Same Song, Second Verse
[The Registry May 2011 Issue]
Up ahead there must be water; I can see it on the horizon! My fellow real estate practitioners and I have been trudging through a Sahara of deal flow for a number of years. Small, private investors trudge along beside us, all looking for any deal with some meat on the bones. We read about large private-equity funds acquiring enormous portfolios at fifty cents on the dollar and REITs with coffers full of cash (raised with the sale of public stock) acquiring trophy assets at astronomical prices. Surely these events indicate a coming bull market in commercial real estate. The water up ahead looks like it could be the cool, clear wellspring of revised CMBS lending. If only we can make it to that oasis of financing abundance and calm.
Surely, Secretary of the Treasury Timothy Geithner will be there, as the chairman of the Financial Stability Oversight Council, the newly-created uber-regulator. He will be waiting at a table set with new rules for mortgage origination and securitization that will restore reason, prudence and order to real estate markets. Throughout the land, mortgage originators and securitizers will set about bringing capital to starved real estate investors; prices will stabilize and transactions will begin anew. Chairman Bernanke of the Federal Reserve and FDIC Chairwoman Sheila Bair will be in attendance. Securities and Exchange Commission Chair Mary Schapiro and acting Comptroller of the Currency John Walsh will be there with HUD Secretary Shaun Donovan, finalizing the place settings. Edward DeMarco, acting Director of the Federal Housing Finance Agency, will be present as the conservator of Fannie Mae and Freddie Mac and will conduct a ceremony blessing the healing powers of transparent markets.
Or is it a cruel mirage?
Financial regulators on March 31 released a draft of proposed rules governing creation of asset-backed securities; they are sure to please no one. Most importantly, the wellspring of financing, which shimmered so clearly on the horizon, likely will not materialize.
The rules for residential mortgages seem certain to send those markets into tailspin because only those with perfect credit and a 20 percent down payment will be able to qualify. No doubt the rules will create a safer residential lending environment for many, but anyone below this proposed threshold will be left to the wolves of the free market. The proposal also is foreboding news for a residential market still struggling for gasps of air. Part of me completely agrees with the need for conservative rules on residential mortgages. The other part knows the further price declines they will induce. Now the real bottom of the market will be explored.
On the commercial side, things are just as insane. There are nine separate proposals to handle the “risk retention” aspect of commercial-mortgage securitization, including one that once again allows loan securitizers to off-load all risk.
From the first hint of financial reform, the CRE Finance Council, the lobbying group for investment bankers involved in the securitization process, has been fighting any hint or suggestion that securitizers should have any liability in the process whatsoever, and they have been largely successful in getting their way. In testimony before Congress in May 2010, Kent Born, a senior managing director for investment advisor PPM America and a spokesperson for the CRE Finance Council, said, “Any regulatory-reform law should ensure that regulators can permit CMBS securitizers to transfer risk to B-piece buyers who—in the CMBS context at least—act as ‘securitizers’ to satisfy any retention obligation.”
A B-piece buyer is an investor who purchases the most junior tranche of a securitization, the riskiest slice of the pie. The theory behind this practice is that these savvy investors will hold the others involved in the transactions accountable. Never mind that this mechanism did nothing but accelerate sloppy underwriting and left those B-piece investors holding an empty bag during the boom. Unrestrained free-market securitization is being touted as the cure for unrestrained free-market securitization. Hair of the dog to cure our financial hangover!
Born’s testimony was persuasive enough to eliminate the inclusion of any risk-retention language for CMBS into the Financial Reform Act and now regulators are actually considering alternatives not requiring any retained liability at all. The strategy of the CRE Finance Council is to bury the regulators in mind-numbing complexity and simultaneously proclaim that without robust securitization the commercial real estate markets are doomed. The argument put forth is that if securitizers are forced to take responsibility for the loans they originate, then no bank or investment bank will be willing to play, leaving the commercial markets to fend for themselves. This threatened boycott seems to have persuaded the impressive array of regulatory powers to consider legitimate this farcical proposal.
To understand why, we need look no further than the motivation of two of the most influential members of the Financial Stability Oversight Council: the Federal Reserve and the FDIC. These two organizations hold more commercial real estate debt than any other organization in the world. If anyone needs the ability to offload a warehouse of inventory, it’s these two shops. They need a way to sell their scratched, dented and remanufactured appliances, and a securitization machine without retained liability has been a proven method to sell stale and moldy inventory.
If CMBS is reborn without any liability to the securitizers, essentially it means that the fraternity brothers who drove the CMBS Lamborghini and crashed it while intoxicated will be allowed to get behind the wheel of a brand-new Lamborghini, without a breathalyzer test, and be able to drive as fast as they want without regard to speed limits or consequences, again. The only limit to reckless lending behavior will be scrutiny from the third-party investor—hardly the reassurance needed to support sound sleep.
The other argument put forth by the CRE Finance Council is that requiring 5 percent risk retention will increase costs so much as to cause the securitization process to grind to a halt. (There is that implied boycott again!) At its core, banking is simple: Take lower-cost deposits and lend the money at a higher rate. The system works fine as long as the money is repaid, and the banks don't suffer losses. The argument that the cost of loans will increase by requiring the lenders and securitizers to take responsibility completely ignores the staggering costs of the recent financial crisis from just such defaults and losses.
Imagine insurance companies refusing to pay claims after a hurricane because they contend that the government is responsible to pay for the losses, and then demanding that they simultaneously be granted an increase in premiums to counterbalance the risk. No one would stand for it, but that is exactly what is being requested by the CRE Finance Council. We really can’t be upset with the investment bankers because in their world the cost of default is being borne by taxpayers. Their skewed perceptions are actually correct: Recent experience proves them accurate in this expectation. Daddy Treasury will indeed buy them a new Lamborghini.
The cause of the financial crisis is not mysterious. It was not caused by Fannie Mae giving loans to unqualified buyers as free-market fundamentalists have been touting at every available opportunity, although that did happen. The financial crisis was caused by unregulated private lending. With the help of the rating agencies stamping “AAA” on any piece of litter presented to them, the shadow banking system became so good at selling loans regardless of asset or credit quality, it single-handedly created unprecedented liquidity in the residential and commercial real estate markets, which created the asset bubble. Without the ability to obtain non-recourse debt at unsustainably high levels and at glaringly loose terms, the price run-up between 2004 and 2007 could never have occurred.
A recent publication by world-renowned economist Susan Wachter proves this conclusion. The Richard B. Worley Professor of Financial Management at the Wharton Business School and Adam J. Levitin, an associate professor of law at Georgetown University Law Center, have unequivocally documented the cause of the financial crisis: unregulated, private-label securitization. For those readers ambitious enough to read their extensive research and irrefutable findings, the paper can be found at: http://bit.ly/hXE5ip.
If investment banks were too big to fail before, today they are too big to fail and also too big to regulate. In the meantime, commercial brokers, small investors and Main Street owners are still trudging through the desert hoping for a drink of water. Whatever form CMBS takes upon its return, will it be enough to quench their thirst? Will the small investor be invited to the table of plenty? Or like the Little Match Girl in Hans Christian Andersen’s tale, will small investors have to be content with peering through the window and merely watch as the financial titans of our age feast on the carcasses of distressed deals?
If the hoped-for financial water is not available, the owners of Main Street commercial real estate will be left in the desert to fend for themselves as the vultures bide their time, watch and wait.
The Financial Stability Oversight Council takes public comment on the proposals for risk retention surrounding asset-backed securities until June 10.
