets, commercial real estate geographic markets, lenders are really doing their homework and reviewing everything they can about the property in question. They are looking at the strength of the tenants, the lease terms, the net cash flow and looking closely at the sponsor’s liquidity globally not just on the subject property for example.
  2. The new risk retention rule has made borrowing more costly and complicated. Some property owners will not be able to refinance loans obtained prior to the financial crisis, or if they are able to it will be at a higher interest rate.
  3. Construction lending by banks (while not a CMBS product) has become more strict– with some of the big banks out of the business for certain property types. Part of this is the supply of new commercial properties, the other part is less permanent lending options available with CMBS. There are other non-bank lenders making construction loans, however. Some property types that remain strong candidates include industrial and multifamily.
  4. Increasing interest rates are causing lenders to underwrite commercial mortgages to higher interest rates than the current market rates -called a phantom rate. Note, a phantom rate is not the contractual rate– think of it as a stress test rate. By using a higher phantom rate, prospective borrowers will find that they are being approved, but at a loan amount lower than what they requested. So be ready to add additional cash to get a deal funded.

These and other lending rules have led to an increase in specialty finance sources to fill the gap that regulation has created with the big bank lenders. We are contacted almost daily by these lenders seeking deals to finance.

Reducing the regulatory burden

The Trump administration is working to reduce the regulatory burden that banks and financial markets are under. It could be a key step to improving the lending environment. Lenders were punished enough through their own mistaken lending practices to have the additional burden of more regulations imposed. Before any of the new regulations were written or became effective lenders had already learned their lessons. Lenders made the necessary changes to reduce their risk and make prudent loans. Banks don’t need post-crisis regulation to do it for them. Lenders are the practitioners, they know better than regulators what mistakes were made and how to correct them.

The regulatory backlash always happens after a crisis. A crisis happens, regulators point to the mistakes (that’s the easy part) and then write more rules to prevent the mistakes from occurring in the future (the hard part)– the problem is every crisis is different and rules don’t get repealed very often. Regulators have never predicted or stopped a financial crisis from occurring and it is not their mission. Even with prudent lending, lenders will have losses when the economy turns down and goes through a recession. If regulators wrote rules to prevent lenders from taking on risk and suffering losses, then there wouldn’t be any banks– because the rules would essentially prevent them from lending in the first place.

Finally, on a positive note, the economic outlook is strong and commercial real estate remains solid, and there are many lenders lending in a competitive environment so it’s still a great time for both lenders and commercial property owners.



Real Estate Investment Trusts Get Their Own Sector

By | Commercial Real Estate, Financial Markets

On September 1, 2016 the public real estate investment trusts (REIT) were given their own sector in the S&P sectors. Now there are 11 sectors. Previously REITs were combined with the financial services sector. It is anticipated that this will increase the attention that REITs receive. If you are looking for a way to compare your commercial property against a basket of other properties, this might be an option for you.

The Wall Street Journal reported, “The Global Industry Classification Standard, since its inception in 1999, has grouped companies into 10 industries, such as energy or health care, allowing investors to see and compare broad trends. Real estate will form group No. 11. The new classification from MSCI Inc. and S&P Dow Jones Indices LLC, which manage the indexes, is a recognition of the growth of the listed real-estate sector. With a market capitalization of $1.48 trillion, it now accounts for 3.5% of the global equities market, up from a 1.1% share in 2009, according to the European Public Real Estate Association, or EPRA. The new classification means “there is going to be more money looking at the sector,” said Matthew Norris, executive director for a real-estate fund at London-based property firm Grosvenor Group. “This is going to bring real estate into focus.”

For those of us in commercial real estate, we already know the yields are better than many bonds. The separation should generally help investors more clearly see the opportunity available to them in REITs. The additional investor attention should lead to increased capital being invested in these funds which should bode well for commercial properties, generally. Read the full article here (WSJ).

You can also check out the new index and get additional information on the new REIT index at the S&P Dow Jones site here.

Manage Cash Flow to Improve Your Business Credit Score

By | Commercial mortgages, Financial Markets, Lenders

By better managing cash flow in your business you can utilize both your capital and credit in a more efficient way– which will improve or maintain a strong business credit score. Cash flow becomes very important if you have a line of credit that you are drawing on. If you have a line of credit, it is to your advantage to show that you have the ability and capacity to repay the line on a consistent basis. Ideally, the balance should be paid down to zero for each billing cycle. If it is a commercial mortgage loan, whatever you do, don’t make a late payment and plan ahead for the balloon payment by seeking a replacement loan well in advance to give enough time to correct any weaknesses.

Here are some ways to improve cash flow and therefore improve your business credit score.

  • Know what your credit terms and conditions are and live by them. Do all you can to prevent violating those loan covenants.
  • Review your credit terms to ensure you are receiving competitive terms. Look at the whole relationship. Shop around find out what others are paying to give you leverage to negotiate better terms and fees.
  • Improve incoming cash by giving your customers incentives to pay you early.
  • Don’t out spend your growth by trying to grow too fast.
  • Control your costs associated with advertising, sales and administration.

At the end of the day, the more cash you report on your financial statements the better!

Banks Are Far Better Prepared For Next Downturn

By | Economy, Financial Markets, Lenders

In a recent interview with American Banker, Comptroller of the Currency Thomas Curry acknowledged the challenges facing the banking industry but said recent reforms have made the U.S. banking system more resilient. “I do think that this is an unsettled environment currently,” Curry remarked. “I think our focus as prudential regulators is really on making sure that our supervised entities are prepared for all environments. … Whatever happens with the economy, we have a much stronger banking industry.” He cited higher industrywide capital levels, improved liquidity, and more robust loss provisioning as reasons to be confident that the industry is better prepared for the next downturn. Curry also discussed efforts by the Office of the Comptroller of the Currency to warn about asset classes where banks are weakening their standards, such as subprime auto loans. He added that cybersecurity is a “constant worry,” indicating that a massive enough security breach could threaten the solvency of a smaller bank, and incidents at major banks could undermine confidence in the entire banking industry. “The first step is to have the banks be the first line of defense,” Curry said. “Then the value of the regulatory system, at least in the banking sector, is to be able to supplement that and get a horizontal view of what’s going on in the entire industry.”

From “OCC’s Curry: Banks Are Far Better Prepared for Next Downturn”
American Banker (02/11/16) Wack, Kevin

Fed Nods to Negative Rates, Hurdles and All

By | Bond Market, Commercial mortgages, Federal Reserve, Financial Markets

Legal and practical obstacles make negative rates unlikely, but Janet Yellen suggests such a move is possible

Federal Reserve Chairwoman Janet Yellen waded into fraught territory before Congress, suggesting the central bank could turn to negative interest rates in an economic downturn despite legal and other uncertainties.

Her comments Wednesday came as concerns about unsettled markets and weak global growth pushed benchmark U.S. Treasury rates to a one-year low. The yield on the 10-year note fell to 1.706%, leaving it down more than half a percentage point so far this year.

Central banks in Europe and Japan have turned to the once-radical idea of negative interest rates to spur their moribund economies. The idea that their U.S. counterpart might follow suit is unlikely but not impossible. The Fed raised interest rates in December for the first time in a decade and is weighing whether to raise them further. Ms. Yellen in her testimony said it was unlikely the central bank would need to cut rates soon, much less go negative.

When questioned about the possibility, however, she said it could be done if necessary.

“I’m not aware of anything that would prevent us from doing it,” Ms. Yellen said.

That the question even comes up is a sign of the bind central banks find themselves in seven years after the financial crisis. Growth remains weak, and investors have retreated from risky assets this year, putting pressure on monetary-policy makers to find more aggressive ways to stimulate demand.

The  Janet Yellen adopted negative rates in January, following the example of the European Central Bank and policy makers elsewhere in Europe. Countries representing more than a fifth of global economic output now are experimenting with negative rates.

Fed officials are taking the idea seriously after watching the efforts overseas. Negative rates are “working more than I could say I expected” only a few years ago, Fed Vice Chairman Janet Yellen said this month. The Fed said in recent materials related to its annual bank “stress tests” that big financial institutions need to model how they would perform under negative borrowing costs.

The prospect would face a number of challenges. A central impediment is the law authorizing the Fed to pay interest to banks on reserves they deposit with the central bank. The Fed now is paying 0.5%, a rate it moved up from 0.25% in December in hopes the economy and job market would keep improving.

The 2006 law granting the Fed that authority says depository institutions “may receive earnings to be paid by the Federal Reserve.” That language—“to be paid”—might prevent the Fed from charging interest on deposits without new legislation from Congress. The Fed looked at the legality of negative interest rates in 2010 but didn’t reach firm conclusions, Ms. Yellen said Wednesday.

The Fed faces more practical barriers, too. Fed computer systems for calculating interest on reserves don’t allow for negative rates, though they could be modified, according to an internal Fed memo from 2010 that was authorized for public release late last month. Negative rates also could pinch bank profits and the $2.7 trillion money-market fund industry that households and corporations rely on as a place to keep money readily accessible.

“We would need to see recession-like conditions before the Fed seriously considered this option,” Michael Feroli, an economist with J.P. Morgan Chase, said in a recent note to clients.

Meanwhile, the yield on the 10-year U.S. government note fell after an auction of government debt Wednesday drew strong demand from investors at home and abroad. Investors accepted a 1.73% yield on new 10-year Treasury notes, the lowest auctioned yield on that maturity since 2012.

Those results reflect investors’ struggle to obtain assets that offer a good mix of safety and income. Thanks to negative rates elsewhere around the globe, U.S. Treasury bonds offer some of the highest yields in the developed world.

“U.S. yields are still much higher than many other peers, creating demand,” said Mary Ann Hurley, vice president of trading at D.A. Davidson & Co. “There is no inflation, and the global economy is struggling.”

Should the economy sink, some economists say the Fed will have no choice but to find a way around the impediments to engineering negative rates.

In almost any likely recession scenario, the Fed won’t have been able to raise rates high enough to then lower them enough to provide real economic lift, said Scott Sumner, an economics professor with George Mason University’s Mercatus research center. So to get there, the Fed will have to go under zero with its short-term rate target, he said. “When we next go into recession, we’ll go negative,” he said.

via (wsj)

Fed Tipping Toward December Rate Hike, Minutes Show

By | Bond Market, Economy, Federal Reserve, Financial Markets, Interest rates

The official minutes of the Fed’s October 2015 meeting are available here. The key point making headlines in the press is the following section of the minutes:

“the Committee decided to indicate that, in determining whether it would be appropriate to raise the target range at its next meeting, it would assess both realized and expected progress toward its objectives of maximum employment and 2 percent inflation. Members emphasized that this change was intended to convey the sense that, while no decision had been made, it may well become appropriate to initiate the normalization process at the next meeting, provided that unanticipated shocks do not adversely affect the economic outlook and that incoming data support the expectation that labor market conditions will continue to improve and that inflation will return to the Committee’s 2 percent objective over the medium term. Members saw the updated language as leaving policy options open for the next meeting. However, a couple of members expressed concern that this wording change could be misinterpreted as signaling too strongly the expectation that the target range for the federal funds rate would be increased at the Committee’s next meeting.”

The Wall Street Journal reports that the Fed “minutes stated ‘some’ Fed officials felt in October it was already time to raise rates. ‘Some others’ believed the economy wasn’t ready. The wording meant that minorities on both sides of the Fed’s rate debate are pulling in different directions, with a large center inside the central bank inclined to move.”

But even if they do increase short term rates, a trend towards increasing rates will be slow, “At the same time, the Fed minutes included several new signals that after the Fed does move rates higher, the subsequent path of rate increases is likely to be exceptionally shallow and gradual.” Additionally the Wall Street Journal noted, “Looking ahead, Fed officials see new factors—most notably low productivity growth and an aging population—continuing to put downward pressure on growth. As a result, Fed staff argued the Fed’s target interest rate will rise only gradually as the economy strengthens. Many Fed officials have embraced that view and are trying to telegraph it to blunt the blow to markets of the first rate increase.”

Looking out longer-term,

“Beyond near-term planning on rates, discussions at the Fed turned at the October meeting to an ominous longer-run outlook.

With rates already low and not likely to move up much, the Fed’s target interest rate could return to near zero in the years ahead if the economy is hit by some new shock and the Fed decides to cut rates to cushion the blow.

One such shock might be if the Fed itself raises rates more quickly in the months ahead than the economy can bear.

“They could end up killing things pretty fast,” Mr. Blitz said. The other side of that risk, however, is that the Fed could cause a new bubble if it leaves rates too low. “They don’t have a lot of room here to get it wrong.”

Read the full Wall Street Journal article here.

Fed Keeps December Rate Hike in Play

By | Bond Market, Federal Reserve, Financial Markets, Interest rates

“Federal Reserve officials explicitly said they might raise short-term interest rates in December, pushing back against investors who have bet that the central bank wouldn’t move this year.

The message appeared to have the desired effect. Before the Fed released its policy statement Wednesday, traders in futures markets put about a 1-in-3 probability on a Fed rate increase this year; after the release, that probability rose to almost 1-in-2.

While the Fed kept rates steady after its two-day meeting this week, investors appeared to welcome a vote of confidence in the economy from the central bank. The Dow Jones Industrial Average rose 198.09 points, or 1.1%, to 17779.52.”

via (wsj)

The Fed’s October 2015 press release after the meeting can be read here.

More “TIC’ Loans Showing Up in CMBS Deals

By | Commercial mortgages, Commercial Real Estate, Financial Markets, Lenders

Commercial MBS lenders are increasingly securitizing mortgages on properties that have a complex form of ownership, creating a fresh credit-quality concern for bond buyers.

The ownership structure, called “tenants in common” or TIC, permits up to 35 investors to take passive, undivided interests in a property. The fear is that such an unwieldy ownership group can complicate workouts if a mortgage runs into trouble.

While TIC loans were securitized with some frequency before the market crash, issuers largely avoided them when the conduit sector started to revive in 2010. But such loans have turned up more often recently, as fierce competition for business has made conduit originators more receptive to such borrowers.

Loans to TICs accounted for 8% of the collective collateral pool of conduit deals that closed in the third quarter, up from 5% a year earlier, according to Moody’s.

“It’s a real demonstrable increase,” said Dan Rubock, a senior vice president at the rating agency. “Tenants-in-common are becoming more common once again, and they need to be handled with care. I’ve noticed analysts coming by my desk more often to ask me how to deal with these.”

Among the last 20 conduit deals rated by Kroll, the percentage of TIC loans ranged from 0.5% to 16.2% of the collateral balance, with the level topping 7% in 12 deals, said managing director Robin Regan.

Before the crash, some securitized TIC loans had as many as 20-25 borrowers. But over the past few years, the number of borrowers has generally been limited to five. For example, there were typically only 2-4 TIC borrowers per loan in the recent Kroll deals. That is a key factor, because there’s less risk with fewer borrowers, Regan said. But word has it that some recent TIC loans have had 10-15 borrowers, increasing the potential for problems.

While TIC loans weren’t a major source of woes during the downturn, CMBS investors and servicers are wary of them because each owner has to sign off on workouts — meaning that a single TIC investor could potentially derail an agreement. They also worry about the possibility that individual investors in a TIC could block foreclosure by organizing “serial bankruptcies” — that is, filing successive bankruptcy claims to trigger a series of automatic stays on a property seizure.

Legal protections can be built into loan terms to curb the risks. For example, lenders usually insist that a single TIC investor be designated as the loan sponsor and take responsibility for dealing with servicers, with any workout agreement binding on the other TIC owners. Likewise, a recourse provision can discourage bankruptcy filings by making each TIC owner personally responsible for repaying his share of the loan. Another option is to set up the CMBS collateral as a financeable lease, making it easier to take control of the property in case of a default.

“If you properly structure these loans, you can make them close to credit-neutral,” said Gerard Keegan, a partner at law firm Alston & Bird.

But, he added, there’s still inherent risk in dealing with multiple direct owners of a property because there is nothing to stop those owners — who are often unsophisticated mom-and-pop investors — from seeking to block workouts or file for bankruptcy regardless of the protections.

It takes considerable time and effort by originators, their attorneys, the rating agencies and bond buyers to vet TIC loans and make sure all of the necessary bondholder protections are in place. For that reason, CMBS issuers steered clear of such loans when the market revived, because they had plenty of alternative lending opportunities. But as the number of lenders competing for assignments has grown, CMBS programs have become more willing to write loans to TICs.

Another factor could be a rise in loan demand from TICs seeking to arrange financing before potential curbs on the ownership structure take effect. A bill proposed by Sen. Bernie Sanders (I-Vt.) and a companion measure sponsored in the House by Rep. Marcy Kaptur (D-Ohio) would effectively repeal Section 1031 of the Internal Revenue Code, which allows real estate owners to defer capital-gains taxes when selling a property if the proceeds are used to purchase another property of equal value within 180 days. The IRS started allowing those proceeds to be funneled into TICs in 2002.

via (cma)

Concern About China’s Sale of U.S. Debt Is Overdone

By | Bond Market, Financial Markets, Interest rates

China has and still does hold a significant share of U.S. sovereign debt. The main concern is that should China sell their US Treasury securities, it would cause U.S. interest rates to increase and be a shock on our domestic economy. These concerns were highlighted recently when China began selling their U.S. Treasury bonds and use the cash to keep their currency cheap against the U.S. dollar. By doing this, China would be able to sell more stuff at lower prices here in the US. As China’s economy has slowed down there has also been downward pressure on its currency.

But China’s sale of U.S. debt has not caused Treasury yields to increase–as so many were anxiously suggesting. Instead others have been buying those very U.S. debt securities that China has been selling. So as China has stepped out, other investors have come in buying U.S. Treasuries and maintaining the demand for U.S. Treasuries and keeping U.S  interest rates low. Another similar instance was when the Federal Reserve began to tapper their quantitative easing program and scaled back their bond buying.

What these two recent financial market events tell us is that the U.S. government bond market is much larger in depth and breath than previously thought. What this market action shows is that the world still finds U.S. debt a safe haven along with the strong U.S. reserve currency. When there is financial distress or world events that provoke fear in foreigner investors, they still come here to the U.S.A with their cash. And when they do, these investors take shelter from the storm by buying U.S. Treasuries. It is also why during the Great Recession, the U.S.A. was one of the few countries that had a strengthening currency or the least bad currency during that time. Thus, you can strike this from your list of things to keep you up at night.

Buck Stops Where? CMBS Shops Must Choose

By | Bond Market, Commercial mortgages, Financial Markets, Lenders, Regulation

Commercial MBS issuers will soon have to decide which executive at their operations will personally vouch that deal information supplied to investors is accurate.

Under an SEC rule that takes effect Nov. 24, a senior executive must sign a one-page form saying that he has personally reviewed the prospectus of a transaction being floated and is familiar “in all material aspects” with the collateral assets, the deal’s structure and “all material underlying transaction agreements.”

The form goes on to say that the signer certifies that the prospectus and supporting documents don’t contain untrue statements or omit material information.

Industry lobbyists last year tried to persuade the SEC to permit the signer to stipulate that he is relying on information provided by other parties, because a transaction’s collateral can be contributed by multiple lenders. But the regulator wouldn’t budge on the wording, which is outlined in the latest version of “Regulation AB,” the SEC’s sweeping set of disclosure rules for all types of securitizations.

The rule is intended to force issuers to more closely scrutinize collateral and raise their credit standards, following extraordinary losses on residential MBS transactions during the market crash. Violations of the certification carry no criminal liability, but could leave signers personally liable to civil lawsuits by investors or to SEC charges of civil violations of securities law.

The form must be signed by the chief executive of a securitization’s “depositor” — the entity that registers the transaction with the SEC and transfers collateral mortgages from the originators to the securitization trust.

While the depositor is essentially a paper entity, it has a board of directors made up of executives from the securitization’s lead bank. In the past, the chief executive was usually a CMBS executive, but sometimes has been a more-senior officer — such as the overall head of securitization or a risk officer. But going forward, because of the certification requirement, that post will have to be given to an executive working closely on the transaction. The most likely candidates are CMBS group heads or senior executives on their teams.

“Clearly, no one expects that Jamie Dimon will be signing the certification for J.P. Morgan deals,” said one industry attorney. “It will have to be somebody more familiar with the ins and outs of the actual deals.”

That will mean more time and effort for the selected executive and for other bankers delegated with performing some of the due diligence and briefing that person. “Signers of the CEO certification will need to consider what level of diligence will provide them with sufficient familiarity with the overall transaction to be comfortable making the required certifications,” said Janet Barbiere, a partner at law firm Orrick Herrington.

Some CMBS bankers are upset about the requirement, arguing that it’s unfair to subject them to personal liability for what should be a corporate responsibility.

“If something goes wrong in one of these deals — and you never really know everything that’s going to happen over the 10-year life of a loan — the SEC will come after you personally with all guns blazing,” said one group head at a major bank.

Another senior CMBS executive was less concerned, saying he assumed his employer will indemnify him against personal responsibility. What’s more, he added, “I have a high comfort that the descriptions of the loans we’re providing in the prospectus are accurate.”

The certification, required for public offerings, is one of a host of changes required under the Regulation AB amendments, which were finalized last year. Three conduit shops — Bank of America, Deutsche Bank and J.P. Morgan — participated in a pilot program with the SEC to devise model versions of shelf registrations that would comply with the changes. Those shelf registrations contain the boilerplate language to be used in the prospectus and the pooling and servicing agreement, with blank spaces to be filled in later with deal-specific information.

The templates, finalized in the past several weeks, followed months of discussions between the lenders and the SEC that clarified uncertainties about the changes and the exact wording to use. But there was virtually no discussion of the language for the certification, because the SEC had previously indicated it would not change the draft wording for the certification that it had unveiled last year.

via (CMA)