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NAREIM DIALOGUES FALL 2017 41 RISK RETENTION? NO WORRIES The big question headed into the year was how the market would react to risk retention, part of the Dodd-Frank banking industry reforms that went into effect in December 2016. The regulation requires sponsors of securitizations to hold 5 percent of securities they issue. Although there were concerns in the lead-up to implementation the market would be fundamentally damaged, risk-retention has largely been a non-issue. Fears that higher compliance costs would make CMBS not competitive on loan pricing, or that there would be a shortage of investors for the junior classes of CMBS, have either proven to be not debilitating or have not materialized. In fact, there are a healthy number of investors buying junior CMBS, while profit margins have soared. Increased compliance costs have been more than offset by higher prices fetched by the bonds, as investors show they are willing to pay up for deals in which sponsors "eat their own cooking." For example, between the start of the year and August spreads of senior triple-A rated CMBS fell roughly 15 basis points to about 90 bps over swap spreads, while BBB spreads dropped about 140 basis points to roughly 330 basis points over swaps. Three basic options have emerged for CMBS issuers to comply with the risk-retention regulations. One, called vertical, is for the loan contributors to maintain a 5 percent portion of each class. A second option, horizontal, involves selling the bottom 5 percent of the securities to a qualified investor known as a B-piece buyer (which is the closest to the way the industry worked in the past). The third option called "L-shaped," is a combination of the vertical and horizontal structures. Issuers are sampling the structures, with equal use of all three in mixed pools. Through early August, nine conduit deals totaling $7.8 billion employed the vertical structure, eight deals totaling $7.4 billion employed the horizontal structure and 10 deals totaling $9.7 billion have employed the L-shaped structure. Horizontal also led the single- borrower market, with 17 deals totaling $8.5 billion, while 14 deals totaling $8.1 billion employed the vertical structure. That's not to say risk retention has no aftereffects. One consequence is that it favors larger banks that have the resources to hold securities on balance sheet. Those banks are reluctant to team up with originators that don't have the same financial wherewithal, which has prompted at least 10 specialty lenders that contributed collateral to CMBS pools in recent years to drop out of the market. Some 26 lenders contributed to CMBS pools in 1H17, down from 40 that contributed to pools in 2016, per CMA. LOAN QUALITY IMPROVED Although there is some debate, loan quality seems to have improved in 2017. CMBS quality metrics, as measured by issuers, are better this year. The average issuer loan-to-value (LTV) ratio of pooled conduit deals through August 4 was 57.7 percent, down from 60.0 percent in 2016, 64.4 percent in 2015 and 65.5 percent in 2014, per CMA. Debt-service coverage (DSC) levels have averaged 2.07 in 2017, up from 2.0 in 2016, 1.8 in 2015 and 1.7 in 2014 (CMA). Yet at the same time, CMBS lenders are also increasing their use of interest-only (IO) periods. Rating agency KBRA's "IO Index" tracks the weighted average number of months of IO periods in CMBS pools. For conduit-loan pools, the average has risen to just over 50 percent in 2017. That means, essentially, that half the collateral in CMBS pools is subject to interest-only periods, up from less than 30 percent in 2013 and 40 percent in 2015. Tightening spreads are a sign that investors are buying the high-quality argument. "Investors are willing to pay up for lower leverage," said one CMBS portfolio manager. "That's what the market wants." ©iStock.com/maxsattana ©iStock.com/royyimzy ©iStock.com/yotrak