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CMBS Risk-Retention Deals Gaining More Attention

Delinquency rates expected to rise in 2017.

New regulations for collateral mortgage backed securities (CMBS) that were implemented on Dec. 24, 2016, are now entering the marketplace and investors in CMBS risk retention deals are waiting to see how the new regulations will be interpreted before they invest, according to a national law firm.

While the firm of law firm of Katten Muchin Rosenman  said the first commercial mortgage CMBS risk retention deals hit the market in mid-2016, there is still a “great deal of uncertainty” about how the new regulations will work in 2017.

In a report on their web site, the law firm said, “While there remains a great deal of uncertainty with respect to how the market will digest risk retention, issuance ahead of the implementation date fleshed out some details. It includes the issuance of horizontal-strip, conduit deals, beginning with WFCM 2016-BNK1, demonstrating the EVI formulation; and potential templates for the retention of an EHRI held by a sponsor in COMM 2016-COR1 and by a third-party buyer in COMM 2016-667M. “

In short, this means that this new market started with WFCM 2016 BNK1, an $870.6 million CMBS conduit transaction collateralized by 39 commercial mortgage loans secured by 46 properties. This deal meant that on the securitization closing date, the loan originators were each expected to purchase and retain a portion of the RRI Interest. (The RRI is the annual rate of interest for savings and is used to calculate the interest rate you would need to reach a future sometime in the future.) The COMM 2016-COR1 refers to the German American Capital Corp.'s COMM Mortgage Securities Trust 2016-COR1 commercial mortgage pass-through certificates.

The issue of risk retention requires that at least one sponsor of a securitization (or its majority owned affiliate) retain a 5% interest in the credit risk of the securitized assets. This can be done in three ways, the law firm said, but each requires that either a sponsor of the securitization hold a 5% interest, or in something called either a “Eligible Vertical Interest" or an “Eligible Horizontal Residual Interest.”

CIOs often expand their allocations to commercial mortgage-backed securities and other structured debt as fixed income yields fall. 

Why the Changes in the CMBS Market

The CMBS market changed when new rules regarding mortgage-backed securities were implemented on Dec. 24, 2016, years after the financial instruments were linked to the cause of the 2007 recession. 

After the savings and loan crisis, commercial mortgage securitization became “the dominant source of new financing by the property market's peak in 2007,” according to the Wharton School.

“Its roost atop the lending hierarchy was short-lived, however, as the next year's financial collapse upended securitization across a broad range of asset classes. Issuance of commercial mortgage-backed securities (CMBS) fell from $229 billion in 2007 to $12 billion in 2008 and just $3 billion in 2009,” Wharton said.

This drop in issuance meant that “for all practical purposes, the CMBS market had ceased to function.” Intervention by the federal government to re-invigorate CMBS activity at that time included “the non-legacy provisions of the federal Term Asset-Backed Securities Loan Facility (TALF), but even this effort was “largely unsuccessful.”

One reason was that this market was “structurally unsound.” According to a Federal Reserve Board of Governors report, "the financial crisis has highlighted several ways in which the incentives of participants in [CMBS] securitization markets may have been misaligned with incentives one would expect to find in a well-functioning market.”

This meant the need for new risk retention rules and the need for more complex securitization deals.

Most recently, a new report by Morningstar found that 2016 ended with a 3% delinquency rate in CMBS deals.  This was a decrease of 43 basis points from a year ago. Morningstar Credit Ratings, LLC said it expects delinquency rates to increase in 2017 “because of a sharp increase in the volume of newly delinquent CMBS loans, many of which will default at or near maturity.”

Their report also found that “many of the maturing loans [were] overleveraged and lenders being more conservative, we expect the maturity payoff rate to fall further because loans issued in 2007 were often originated under more aggressive terms than those of 2006-vintage loans.

“We project that only about 50%-60% of the nondefeased loans coming due in 2017 will be able to refinance, down from 75.6% in 2016. The delinquent unpaid balance of commercial mortgage-backed securities amounted to $23.86 billion, up $357 million from the prior month and down 12.2% from the year-earlier period. 

Chuck Epstein