After years in the doldrums, CMBS is on its way back. Although deal activity remains low compared with the heights of 2006, it is increasing across the US and EU as investors seek higher yields. As the market starts to recover, the regulatory landscape has shifted, to one of risk retention and closer bed fellows.
Recently, the Bank of England and European Central Bank published a joint response to a European Bank Authority report late last year on how to improve (or retrain, depending on your perspective) the securitisation markets, mainly by tightening EU risk retention rules.
The focus of the BoE, ECB and EBA reports was to narrow the second ‘limb’ of the originator definition, whereby an entity buys loan exposure from third parties then securitises them, as a means to more closely align the interests of investors, sponsors, originators and original lenders. The idea of risk retention is to prevent the proliferation of toxic assets jeopardising long-term stability for short-term profit.
The proposals are not, at face value, directly relevant to a CMBS market reliant on the first limb of the originator test as its first port of call. Nor are they binding. But they are highly persuasive to the European Commission in its approach to securitisations, and feed investors’ increasing anxiety about the need to comply with the regulations.
The UK’s 2014 Westfield Stratford CMBS is a case in point: popular with investors and backed by a high-value asset, the deal stumbled at the first hurdle for failing to provide risk retention, on the understandable basis that a single-tranche structure was not, arguably, a securitisation as per the letter of the regulation.
Investor pressure led the deal to be restructured to accommodate a risk retention slice, then successfully launched. Then, as now, the problem investors face is compliance with the regulations’ spirit, particularly when the consequences of failure to adhere to these issues are potentially eye watering capital charges.
So these latest recommendations provide a useful insight into what we can expect from the market in coming months. The BoE/ECB response is not clear on how to tighten the originator test language. But it broadly supports the EBA’s proposals, principally to align originators’ and investors’ interests, by redressing what regulators see as a weakness in the system allowing for limited abuses of the originator definition, eg. an originator that only held the exposures for its account for one business day.
Much of the EBA, BoE and ECB proposals pay lip service to a market that has already developed a risk retention regime, due to these spirit and letter requirements. In other structured products, the market has driven holding periods and ways to ensure substance in the risk-retaining entity, as investors take a cautious approach to regulatory requirements.
However, these proposals suggest that European regulators are keen to align the risk profile of European investors to that of their US cousins. This is the most striking element of the EBA, BoE and ECB proposals: to place a new, direct obligation on originators to verify risk retention compliance, alongside the current indirect obligation. This will lead to a more conservative market, as investors rely on sponsors’ or originators’ attestations that the deal complies with risk retention rules.
The threat of capital charges for originators matching those of investors will align the interests (or desire for self-preservation) of both parties, satisfying the regulators’ objective. In the long term, it is likely to result in a more consistent market and lower legal costs, as standardised risk-retention-compliant documents become entrenched. But in the short term, we are looking at months of increased time, legal costs and higher risks for originators and investors.