Investment Analysis

Ready for Reform?

Dodd-Frank requirements may put the squeeze on borrowers.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. The risk retention requirements under Dodd-Frank for asset-backed securitizations, including commercial mortgage-backed securities, have garnered substantial attention from the lending and originator community. This article focuses on the anticipated effects of the risk retention requirements from the perspective of another important but often overlooked stakeholder — the borrower.

By mid-April 2011, federal banking agencies and the Securities and Exchange Commission must propose regulations requiring issuers of asset-backed securities, or in certain cases, originators of the assets, to retain an economic interest in the credit risk for the securitized assets. The final regulations will become effective within two years. Securitized loan documentation may begin to reflect these new requirements as early as 2011.

The 5 Percent Rule

Dodd-Frank generally requires securitizers/originators to retain not less than 5 percent of the credit risk for the subject asset, or less than 5 percent if the originator meets certain underwriting standards. The SEC previously proposed a similar rule, commonly known as the “vertical slice rule,” that sought to impose a 5 percent risk retention with respect to all classes of securities issued in a securitization offering. Based on input from industry participants, Dodd-Frank emphasizes risk retention with respect to the underlying asset, as opposed to retained risk in each class of securities.

Dodd-Frank regulations also will prohibit the direct or indirect hedging or other transfer of the risk required to be retained. New regulations also may impose minimum risk retention periods. Market participants are widely opposed to both of these requirements.

CMBS Application

In simple terms, the 5 percent rule is intended to promote improved underwriting and to better align the risks of the investor and the originator. That is, if the originator is now required to hold a portion of the debt, one might presume that the originator will look more closely at the underwriting. Further, if the asset does not perform, the originator’s return, like that of the securitization investor, will be adversely affected, thereby assuring alignment of interests.

Such reasoning overlooks or gives little credence to specific industry practices that are intended to promote the same outcomes. For example, an originator of CMBS assets often is required to make qualitative representations and warranties about each asset it contributes to a securitization. Furthermore, it may be required to repurchase assets if those representations prove to be incorrect.

Recognizing that the 5 percent risk retention rule needs to account for such industry-specific practices, Dodd-Frank expressly contemplates flexibility and custom tailoring for CMBS. The risk retention regulations for CMBS are anticipated to specify alternative types, forms, and amounts of risk retention that meet the requirements of the 5 percent rule. (Read “Alternative Risk Retention for Commercial Real Estate” at

Effects on Borrowers

Pending final regulations, the effect on stakeholders from the Dodd-Frank risk retention provisions remains uncertain. Borrowers are, however, anticipating some or all of the following.

Less available credit. Retained risk likely will lead to diminished lender liquidity and fewer deals, resulting in less available credit to borrowers.

Increased fees, costs, and expenses. As noted by the Mortgage Bankers Association’s response to the SEC’s proposed 5 percent retention rule: “Lenders would have no choice other than to raise the cost of borrowing and certain lenders would simply decline to participate in the market.” Fewer deals mean diminished fees for originators, potentially resulting in higher fees on individual transactions. In addition, it would not be surprising to see new annual servicing fees imposed on borrowers to compensate for periodic administrative costs associated with retained risk. Greater due diligence by originators also would increase loan origination expenses for borrowers.

Stricter underwriting. Some may argue that stricter underwriting is exactly the point of such regulations; however, this ignores market mechanisms that typically drive the types and extent of underwriting. Further, it seems unlikely that enhanced underwriting will result in any corresponding benefits to borrowers.

Underwriting flexibility. With appropriate disclosure, market investors are able to assess and account for risks associated with underwriting issues through pricing, demand for the issuance, and other factors. A lender that must retain a portion of the loan on its balance sheet for sustained periods without the ability to hedge may have different risk tolerances than market investors, particularly with forthcoming capital requirements and accounting standards. These risk tolerance differences may result in a “race to the bottom” as the needs of the most cautious investor are met.

Conflicts of interest. The tug of war currently being waged between special servicers and investors with respect to loan workouts, and the related claims of conflicts of interest, may be further complicated by the introduction of yet another party — the party that is required to retain the risk under Dodd-Frank.

Stricter loan terms. Risk retention requirements may increase asset monitoring and prompt loan agreement provisions intended to pre-empt asset-level risks. For example, borrowers may witness the re-introduction of “material adverse change” devices, as to periodic reporting and defaults; enhanced insurance requirements; more-restrictive management and transfer rights; increased and more frequent reporting obligations; new financial covenants; and other loss-monitoring and loss-mitigation mechanisms.

Diminished appetite for CMBS. Borrowers generally perceive CMBS requirements as onerous, and the loan workout and servicing challenges over the last two years have only reinforced negative impressions of CMBS. Risk retention rules that result in greater costs of capital and other effects noted above may lead borrowers to prefer alternative financing sources, such as conventional mortgage loans.

As the discussions between stakeholders and regulators evolve, the actual effects of Dodd-Frank and risk retention requirements will become known. Borrowers should hope — and advocate — for tailored regulations that reflect the unique risks and needs of commercial real estate. Such regulations also must be responsive to the challenging economy and impending day of reckoning for maturing real estate debt.

Michael Hamilton

Michael Hamilton, a partner in the Los Angeles office of law firm DLA Piper, focuses on finance and real estate matters. Contact him at more on the Dodd-Frank financial reform act, read CIRE’s November/December 2010 Investment Analysis column, “Ready for Reform? Dodd-Frank requirements may put the squeeze on borrowers.”


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