One of the most significant benefits of being a CMBS lender is having the money that is loaned to the real estate investors replenished as soon as the bonds are sold to investors on the open market. Because these loans are not kept in the lender’s portfolio, the money paid for the bonds heads back through the securitizers to replace the money lent to the borrowers originally.
Impact of Risk Retention
The CMBS lenders now have 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.
However, neither of these options is ideal for the CMBS securitizers because of the consequences.
If the CMBS securitizer keeps the 5% risk retention themselves, it is possible their liquidity would go down with each pool of mortgages in the number of bonds retained. This could add up incredibly quickly. The only way forward down this route would be for the pools to contain higher amounts of qualified CRE loans, which are the only loans exempt from the retention rule.
If the CMBS can find a B-piece, qualified buyer who is willing to take on the associated risk, the bond investors would most likely require a higher yield than they do now because of the longer hold periods and higher yield requirements.
Research has found that risk retention significantly impacted the underwriting of mortgages that were securitized. It was found that borrowers were paying a significantly higher interest rate to borrow on less favorable terms if their loan was going to be placed in a deal subject to the new risk retention rules. Therefore, the implementation of the risk retention rules seems to have achieved a policy goal of making securitized loans safer but at a significant cost to borrowers.
Risk-retention rules have substantially altered the look of commercial mortgage securitization. For example, the amount of risk being retained following implementation is roughly three times that of before, while lenders also seemed to accelerate the securitization of originated loans during the months immediately before the rules took effect.
Risk Retention under Dodd-Frank
The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in July 2010, created a financial stability oversight council to detect potential risks to the financial markets to prevent financial crisis. It also enables FDIC (Federal Deposit Insurance Corporation, a regulatory agency monitoring banks) to regulate non-bank institutions, including CMBS originators/securitizers that once had very little oversight.
The FDIC enacted the “Securitization Safe Harbor Rule” in September 2010 and revised it in October 2015. While explaining when the principal and interest payments should be made to investors, this rule established risk retention, which came into effect on December 24th, 2016. Risk-retention means any financial institution securitizing a group of CMBS mortgages and providing the bonds to investors must retain at least 5% credit risk of those bonds, except for qualified CRE loans.
This risk retention can be held either by:
- Keeping 5% of each bond’s tranche (vertical strip)
- Taking a 5% residual interest in the first-loss position (a horizontal strip), where strips’ value is according to actual deal proceeds (market value), unlike notional balances (par value)
- Taking an ‘L strip’ that is the ideal balance between the vertical and horizontal strips
These strips can be passed to B-piece buyers (investors who buy riskier bonds with a discount). However, the bonds must be retained for at least 5 years and may only be sold to other eligible B-piece buyers, which can take 7-10 years. Residual interest cannot be financed if passed to B-piece buyers.
Do you have questions about risk retention? At Fidelity Mortgage Lenders, we’re here to help. To get started, call us today at 800-752-9533.