Can securitisations be treated as loan exposures when calculating risk-based capital requirements? That is the question three big US banks – Bank of America Merrill Lynch, Morgan Stanley and Wells Fargo – will put to regulators when they file their third-quarter financial statements.
The filings will reveal how the banks are classifying the retained risk of a landmark commercial mortgage-backed securities (CMBS) deal issued on August 4. The deal – an $870 million securitisation of 40 commercial mortgages, dubbed WFCM 2016-BNK1 – is a test case for compliance with new US risk retention rules, which from December 24 will require CMBS issuers to hold onto 5% of the risk of the securitisations they sell into the market.
The banks are seeking clarification on the treatment of these retained securitisation exposures under the Basel III risk-based capital rules. On the face of it, they should be treated as securitisations, but this would attract punitive capital charges and could put a brake on bank issuance (see box: A weighty matter). Alternatively, the retained risk could be treated as an exposure to the underlying whole loans, which would attract a lower capital charge. That is if regulators allow it.
The capital implications are significant. A securitisation treatment could result in capital charges that are four times higher than if these same exposures were treated as whole loans, according to a source at a large New York-based accounting firm. As an example, a CMBS issuer would need to retain a $50 million slice of a $1 billion securitisation under the new rules. Under a securitisation treatment, this would attract a $15 million capital requirement, assuming a minimum capital ratio of 8% against total risk-weighted assets. If the same exposure was treated as a bundle of whole loans, the capital charge would be just $4 million, the source at the accounting firm says.
Some fear banks may exit the CMBS market if regulators insist on the more punitive treatment. "We've seen banks have ceased trading in certain securitisations because of the amount of regulatory capital needed to be held against them," says Zach Cooper, deputy chief investment officer at New York-based Semper Capital Management, a hedge fund specialising in mortgage strategies. "If supervisors assign a high charge [to CMBS], I would expect the same outcome."
It will affect the CMBS business… The lower turnover ratio that would result from aggregation of retentions over multiple years is going to reduce your returns
Greg Murphy, Natixis
Regulators are not expected to opine on the matter until after the three banks behind the WFCM 2016-BNK1 deal file their quarterly 10-Q reports to the US Securities and Exchange Commission. The deal itself is backed by high-quality loans originated by each of the issuing banks and was rated by four separate rating agencies. The three banks cumulatively took down a so-called eligible vertical interest equal to 5% of the face value of each tranche of the securitisation, split between them according to the percentage of the underlying loan collateral they contributed to the conduit. The rules stipulate that, with few exceptions, these retained slices cannot be transferred off balance sheet unless strict sunset conditions are met.
The New York-based head of CMBS at one large bank, who has spoken with executives close to the WFCM 2016-BNK1 transaction, says the three issuing banks are optimistic that regulators will allow them to treat the retained slices as whole loans when calculating risk-based capital requirements.
"As the 5% they are retaining went in as one lump sum and effectively mimicked the underlying mortgages, they were able to convince their accountants that even though they were holding a bond, it should get capital treatment as a mortgage because it looks and smells like a mortgage," he says.
The source at the large accounting firm in New York confirms that by incorporating the retained slice as a single security on their balance sheets, instead of in tranches, the banks bolstered their chances of receiving loan treatment. This is a regulatory "grey area", he says.
One of the banks involved in the transaction disputed this assessment but declined to provide further comment. The two other banks declined to comment.
The ball is now in the regulators' court. Five separate regulatory agencies contributed to the risk retention rules, but it is understood that the US Federal Reserve would oversee the application of risk weightings to the retained slices held by systemically important firms, such as the three engaged in this transaction.
Obtaining favourable capital treatment is just one of the challenges facing CMBS issuers. Even if regulators allow them to treat the retained slices of commercial mortgage securitisations as whole loans, the prospect of warehousing scores of illiquid mortgage securities on their balance sheets should give pause to even the most aggressive bank issuers.
"It will affect the CMBS business," says Greg Murphy, head of real-estate finance for the Americas at Natixis in New York. "There is a certain rate of return expected. The more you turnover your balance sheet, the more fees you make [and] the higher your return. The lower turnover ratio that would result from aggregation of retentions over multiple years is going to reduce your returns."
For its part, Natixis has ample capacity on its balance sheet to absorb retained slices, Murphy says, but that may not be true for every bank.
For those that don't, the rules offer two other avenues to comply with risk retention obligations. The first is the so-called B-piece buyer option, which allows issuers to offload their retention responsibilities to a third party. B-piece buyers are typically real-estate asset managers or hedge funds that invest in the first-loss tranches of existing CMBSs. Big players in this business include Rialto Capital Management, Ellington Management Group and LNR Partners, among others.
Under the current regime, B-piece buyers are able to flip slices of the purchased piece to other participants for a fee and retain only those securities they are comfortable with from a risk/return perspective.
"One of the strategies B-piece buyers employ is to buy the bottom of the stack, season that for a little while, then finance some portion of the BB or B tranches and sell a portion of it so they are able to see credit improvement and spread contraction. That gives them the ability to recapture a significant amount of what they paid for the bond while continuing to own the non-rated class below," says a managing director at one B-piece buyer in New York.
This is exactly the sort of behaviour the risk retention rules are designed to stamp out, however. Under the new rules, B-piece buyers will continue to be able to purchase the first-loss securities, but this piece – called a horizontal interest – must equate to 5% of the fair value of the entire CMBS issued. Today B-piece buyers generally bid for 2.5% to 3.5% of the fair value.
The fear is that a typical hedge fund with 90-day liquidity can’t be majority invested in assets they are required to hold for five years because they could be redeemed out of all their capital
Zach Cooper, Semper Capital Management
Furthermore, B-piece buyers will be legally required to hold onto this thicker piece for a minimum of five years and are barred from using leverage to acquire the securities. This will end the practice of flipping and make B-piece buyers more dependent on cash to finance their activities.
This minimum quota also means B-piece buyers will be forced to hold higher-rated tranches in the securitisation structure, perhaps all the way up to the BBB-rated tranches. These securities yield significantly less than the investors who fill B-piece buyers' coffers are used to. As a result, some wonder whether issuers will find many takers among traditional B-piece buyers.
"I don't think horizontal retention should be that prevalent. The inclusion of what would otherwise be BBB- securities in that 5% slice is costly and inefficient from a cost-of-funds and securitisation-execution perspective," says Leo Huang, senior portfolio manager at Ellington Management Group in Greenwich, Connecticut. "It's intellectually odd to me that you would have a first-loss piece subject to risk retention which you can't do anything with."
The third risk retention option on the table for CMBS issuers is the so-called L-shaped model, where an issuer and B-piece buyer combine to hold 5% of the fair value of a deal across both vertical and horizontal slices.
"We've spent a lot of time on that model and hope to win approval to issue using it, perhaps retaining a 2% vertical slice ourselves with a B-piece buyer coming in for the other 3% on the horizontal," says the New York-based head of CMBS at a European bank.
But the B-piece buyer would still have to warehouse the horizontal slice for a period of five years. Given the illiquid nature of these securities, this could be a bridge too far for many players.
"The fear is that a typical hedge fund with 90-day liquidity really can't be majority invested in assets they are required to hold for five years because they could be redeemed out of all their capital. One thing we have heard is that issuers are limiting the number of B-piece buyers they are willing to work with because there is that monitoring overhead, and a bank is ultimately on the hook for that retained slice," says Cooper at Semper Capital Management.
The risk retention rules make the original sponsor of a securitisation responsible for their chosen B-piece buyer's compliance on an ongoing basis – including adherence to the minimum holding period requirements.
Yet while the risk retention rules may have been designed to chase B-piece buyers away, some old hands see it as an opportunity to muscle in on the issuance business by partnering with banks, or even replacing them.
This is what Ellington Management has in mind. "I want us to become an issuer-retainer where we sponsor securitisations and retain vertically. We avoid the risk-based capital charge issues for banks retaining vertically and the regulation-imposed illiquidity of being a standard B-piece buyer," says Huang.
There are a number of ways for B-piece buyers to assume this new mantle. They could increase their own conduit lending activities into bank-sponsored CMBSs and take a share of the vertical retention, with a view to profiting from the sale of the securities.
Various B-piece buyers do this already. For example, WFCM 2016-C33, which priced in March, had 21% of its loans originated by Rialto and 27% by Ladder Capital Finance. But it remains to be seen whether these non-bank originators can keep their skin in the game after December 24.
I want us to become an issuer-retainer where we sponsor securitisations and retain vertically
Leo Huang, Ellington Management Group
"We have already heard of a couple of originators that have announced that they are putting their platforms on hold until they get some certainty as to how they'll be able to execute. These are non-bank originators who rely on contributing their loans to larger deals and may not have the balance sheet holding power that the banks have," says Murphy at Natixis.
The European bank's head of CMBS thinks a surge in non-bank-sourced loan collateral will see little take-up among investors. This is because these players typically hunt for more highly levered, higher-risk loans in pursuit of better returns – a strategy that investors are understandably wary of.
"I'm not worried by [non-banks]. The market is very driven by senior investors wanting to see bank-originated collateral getting securitised. The mere fact that special financing institutions are going to take on risk retention is not going to give any more comfort to these investors. I don't see them being much competition to the larger banks. My personal opinion is that there is going to be a lot of consolidation of these special financing guys across the industry," he adds.
Huang at Ellington Management disagrees. He says CMBS investors are concerned with the overall credit quality and leverage of the underlying pool of loans – not the names of those originating the loans.
Another way non-banks could get involved is by gathering loan collateral from originators that do not wish to shoulder the risk retention burden and structuring the transactions themselves – charging a fee to these originators for their services.
Huang is eyeing just this sort of opportunity: "There will be a number of banks that will be vertical retainers, but can all the banks do that? I doubt it. Over time, because of the capital needed and the size of the sector, we think a non-bank issuer-retainer like ourselves will be a natural evolution."
A weighty matter
Under Basel III's risk-based capital rules, securitisation risk weights are calculated using the supervisory formula approach. This considers the riskiness of the underlying exposures, the tranches to which the securities belong, and the amount of delinquencies and loss on the securitised assets, in order to generate a total risk weight. A simplified supervisory formula approach exists for those securitisation exposures for which banks lack insight into some of the above parameters, and firms using the advanced approach for calculating regulatory capital must use these standardised tools to set capital floors, which their model-calculated risk weights cannot fall below.
These formulas will generally produce risk weightings greater than those applied to unsecuritised loans – especially for low-rated and non-rated tranches. Securitisation exposures for which banks lack suitable information to generate an accurate figure can be hit with a punitive risk weight of 1,250%.
"If banks are allowed to hold capital against these risk retention positons at the same level that they hold capital against commercial real estate whole loans, that's a really good outcome. If, on the other hand, the regulators say: ‘No, you have to hold risk-based capital against this position more in line with what we would require a bank to hold against a securitised position,' then the proposition of holding verticals on the balance sheet becomes problematic," says Richard Jones, a finance and real estate partner at law firm Dechert in New York.
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