Last week the boys and girls at the Joint Regulators (The FFIEC, plus SEC, HUD and others) rolled out the final rule (Final Rule) set (found HERE) that structures risk retention under Section 941 of the Dodd-Frank Act for bank assets destined for securitizations. These rules were proposed back in 2011, revised in 2013, and are now finalized to go into effect over the next two years. While there are few community banks that play in the securitization market, the Final Rule does impact overall market liquidity and pricing. Smart community banks will use the Final Rule change to their advantage. Today we briefly explore what these changes are and how community banks can take advantage of these, particularly for commercial real estate. The Final Rule is interesting for not only what it does to the market, but also for the types of assets it excludes as understanding these assets will help community banks better underwrite and price lending risk.
In short, the Final Rule requires those banks that want to securitize assets (auto loans, credit cards, commercial real estate, etc.) to hold not less than 5% of the credit risk of the assets on their books for at least five years. Basically, regulators want to see originating entities keep some “skin in the game” in order to prevent the agency problem of banks originating crappy assets (our technical term) and selling off the risk to unsuspecting third parties such as a pension funds. As a side note, the rule set is much more benign than originally proposed as it did away with the concept that banks had to place their entire profit at risk, they had to continually test cash flow for stability and had to retain the entire risk retention piece for ten years.
Before we discuss how to take advantage of the Final Rule, here are the salient points for your consideration:
Risk Retention: Banks must hold 5% of the market value of the pooled assets that will take the loss on a pari-passu basis (not a first loss piece how some regulators wanted). Interestingly, banks can sell this retained risk position to third parties (a maximum of two) as long as the third party holds the piece for five years. While some argue that this provision basically defeats the original purpose of the Rule, at least third parties are now wiser as a result so the net effect will be the same of pricing this risk higher (at least for the short term).
While many asset classes are covered (including residential mortgages), today we will just focus on commercial real estate since that has the largest impact on community banks. It is interesting to see the types of underwriting that was excluded as a sanity check on your own underwriting. To have an excluded loan, the following criteria must be met:
- Debt service coverage ratio (DSCR) of 1.25x or greater for multifamily, 1.7x or greater for hospitality/specialty CRE and 1.5x or greater for all other property
- Loans where the Loans where amortization is shorter than 25 years (30 years for multifamily)
- Loans where the maximum maturity is 10 years or less
- Loans must not have an interest only portion
- Loans must have a maximum loan-to-value ratio of 65% and maximum combined loan-to-value ratio of 70%
- Loans for five or more single family units that are rented (and leased land associated with this)
Impact To Liquidity And Loan Pricing
Given the qualification criteria, we believe that most current community bank loan participations will either be excluded or that the originating bank will retain a risk position well in excess of the 5% minimum. For loans that do not meet the excluded criteria, after the effective date in two years, the originating bank would have to retain a minimum of 5% should they want to sell the loan into a securitization. This is going to alter the structure and hurt community bank loan liquidity. Banks will need to adjust current loan liquidation procedures to take the new rules into account and will have to adjust their documents. In addition, to accommodate the additional structure and meet the required return, pricing would have to adjust an estimated 15bp to accommodate the potential future sales structuring.
In addition to future bank sales, this new Rule hurts liquidity on the margin from the 40+ securitization platforms currently in the market competing for bank transactions. Similar to how bank loan sales will be impacted, non-bank loan sales will also now have to be structured with a risk retention piece that will increase loan spreads marginally if economics is to remain unchanged. Depending on the loan’s structure, spreads will have to increase between 15bp and 45bp.
In order to help performance and gain liquidity, community banks will strive to meet the Excluded Loan criteria whenever possible.
Impact To Prepayment Speeds (And Near Term Pricing)
One near-term effect will be the increase in prepayment speeds at banks as securitization conduit issuers increase activity in order to capitalize before the Rules go into effect. For the next year, this will drive pricing some 10bp tighter, but also cause greater refinance activity away from banks.
Competition for quality CRE loans is intense and currently growing as securitizations are reaping huge profits. This trend will continue to drive loan pricing tighter in the Excluded Loan category and serve to increase prepayments in the short run. Banks knowing this will be in a better position to price and compete with securitization platforms.
Submitted by Chris Nichols on October 28, 2014