With CMBS prices stabilizing at levels that provide a reasonable interest rate for borrowers, the next cloud on the horizon is risk retention.
Beginning December 24, 2016, under new Dodd-Frank federal regulations, CMBS issuers will be required to retain a 5% slice (“risk retention”) of every new CMBS deal they bring to market or designate a b-piece buyer that is willing to purchase that amount. In addition, the rule requires the investment be retained for at least five years. This rule is quite different from the way the CMBS market works currently.
There are essentially two ways to comply with the 5% risk retention rule — the vertical slice method and the horizontal slice method. Under the vertical slice method, the investor would be required to retain 5% of the face value of each class of securities. Since a typical CMBS deal has 12-13 classes and a $1-billion face value, the investment would be $50 million spread across 12-13 bond purchases. No investors in CMBS securities do this now.
Under the horizontal method, the investor is required to retain the most subordinate CMBS class or classes that equal 5% of the face amount of securities. Typically, investors known as b-buyers do buy the most subordinate class or classes (known as the b-piece) of CMBS. Therefore, this method has feasibility; however, the 5% level is more than the amount typically purchased by b-buyers, particularly after the b-buyer sells off some of its investment, which is not allowed under the new rule. In addition, to avoid usury laws resulting from the high interest rates, b-buyers purchase subordinate bonds at a discount to face value, which is inconsistent with the rule.
Market professionals believe investors will figure out how to comply with the rule, but will want to be compensated for constraints on selling and for making larger investments than under free market rule. This will result in higher interest rates for borrowers. First out of the box to try to figure out how to manage the risk retention rule is Prime Finance (see our 4.11.16 News Article for details).