As we pass the halfway point in 2019, there is every sign that the European commercial mortgage-backed securities market will deliver on its latent potential and enjoy another strong year.
Since March, the structured product has enjoyed a sustained flurry of activity, with arrangers closing multiple deals secured by a range of commercial property assets located across the continent. Assuming this level of activity is sustained – and there is every sign that it will be – 2019 could be a truly bumper year for CMBS, despite the sanguine outlook originally forecast for the year.
The pessimistic outlook was largely attributed to the implementation of the EU’s Securitisation Regulation, which came into force on 1 January. The regulation directly legislates against CMBS on the basis that the overall performance of the product is too intrinsically linked to the disposal risk of underlying commercial properties.
More specifically, it contains a decree that, unlike structured products derived from more granular receivables such as auto loans, residential mortgages and credit cards, CMBS cannot qualify for a designation of being a ‘simple, transparent and standardised’ (STS) securitisation, and is therefore unable to benefit from favourable capital treatment.
The regulators have essentially devised a regime that creates regulatory arbitrage by incentivising fixed-income investors to shun CMBS in favour of more granular structured products.
They risk discriminating against CMBS at their peril, given that it possesses a myriad of positive features that are of huge benefit to the commercial real estate finance industry. These benefits include the fact that CMBS provides an efficient mechanism to transfer loan risk from the banking sector to institutional investors. It also provides a much more liquid alternative to the loan-syndication market, as well as much-needed openness and transparency in the commercial real estate lending market.
Although there is no dispute that the disposal risk inherent in CMBS is a relative structural flaw when compared with other structured products, the stark reality is that this is not something that can be remedied. This deficiency should, however, be addressed at a commercial level in the pricing, rather than by subjecting the entire asset class to penal regulatory interference.
New regulatory regime
Given the infancy of the new regulatory regime and the fact that the relevant implementing infrastructure is still being put in place, the volume of STS transactions that have so far hit the market across various types of asset-backed securities remains subdued. The higher standard that structures need to meet in order to be classified as STS means there is a level of inertia when it comes to structuring transactions that reach this higher bar.
Spurred on by banks and regulators wishing to capitalise on the favourable capital treatment attached to the STS label, the chances are that it will simply be a matter of time until the securitisation markets properly embrace the classification. Indeed, if this happens, the regulatory arbitrage between CMBS and STS certified products will almost certainly widen. However, the magnitude of this will ultimately depend on the volume of regulated investors that find themselves being deterred from investing in CMBS products.
For the time being, given the current buoyancy of the CMBS market, the stance adopted by the regulators can easily be glossed over. However, this does not escape the brutal reality that this arbitrage risk has absolutely no place in the structured product universe. Indeed, its mere presence simply flies in the face of one of the worthy and legitimate aims behind the Securitisation Regulation of promoting standardisation across structured products.
The approach adopted by the regulators is certainly troublesome when you consider the many positive attributes of CMBS. Given the infancy of the new regime and the fact that this arbitrage risk is yet to negatively manifest itself, now is the time for regulators to take heed and eradicate this unnecessary and punitive risk. Failure to do so has the real potential to confine CMBS to the structured product doldrums.
Iain Balkwill is a partner in Reed Smith’s structured finance team, based in London