Between now and 2018, over $200 billion of commercial conduit loans of the nearly $400 billion commercial mortgage loans that mature will need to be refinanced or extended to avoid default. After the issuance of $94 billion of CMBS in 2014 and the more robust issuance of $101 billion in 2015, the general expectation was that further growth in the origination of commercial mortgages for, and issuance of, CMBS in 2016 would easily handle the wave of maturities of conduit loans originated in 2006 and 2007. Unfortunately, the uncertainty occasioned by general volatility of the capital markets for fixed income early in 2016 disrupted the CMBS market and precipitated a significant decline in the origination of loans for securitization. Notwithstanding the increased appetite of commercial and community banks for commercial real estate mortgages in their search for yield and the continuing entry of additional private equity funds into the primary mortgage market, the recent exit of several commercial conduit originators and the falloff in originations by the remaining conduits have jeopardized the potential for refinancing of CMBS loans by CMBS lenders. While CMBS originations resumed in the second half of the year, the spectre of federal risk retention obligations becoming effective on Christmas Eve, the pre-effective date search for regulatory-compliant CMBS structures acceptable to qualified risk retention investors has caused some concern among originators about the certainty and predictability of CMBS as an exit strategy for their loans. But the viability of CMBS as a robust source of continuing capital and liquidity is clearly critical for the health of the commercial real estate markets given Federal banking regulators' continuing expressed concerns about unrelenting growth of commercial real estate lending by banks as well as their calls to reduce the size of bank mortgage portfolios, the uncertainty of the private equity sector's depth of appetite and investment preferences, and the limited investment allocation of insurance companies to mortgages.
As turmoil in the capital markets during the Financial Crisis demonstrated that securitization was not and is not without risk to the banks and systemically to the financial system, federal legislators and federal regulators immediately focused on the failure of securitized mortgage lenders to retain any of the risk inherent in their originations after deposit in, and issuance of, a mortgage securitization. Their perception that a lack of "skin in the game" was one of the principal causes of the near meltdown of the global financial system and their legislative response was to enact the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Dodd-Frank has been the basis for the promulgation of myriad regulations designed to prevent the circumstances and practices that permitted, and a process that tolerated, the "imprudent" lending by lenders who were originating mortgage loans without retaining any risk in their loan portfolios or otherwise jeopardizing their balance sheet. The government wanted to end the "originate to distribute" business model of securitized lenders which had increased liquidity to borrowers, but simultaneously had the unintended consequence of reducing the quality of the mortgage loans originated because the loans destined for securitization were not being underwritten to the same standards as loans which lenders retained for their portfolios. Among the numerous prophylactic measures proposed and adopted by the banking regulators since the enactment of Dodd-Frank, the one that has caused the most concern to the commercial real estate finance community is the requirement of risk retention. Although large loan and conduit CMBS have always had a third party holder of the first loss position (or "b-piece" holder) in the CMBS "senior -subordinate" bond structure – a structure which the regulators expressly acknowledged in the new risk retention regulations (the "Regulation"), the size of b-piece as a percentage of the CMBS issuance was usually determined by the non-investment grade bonds in subordination levels as calculated by the credit rating agencies that rated the senior-subordinate tranches of the CMBS securitization. As of December 24, 2016, unless the commercial mortgage loans meet the extremely difficult to comply with criteria for a statutory "qualified commercial mortgage" loan, the issuer must retain not less than 5% of the aggregate credit risk of the commercial mortgages that are pooled in a CMBS trust. For CMBS risk retention can be structured in three different forms: a horizontal "first loss" interest, a vertical interest composed of a percentage of each class or a combination of the vertical and the horizontal interests known as the "L shape interest." But the eligible alternatives are not all equal or available. The vertical interest requires holding 5% of face value of each tranche (or class) of the CMBS certificates issued, while the 5% horizontal interest is calculated on the "fair value" requiring a higher risk retention amount because B-piece purchasers buy their interest at a discount. Hence, B-piece buyers will need to further up the senior-subordinate tranches than they did before the Regulation to meet the requirements. While the horizontal interest allows for the option that it may be acquired by a third party B-piece purchaser (but may be held by no more than two pari passu B-piece investors), only the CMBS sponsor or its majority owned affiliate can acquire the eligible vertical interest. In addition, mortgage originators (or their respective majority owned affiliates) can also retain its pro rata eligible horizontal or vertical interest (based on its contribution to the Trust which cannot be less than 20%) which is credited to the Sponsor's risk retention; but such originator cannot retain less than 20% of the Sponsor's retention. The combination vertical and horizontal interest structure will allow the Sponsor to retain as permitted above an additional percentage strip to cover any percentage shortfall of the 5% of fair value by the B-piece buyer.
Moreover, in response to the B-piece buyers transferring their interests to Collateral Debt Obligations prior to the Financial Crisis, the Regulation's new requirements: do not permit the financing or pledging or hedging of retained interests; limit the sale or other transfer of the interests subject to some very limited exceptions; mandate specific qualification requirements for B-piece buyers who purchase retained interests; impose the obligation to appoint a qualified unaffiliated operating advisor without any economic interest to monitor the Trust for all the certificate holders; require disclosure of the calculation of fair value (and therefore the purchase price) of the B-piece; impose liability on the sponsor to monitor the third party B-piece purchaser's compliance with Regulation; and impose specific long term hold periods for retention interests. And single borrower/single asset CMBS are subject to risk retention although such transactions were rated investment grade having neither had B-pieces nor investors who purchased the non-existent first loss position.
To test the market and develop compliant structures before they are legally required for issuance, CMBS has been issued with vertical risk retention by the issuer and originators while other issuers have completed CMBS with horizontal risk retention with a third party B-piece. And there has also been a successful single borrower deal issued with horizontal risk retention.
We may not know the full impact of risk retention on the issuance of CMBS or on the issuers – the banks or the new non-bank entrants; which form of retention will dominate the market or be better received by issuers, the originators or investors; or what appetite investors have for the newly constrained B-piece or its heightened disclosed pricing. Yet the limited capacity of the insurance companies, the banks and the alternative lenders would suggest that CMBS will need to continue as a source of financing to assure sufficient capital and liquidity to the commercial real estate industry and markets regardless of the changes occasioned by regulators or investors.