John Cleese, one of the great classic philosophers of the mid-twentieth century, made that inauspicious (from the perspective of the Shop Keeper) observation, "This parrot is dead!" To which Michael Palin responded that it was merely resting. (It's better in drag and with the East Ender accent, but you get the idea.)
The Parrot skit [I wish I could link you to YouTube here, it is really very funny, but the damn lawyers here won't let me.] came to mind recently as I attempted to negotiate yet another Third Party Purchaser (TPP) Agreement in risk retention land. As everyone knows and is heartily sick of hearing, all securitization transactions now require the sponsor, or in commercial real estate deals, a third party purchaser, to hold risk retention securities in accordance with the breathtakingly vacuous Risk Retention Rule. At Dechert, we did one of the pre-effective date pretend risk retention deals and, our TPP agreement was a weighty six pages long. Since the Rule became real, TPP agreements have metastasized into much longer, more complex documents raising numerous dauntingly trying questions.
I have begun to wonder whether the risk retention TPP agreement is already near its death bed just some brief months following its birth.
The TPP construct struggles to bridge the anxieties of a securitization's sponsor which remains liable for breach of the Risk Retention Rule, even though it has placed the risk retention securities with a TPP; on the other hand, with the disinclination of the TPP to devote capital, assume significant indemnification liabilities and assume intrusive contractual undertakings for a relatively small investment.
Making matters worse, the Rule is woefully inadequate as a guide book for compliance with massive white space, periodically interrupted by Delphically obscure bubbles of facial clarity. Unclear rules and potentially existential liability and not the stuff of a deal easily made.
Of course, we've known all this since the final Rule was promulgated when the government apparently got tired of talking with industry about all this complexity and just excreted a final rule without any closure with industry experts around its meaning, function or utility. Now as we actually apply it to real deals the old military adage comes to mind, "Battle plans rarely survive contact with the enemy."
Examples of dysfunction in the Rule are simply too numerous to recount, but for example, what the hell does "full recourse" mean? Did anyone notice the weirdness of getting to an L-shaped structure by adding 5% of vertical OPB and 5% of horizontal fair value? Apples and oranges anyone? Are there real issues around internal or external management for the TPP when it exercises credit judgment over purchasing a risk retention security? Does the two pari passu TPP limitation impact the organizational structure of fund or investment vehicles with multiple owners? Can a TPP hold disparate portions of the risk retention securities in difference MOAs? What happens if those MOAs have different minority owners? Does the provision that limits TPP financing from deal parties include every single, nominal party to the transaction? Does it include borrowers? Does the prohibition upon affiliation with deal parties really apply after the initial credit decision is made and continue for the life of the transaction? What happens if affiliation is created when a deal party buys an equity stake in the TPP? How about deal parties themselves engage in an organic M&A transaction? There's plenty more.
Staring into the abyss of risk retention chaos, we beaver away endeavoring to create certainty where no certainty exists. For sponsors, the line between what's ok and what's not ok is obscured at best. So, what does one do? Push out the guardrails beyond the risk retention event horizon where liability clearly lives, right? Wide guardrails; good for sponsors, not so good for the proposed TPP investor who sees enhanced obligations, reporting, capital at risk and liabilities.
Like one of those Venn diagrams in sixth grade math, the circle representing sponsor needs and the circle representing buyer tolerance are diverging and they may get to the point where they do not intersect at all. It's clear that as sponsors press for more certainty, fewer potential TPP dollars are going to find the investment worth the candle.
Now, not to overstate this, there are TPP dollars that will continue to find these trades attractive and of course one should never forget the ameliorative impact on perceived risk of added yield, but for an industry that needs an industrializable scale for a risk retention solution, this is problematic. With limited money available for risk retention in the TPP universe to start with, the El Dorado-like search for certainty by deal parties will only diminish the supply.
If we are left with only sponsor-held solutions, is that enough? Are there enough banks willing to hold verticals? Do they have enough capital they are willing to devote to this business? Are there enough non-bank sponsors willing and able to take up the slack and will the investors respond well to those structures? The lack of risk retention capital and perhaps even the need to increase the price of risk retention capital will become another headwind for an industry that is already staring at marginalization.
So is the parrot dead, or just resting? As the shopkeeper averred, "Remarkable bird, the Norwegian Blue...e's stunned!"
Is the business model stunned? Maybe we'll get a fix either from our august elected representatives, or from the regulators who could certainly, even without actually changing the Rule, be enormously helpful by providing just some clarity through FAQs or the like on many of the unknowns in the Rule. Maybe I'm just being overly pessimistic and maybe there's enough yield on the table or enough risk appetite to square the circle, but heads up, this is a real problem.
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