If the pricing of a recent commercial mortgage-backed security deal is any indication, risk-retention rules are giving large banks a competitive advantage in this market.
The rules don't take effect until Dec. 24. But the first CMBS deal designed to comply with the Dodd-Frank Act requirement to keep "skin in the game" closed on Thursday. The $870.6 million transaction was well received by investors, and market participants credit the way in which the three sponsoring banks – Wells Fargo, Bank of America and Morgan Stanley – chose to retain the risk.
Few other lenders in the so-called conduit market, where loans on commercial properties are originated for securitization, are in a position to use the same strategy, since it requires a large balance sheet. That means future bank-sponsored CMBS deals may command superior pricing to others' transactions, which in turn would allow the banks to offer more competitive rates to borrowers.
The three banks will collectively retain 5% of each class of securities issued by Wells Fargo Commercial Mortgage Trust 2016-BNK1, or about $43.5 million, according to Fitch Ratings and Kroll Bond Rating Agency. This is known as the vertical option.
Other issuers are expected to take advantage of a concession, unique to the CMBS market, allowing sponsors to satisfy risk retention rules by selling the risk of first loss to a designated third party. In industry parlance, this is the horizontal option, because these investors would hold the riskiest 5% of securities in a deal. It's also possible that some deals will comply with risk retention via an "L-shaped" strategy that combines features of the vertical and horizontal strategies.
Here are a few important observations about the inaugural vertical deal.
It priced at levels not seen in the CMBS market in months.
The yield spread on the junior-most triple-A rated tranche of the deal was several basis points less than even initial market chatter had indicated, according to the research firm Trepp. (There are senior classes that feature more protection than the rating agencies require for a triple-A grade.) At 94 basis points over the swap rate, it was also the tightest spread for this particular class of securities so far this year and some 14 basis points tighter than the comparable tranche of the previous CMBS deal, which did not comply with risk retention.
"It appears the deal priced so favorably that there should be price advantage, going forward," said Peter McKee, a partner in law firm Alston & Bird's finance group.
That warm reception bodes well for the impending wave of commercial mortgages that were originated and securitized at the market peak right before the crisis, are about to mature and will need to be refinanced.
Between November of this year and June 2017, $10 billion to $14 billion of securitized commercial mortgages will mature each month, according to Trepp. It would be an inopportune time for market disruptions resulting from the risk-retention rules taking effect.
"The fact that we not only have a market-clearing, $871 million transaction, but the fact that it was so well received, and beat all pricing expectations, is an unalloyed good," said Brian Olasov, an executive director with the law firm of Carlton Fields who chairs the risk retention task force at the Commercial Real Estate Finance Council.
It's only a partial solution to the risk retention challenge.
"Not all sponsors can afford to hold on to a vertical strip for five years, subject to all restrictions -- no hedging, nonrecourse financing, no ability to trade," Olasov said. "There is a relatively small group of sponsors who either have the capacity to do that and are willing to do that. The capacity of the overall industry to do [this] is going to become increasingly taxed. If a sponsor has to hold these positions, year after year after year, it becomes a big position on its balance sheet."
Initially, CMBS market participants expected that most deals would comply with risk retention using the horizontal strategy, since that most closely resembles how the market currently works: investors known as "B-piece" buyers acquire the riskiest classes of securities.
But the 5% threshold introduced by risk retention is much higher than what B-piece buyers typically purchase from a deal, which is around 2.5%.
That means B-piece buyers would be required to buy as high up in the credit stack as single-A, rather than just bonds below BBB-. And it would be hard for these investors to achieve their targeted returns holding such highly-rated, low yielding securities.
"The risk retention exception for B-piece buyers appears not to be the panacea we thought it would be," said Patrick Sargent, another partner at Alston & Bird's finance group. "Traditional B-piece buyers don't raise capital to hold for five or possibly 10 years; they are going to have to find new money sources."
While it may take six to nine months to see where the CMBS market will settle, Sargent said it looks like there will be two or three retention structures. "We're going to see some banks retain a vertical slice, and some nonbanks putting together either a subordinate horizontal or an L-shaped piece that is either retained or sold to the B-piece buyer. It won't be one size fits all."
The collateral was squeaky clean.
As you'd expect in a deal that served as trial balloon, the loans used as collateral for the Wells Fargo BNK-1 pool were conservatively underwritten, at least by recent market standards. For example, the deal is less highly leveraged than the average conduit transaction rated this year by Fitch. The loans in the pool have a weighted average debt service coverage ratio of 1.22 and a loan-to-value ratio of 107.5%. (Rating agencies calculate leverage statistics using what they expect will be the average value of the underlying properties at different stages of the credit cycle; this figure tends to be lower than current valuations.)
It's difficult to tease out how much of the price differential for the first risk retention-compliant deal was attributable to the quality of the collateral, versus the fact that the sponsors retained a vertical strip.
"The deal gets better treatment from investors who looked at the pool on a pure credit quality perspective," said Joseph Franzetti, senior vice president for capital markets at Berkadia Commercial Mortgage, a mortgage brokerage. "The fact that the originators of loans share risk also brings a tremendous amount of confidence to investors because the interests of all parties are aligned."
However, "if you look at subsequent deals done in a more traditional mold [i.e., without risk retention], they priced wider," Franzetti said, meaning those deals had to offer investors a fatter risk premium. "And the collateral was just as good as in the bank deal. This suggests there was a price benefit to originators eating their own cooking."
Olasov said "it's an open question" how much of the pricing success is attributable to the conservative nature of the collateral pool and how much has been derived from alignment of interests.
"If the oversubscription of the bonds is solely attributable to the collateral quality, that would be less beneficial to the market," he said. "If risk retention in and of itself has the serendipitous effect of driving down yields, that could ... support higher volume."
The banks may get favorable capital treatment.
Strong pricing may not be the only benefit that Wells Fargo, Bank of America, and Morgan Stanley achieved with the first risk retention-compliant deal. Market participants say that the three banks may be able to get favorable capital treatment for the exposure that they are retaining to the deal. Because of the way that the deal was structured, banking regulators may treat their interests as loan participations, rather than as commercial mortgage bonds.
While the banks are not actually holding the loans, the risk retention is intended to reflect a participation in the whole pool of loans, top to bottom, bearing the risks and receiving the payments as if the assets were on the balance sheet. And the risk-based capital charges on a loan are expected to be better than on a bond or other type of security, though the actual weighting will vary by institution.