It wasn’t a surprise to see legislation like the Dodd-Frank Wall Street Reform and Consumer Protection Act come into the market in 2010. Dodd-Frank was an expected response to the nearly catastrophic financial crisis that shook the nation’s financial institutions, the commercial real estate market in general and the commercial mortgage-backed securities (CMBS) market in particular.
Blame for the havoc created by the financial crisis aside, the fact is that billions of dollars — or perhaps even trillions of dollars — in investment capital were wiped away along with the confidence of investors and borrowers, and it’s not over yet. Although many professionals agree that changes were necessary to ensure that a crisis won’t happen again, the case of this legislative solution is a clear display of the law of unintended consequences, where well-meaning actions lead to unexpected results.
Dodd-Frank contains provisions that are long overdue, and considering that, these provisions could have significant negative ramifications for the CMBS industry. Most prominent in this regard is the provision related to risk retention and the premium capture cash reserve account (PCCRA). Although there have been predictions that the provision will be dropped, the industry anxiously awaits the final ruling that is expected to come as early as this month.
As proposed, the objective of the PCCRA provision is to properly align the economic interests of the issuer and the investors so that the issuers do not pocket large fees at securitization and then leave the investors “holding the bag” for losses. On the surface, the alignment of these interests seems to be a logical response to events in the recent past, but the requirements of the provision could take the industry in an unwanted direction.
The PCCRA provision requires issuers to deposit their income from securitization into reserve accounts that would be used to absorb losses ahead of, or instead of, the most junior tranche of bondholders. Issuers are not only required to defer their income, but also must submit to a first-loss position in the capital stack.
Because many issuers are in the business of originating to securitize only, the PCCRA provision is likely to erode any economic interest they otherwise would have had in participating in the CMBS market. Their motivation to provide their services likely will be diminished, and they may elect to stand on the sidelines.
Considering the level of CMBS financing in the commercial real estate market, there is a realistic possibility that if this provision is put into place as written, the liquidity provided by these issuers would vanish and the commercial real estate credit markets would freeze. This in turn would precipitate a set of circumstances similar to what the legislation was attempting to prevent in the first place. This is the law of unintended consequences in action. Purposeful, well-meaning legislation has been passed as a way to shore up confidence in the market and bring about a better economic future for the country. Nonetheless, if the final ruling does not amend these key provisions in the proper context of the market, it may have the opposite effect.