New risk weight rules, known as Basil III, are having a significant negative impact on banks’ required capital allocation for investment in CMBS securities rated below AAA. Previous to impending Basil III capital rules, CMBS securities rated from AAA to AA- had a 20% risk weighting. When Basil III is fully implemented AAA-rated CMBS will remain at roughly a 20% risk weighting, but CMBS rated AA+/AA/AA- will see their risk weighting increase from 20% to anywhere between 50% and 200%, requiring banks to set aside 2.5-10.0 times more capital to support investment in AA+/AA/AA- CMBS. This will make CMBS rated AA+/AA/AA- much less attractive as investments for banks. This rule will primarily affect Class B and Class C CMBS securities, which are rated AA- and A, respectively. Class A CMBS securities, currently rated AAA, will be unaffected.
“We manage a $75-million CMBS securities portfolio for the benefit of our affiliated bank, Country Bank,” commented Michael D. Sneden, Executive Vice President at ValueXpress. “The portfolio is 35% AAA-rated and 65% AA- rated. The AA-rated CMBS risk weighting increased from 20% to an average of 80%. Given that portfolio loans are 100% risk weighted in general, and yield approximately 100 basis points more than AA+/AA/AA- CMBS, the bank is likely to sell its AA+/AA/AA- CMBS and reinvest in portfolio loans with better yield and effectively the same use of bank capital.”