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.
- 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.
- 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.
- 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.
- 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.