Risk Retention and Funding Private Equity Deals

From Federal Reserve's Section 946 Risk Retention Study

There is no doubt that securitization helped fuel the residential housing bubble that lead to the Great Panic of 2008. Lenders found ready buyers for their loan portfolios, could sell them, then lend the money out again to create new loan portfolios to resell. One of the issues is that the lenders became purely loan originators, selling off 100% of their interest. So their focus was on generating new loans and not making sure the loans were re-paid. Their lending standards consequently grew more and more lax.

That’s an oversimplification of the process, but shows the general problems of not “having any skin in the game.” By removing the credit risk, securitization may reduce an originator’s incentives to properly underwrite and evaluate borrowers. In addition, since the investor in the securitization is generally several steps removed from the loan origination, there is an information asymmetry.

Section 941 of Dodd-Frank requires securitizers to retain economic interest of at least five percent of credit risk of assets they securitize. As with much of Dodd-Frank, it’s up to the regulators to figure this all out and promulgate the rules. The idea is that properly structured risk retention can address some of the inherent risks of securitization.

Although risk retention may be good for bondholders, it may be bad for the amount of credit and liquidity available. It may also result in higher costs for borrowers. The banks need to retain some its capital in the form of retention. That capital will just be sitting there until the underlying debt obligations are repaid.

On April 29, 2011, the OCC, Board, FDIC, Commission, FHFA and HUD published a joint notice of proposed rulemaking for public comment to implement the credit risk retention requirements of section 15G of the Securities Exchange Act of 1934 (15 U.S.C. § 78o-11), as added by section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The rule will inevitably affect the amount credit available for deal flow and re-investment. There will likely be higher borrowing costs and barriers to execution.

The rule will also affect the residential real estate market since it creates a new category of “Qualified Residential Mortgages” that are exempt from risk retention requirements. I assume that loans that fall outside the exemption will be more expensive for the borrowers and limit the availability of credit for home purchases.

The proposed regulations extend for about 100 pages. That’s a big chunk of new law that will have profound effects on the lending industry.

For commercial mortgage backed securities, the sponsor must retain a “horizontal residual interest” of at least 5% of the par value. There is an option to hold a cash reserve account instead of equity. There is an exception to the risk retention requirements for commercial real estate loans with a laundry list of requirements:

  • Secured by a first lien on the commercial real estate.
  • Verified and documented the current financial condition of the borrower;
  • Obtained a written appraisal of the real property securing the loan that
  • Qualified the borrower for the CRE loan based on a monthly payment amount derived from a straight-line amortization of principal and interest over the term of the loan (but not exceeding 20 years);
  • Conducted an environmental risk assessment to gain environmental information about the property securing the loan and took appropriate steps to mitigate any environmental liability determined to exist based on this assessment;
  • Conducted an analysis of the borrower’s ability to service its overall debt obligations during the next two years, based on reasonable projections;
  • Determined that, based on the previous two years’ actual performance, the borrower had:
    (A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
    (B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
    (C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan;
  • Determined that, based on two years of projections, which include the new debt obligation, following the origination date of the loan, the borrower will have:
    (A) A DSC ratio of 1.5 or greater, if the loan is a qualifying leased CRE loan, net of any income derived from a tenant(s) who is not a qualified tenant(s);
    (B) A DSC ratio of 1.5 or greater, if the loan is a qualifying multi-family property loan; or
    (C) A DSC ratio of 1.7 or greater, if the loan is any other type of CRE loan.
  • The loan documents  require the borrower to provide financial statements and supporting schedules on an ongoing basis.
  • The loan documents impose prohibitions on:
    (A) The creation or existence of any other security interest with respect to any collateral for the CRE loan;
    (B) The transfer of any collateral pledged to support the CRE loan; and
    (C) Any change to the name, location or organizational structure of the borrower, or any other party that pledges collateral for the loan.
  • The loan documents require the borrower to maintain insurance that protects against loss on any collateral.
  • The loan documents require the borrower to pay taxes, charges, fees, and claims, where non-payment might give rise to a lien on any collateral for the CRE loan.
  • The loan documents require the borrower take any action required to perfect or protect the security interest and to defend such collateral against claims adverse to the originator’s or subsequent holder’s interest.
  • The loan documents require the borrower to allow inspection the collateral for the CRE loan and the books and records of the borrower or other party relating to the collateral for the CRE loan.
  • The loan documents require the borrower to maintain the physical condition of the collateral for the CRE loan;
  • The loan documents require the borrower to comply with all environmental, zoning, building code, licensing and other laws, regulations, agreements, covenants, use restrictions, and proffers applicable to the collateral.
  • The loan documents require the borrower to comply with leases, franchise agreements, condominium declarations, and other documents and agreements relating to the operation of the collateral, and to not modify any material terms and conditions of such agreements over the term of the loan without the consent of the originator or any subsequent holder of the loan, or the servicer.
  • The loan documents require the borrower not materially alter the collateral.
  • The loan prohibits the borrower from obtaining a loan secured by a junior lien on any property that serves as collateral for the loan
  • The CLTV ratio for the loan is:
    (i) Less than or equal to 65 percent; or
    (ii) Less than or equal to 60 percent, if the capitalization rate used in an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section is less than or equal to the sum of:
    (A) The 10-year swap rate, as reported in the Federal Reserve Board H.15 Report as of the date concurrent with the effective date of an appraisal that meets the requirements set forth in paragraph (b)(2)(ii) of this section; and
    (B) 300 basis points.
  • All loan payments required to be made under the loan agreement are based on straight-line amortization of principal and interest over a term that does not exceed 20 years; and
  • Loan payments made no less frequently than monthly over a term of at least ten years.
  • Maturity of the note occurs no earlier than ten years following the date of origination.
  • The borrower is not permitted to defer repayment of principal or payment of interest.
  • The interest rate on the loan is:
    (A) A fixed interest rate; or
    (B) An adjustable interest rate but the borrower obtained a derivative that effectively results in a fixed interest rate.
  • The originator does not establish an interest reserve at origination to fund all or part of a payment on the loan.
  • At the closing of the securitization transaction, all payments due on the loan are contractually current.

That is big set of regulations for commercial loan documents. A positive result of the rules would be to have a more standardized set of loan documents used for loans. That could help offset some of the additional costs that may result from the rules.

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