An Unwanted Christmas Gift for CMBS


As President-elect Trump prepares to take office, he said he wants to repeal much of President’s Obama’s signature legislation. That would include the Dodd–Frank Wall Street Reform and Consumer Protection Act. Politicians and pundits debate whether this might actually happen. Most say it won’t.

The commercial mortgage-backed securities industry would gladly say goodbye to Dodd-Frank, thus avoiding another impending headache. This time the headache will consist of the so-called “risk retention” rules set to take effect on Dec. 24—a Christmas gift the Industry definitely did not want.

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The “risk retention” rules try to force a CMBS sponsor to hold at least 5 percent of the risk (a 5 percent “slice”) of the transaction. This way, in theory, the sponsor won’t sell garbage to the market, because the sponsor has “skin in the game.” A sponsor’s retained slice can take three possible forms.

First, it can be “vertical.” Here, the sponsor keeps 5 percent of the face value of each class of securities issued in the transaction. They must hold their slice until two-thirds of the loans have paid off, two-thirds of the bonds have paid off and at least two years has passed since the transaction closed.

Second, the retained slice can be “horizontal.” Here, the sponsor keeps the most subordinate class of securities representing 5 percent of the fair value—not face value—of all the CMBS in the offering. Alternatively, the sponsor can bring in a third party buyer to play this role and retain this slice of risk. Whoever buys a “horizontal” slice for risk-retention purposes must hold it for at least five years. After that, they may be able to sell to a third party that meets a complicated set of requirements.

Third, the sponsor can mix and match. The sponsor can keep less than 5 percent of the most subordinate class of bonds but bring its total retained slice to 5 percent by keeping a suitably sized vertical interest in all other classes.

A CMBS sponsor can sometimes lay off part of the required risk retention on the institutions that actually originated the loans in the pool. Only if an originator contributed at least 20 percent of the face amount of those loans, it can retain a corresponding share of the risk that the sponsor would otherwise have had to keep. This reduces the sponsor’s retention accordingly. But it doesn’t work with originators that contributed less than 20 percent of the pool.

A multitude of federal agencies promulgated the risk-retention rule in 2014. Ever since, the CMBS industry has struggled to decide how to deal with the new rules.

In August, sponsors sold a “test case” conduit transaction constructed to meet the new requirements, even though not yet effective. Three bank sponsors kept their 5 percent retained slice in a separate class. The deal had high quality collateral. The industry was ready for it after a slow spell. It priced favorably.

A second transaction backed by a single Manhattan skyscraper followed in October. A third party bought the subordinate slice, agreeing to hold it for the required five years. It was another conservative deal with low-leverage, high-quality collateral and strong historical occupancy. It too was warmly received. A second test conduit transaction, this time structured with a vertical slice, hit the market in early November.

Many questions remain. For horizontal slice deals, banks must determine whether they can hold their 5 percent slice on their balance sheets or must rely on third party buyers—who turn out to be expensive. For example, they can’t finance their purchase with financing from certain other participants in the CMBS transaction, so they may need to use their own cash, which typically costs them more.

Rick Jones of Dechert LLP, who runs a popular and very readable industry blog,, recently collected a long list of uncertainties on risk retention. For example, how can sponsors and third party buyers allocate liability between themselves? What happens if they can’t agree on pricing?

We also note that the few transactions with risk retention closed to date have been relatively conservative in collateral quality and leverage. What will happen when this changes? Will the Christmas Eve effective date paralyze the market as everyone struggles to decide what the new rules require? Aside from the test transactions, no clear guidance yet exists on how to move forward.

Finally, with the Trump election and Republican-controlled Congress, will the rules change in 2017? In a post-election blog post, Jones said he doubts that. Others in the industry feel likewise, given that Trump’s base doesn’t love the financial industry. Considering how slowly Washington works, any real change is probably many years away. The CMBS industry will just have to figure out how to live with its Christmas present.

Joshua Stein and Joel M. Omansky are commercial real estate attorneys in New York City.