I attended a CREFC mini-conference in New York this week titled “2010 Market Initiatives: Overview and Updates.”
The half-day session provided an update on financial regulatory reform and CREFC’s efforts to improve transparency outside SEC directives by creating industry consensus.
Some of the results are good, some are not good.
The conference started with an update from the CREFC lobbyists on the status of financial regulatory reform. They predicted the elections would have minor impact. They focused on the implementation of Dodd-Frank, assuming the law would not be changed. Risk retention and disclosures remain the biggest issues facing CMBS. The SEC is expected to finalize its recommendation around Thanksgiving, at least as it relates to disclosures and shelf eligibility.
In anticipation of the SEC ruling and in an effort to influence the outcome, CREFC set up committees to reach industry consensus on standards so the industry could argue the SEC should leave CMBS alone. Four working committees were set up to work on:
- Annex A standardization
- Loan underwriting standards
- Reps and warranties
- Pooling and servicing agreements
Each committee presented its findings:
Annex A standardization
Annex A is the data set attached to the prospectus. It represents the initial public disclosure the issuer makes to the investors when the deal is launched. While disclosures had similarities in the past, there was no “industry standard” file. The SEC proposed standardizing this data (they called it Schedule L), and the CREFC decided standardization was a good idea. CREFC organized by setting up two subcommittees headed by investors: one focused on loan level disclosures and one focused on property level disclosures. Those two groups had several conference calls that “negotiated” with the issuers on what they would agree to disclose. The results were mixed.
Loan level disclosures:
The committee successfully filled the existing reporting gaps (good news!).
Specifically, the issuers agreed to share all information required to model the debt on the entire capital stack of a deal, not just the terms of the loan in the securitization. Previously, when a loan was securitized, you would not always know if the property had junior (or even pari purse) liens on it. Now, issuers agree to disclose the junior/pari purse positions and who owns them (debt outside the trust).
Property level disclosures:
This was a failure (bad news!).
While the issuers conceded some improvements — specifically related to hotel income disclosures — they refused to disclose full rent rolls. The investors first asked for full rent rolls. After being denied, they asked for roll-over schedules for each property so they could see when the in-place rent expired. The issuers rejected that as being too cumbersome. In the end, investors convinced issuers to increase tenant level disclosure from the top three to the top five. Investors gained inadequate information on two additional tenants: That’s it.
As I’ve stated many times on this blog (and in person), the biggest reporting gap in CMBS is the lack of rent roll disclosures.
At the conference I applauded the progress made on loan level disclosures, but I stated that five tenants isn’t enough, and I criticized the lack of rent rolls. I reminded the room that Dodd-Frank’s definition of transparency is basically issuers must disclose enough information for both rating agencies and investors to value the underlying collateral, model the loans and model the cash flow waterfall of the bonds. Since a rent roll is required to value a commercial property, and the proposed Annex A does not include rent rolls, I asked how our industry could be compliant with Dodd-Frank if we used this standard. The response was basically they tried but, if consensus was required, top five was as good as they could get.
Loan underwriting standards
Dodd-Frank says some loans may be exempt from the five percent risk retention requirement if they are found to be “low risk” because of conservative underwriting. So another committee was set up to establish minimum underwriting standards that could exempt certain CMBS loans from the risk retention requirement.
The committee took the position that it’s impossible to classify CMBS loans as “low risk” based solely on underwriting metrics. Instead, they decided to create a detailed underwriting document similar to a “best practices” guide. The committee avoided recommending specific assumptions (so it really was not a best practice guide), but rather created a list of all the “rituals” a lender should/might perform when originating/analyzing a CMBS loan. I spoke up one more time and stated that while different prudent investors may apply different rituals to determine risk, they all need the same data (including a rent roll) to reach conclusions. The committee conceded a rent roll is needed to underwrite and I pointed out “but yet we decided not to disclose it.” I think I got my point across.
Reps and warranties; pooling and service agreements
The other two committees were much less controversial. The Reps and PSA committees are tasked with standardizing two sets of agreements that should have been standardized a long time ago. It sounded like there wasn’t much conflict in these committees. Everyone felt like sensible consensus was likely.
The consensus that the CREC achieved regarding property level disclosures is not acceptable. CMBS 2.0 without fully disclosing the rent rolls and underwriting models is a bad idea. Hopefully the SEC will recognize this and force disclosure — it doesn’t seem like the industry will by itself. With an SEC announcement expected around Thanksgiving, we should know soon.
Sweet view of the Empire State Building.
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Jim Flaherty is CEO of CMBS.com and the creator of the Backshop loan origination system. He is a trained credit professional with experience installing enterprise underwriting systems for commercial real estate lenders, rating agencies and investors.