Wall Street bucks for commercial-property debt it must invest in

NEW YORK / Bloomberg

A provision of the 2010 Dodd-Frank law that takes effect in December forces banks to keep a stake in the commercial-property loans they package into securities and sell off to investors. The rule is intended to deter the type of risky lending that helped fuel the last decade’s boom and bust. Under the current business model, banks are encouraged to issue as many loans as they think they can securitize and sell, with underwriting standards sometimes falling by the wayside, said Lea Overby, a debt analyst at Nomura Holdings Inc.
“Originators know their product better than anyone, and they are less likely to underwrite really bad stuff if they have to hold it,” Overby said in an interview.
The biggest players in the $550 billion market for commercial mortgage-backed securities, such as Wells Fargo & Co., Deutsche Bank AG and JPMorgan Chase & Co., are juggling multiple scenarios as they prepare for the new rule, according to bankers with knowledge of the deliberations. Banks may be required to hold as much as $50 million in capital for a $1 billion deal, a tough prospect to stomach with banks under pressure to keep their balance sheets in check. The rule also creates an opportunity for investors to team up with banks on the debt.
Turmoil in global markets is exacerbating the uncertainty surrounding how lenders will adjust to the new regulations. The CMBS market is already on shaky ground as the rout in oil prices, slowing growth in China and uncertainty over the Federal Reserve’s course on interest rates spook investors in stocks and bonds around the world.
The extra yield buyers demand to own commercial-mortgage bonds relative to benchmark interest rates has surged to the highest since 2011, meaning investors view the securities as increasingly risky, according to Morgan Stanley. Since January, the spread between the benchmark and CMBS rated BBB-minus, the lowest investment-grade ranking, has jumped 240 basis points, or 2.4
percentage point, the bank’s data show. Dealers are struggling to sell CMBS deals that have been in the pipeline for months, according to Leo Huang, who oversees commercial real estate debt at Ellington Capital
Management.
“Money is being lost in amounts that hasn’t been seen in years,” Huang said. “This should remind people there is substantial risk in this
business.”

Risk Retention
The new requirement, dubbed risk retention, applies to all types of
securitization, the process by which debt is pooled together and sliced into bonds of varying risk and
reward. Such offerings backed by home loans were ground zero for the financial crisis.
The changes are creating an opportunity for real estate investors. Industry lobbyists won a concession from lawmakers to create an exemption for the CMBS market, allowing a third party to take on the risk on behalf of lenders as long as they agree not to sell their investment for at least five years. Banks will be held legally accountable if the firm they sell to violates the rules.
The CMBS market has a built-in cohort, called B-piece buyers, that buys the riskiest portions, absorbing losses first in exchange for a hefty yield. Firms including Ellington, DoubleLine Capital and KKR & Co. have entered the space in recent years, which was dominated by a handful of specialists prior to the financial crisis. Several B-piece buyers are seeking to raise funds to step in for the banks, though it may be difficult to find investors willing to lock up their cash for five years or more, said Warren Friend, an executive managing director at Situs, a commercial real estate consulting firm.

Costs Weighed
Wells Fargo, Deutsche Bank and JPMorgan are among lenders weighing the costs of tying up their own capital versus the economics of compensating B-piece buyers for buying and holding large chunks of new deals, according to bankers at the firms who asked not to be identified because talks aren’t public. Banks with larger balance sheets are more likely to take on the risk themselves, they said.
Representatives for Wells Fargo, Deutsche Bank and JPMorgan declined to comment on regulatory issues.
One option is for B-piece buyers to buy loans from the banks — as opposed to just buying a slice — with the banks selling securitized debt to investors on behalf of the B-piece buyers, said Huang of Ellington, the hedge fund firm founded by Michael Vranos. The bank’s role in the deal would be more of an agent, as opposed to taking on principal risk, Huang said.
“Our vision is for banks to do what they do well: using the relationships they have to originate loans and distribute bonds through their sales and trading desks,” Huang said.

Pushed Out
Some lenders probably will get pushed out of the business by escalating costs, said Overby of Nomura Holdings. Recent volatility has already claimed at least one of the smaller firms. Redwood Trust Inc., a Mill Valley, California-based real estate finance company, said this month that it’s exiting the business of making loans for CMBS deals, citing the challenging market and escalating risks. About 25 employees will be cut, the company said.
Other lenders are likely to become pickier about the commercial-property loans they issue as the end of the year approaches, said Friend of Situs. That may make it harder for property owners to refinance just as a wave of loans made during the market’s 2007 peak starts to come due, and some borrowers will have to swallow higher costs passed along by lenders, said Friend, who spent more than 14 years as a managing director in the CMBS groups at Morgan Stanley and Deutsche Bank.
“Rates will have to go up,” he said, “and the amount of equity they will have to put in the deal will increase.”