A standalone securitization of a portfolio of properties closed in June. To our knowledge, this was the first transaction in recent memory done in a direct issuance format. In this case, direct issuance means that the sponsor organized the lender and the depositor as well as a borrower and crafted the loan between the lender and borrower, which was simultaneously closed and funded by the bond proceeds from the securitization at closing. An additional unique feature in this transaction was that the sponsor met its obligations under the risk retention rules with a horizontal cash deposit equal to 5% of the fair value of the certificates. More on this later.
In this annoying new world of risk retention, the direct issuance model embodied in this transaction can be a paradigm for transactions in the SASB space.
The positives and negatives of this transaction are:
On the plus side:
- The borrower has materially increased control over the structure of its loan. The bankers provided advice as to marketability and in connection with market acceptance of the structural features of the deal, but the sponsor, in large measure, constructs a bespoke deal that works for it. Works for the sponsor both in terms of the borrower's strategic plans as well as operational concerns and needs. Does the borrower need a particular release price structure? Can be done. Does the borrower need the right to release some non-income producing parcels from the transaction? Can be done. Does the borrower need to adjust the accounting reporting package to better match the timing and structure of its internal accounting system? If the borrower wants a particular yield maintenance payment structure, can it do it that? Sure.
- The bank is not long the credit exposure. The bank continues to discharge its traditional role in a securitization by assisting in managing the rating agency process, investor relations, providing structural guidance and, of course, distribution. The bank may have views on the borrowers "asks" and may tell its customer that some of these features may impact marketability, but, hey, it's the sponsor's deal.
- The structure takes the poison chalice of risk retention away from the banks. The borrower, in effect holds its own risk retention, which amounts to a reduction in the mortgage leverage available to the borrower in the transaction. (This could be made up with mezz particularly in light of how cheap mezz is these days.) As the borrower owns the risk retention piece, the structural friction of lack of control of duration which is embedded in the risk retention rule structure goes away as the borrower can pay off its loan whenever it wills.
Negatives on the transaction are:
- There's a novelty drag in our market on anything that's new and that could affect marketability of the bonds.
- In some cases, state mortgage lending licensure issues can become problematic. This is troublesome particularly in California, Nevada and a handful of other jurisdictions. A newly organized lender in the borrower corporate structure is unlikely to be a licensee, so this needs to be checked carefully. One could argue without embracing a great deal of audacity, that it's hard to find an aggrieved borrower when the lender and borrower are commonly controlled, but it's often a mistake to assume that regulation and government enforcement acknowledges any duty to common sense.
- In a very straightforward way, the borrower is taking market and spread risk on pricing as the loan is only ultimately sized and priced based upon bondholder appetite. However, let's agree that in the SASB space, hard commitments without market flex are rather rare.
Does this risk retention structure really work? The party required to retain risk under Regulation RR is the sponsor (or a majority owned affiliate of the sponsor) (17 C.F.R. 246.3). The definition of sponsor is "a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity" (17 C.F.R. 246.2). In the direct issuance model we have a depositor and an upstream entity with assets and employees that functions as the sponsor. It organizes and initiates, it has primary responsibility for the structure of the securitization and it transfers the financial asset to the issuer indirectly through the depositor. Voila. A sponsor. Did the agencies think about the direct issuance model when the risk retention rule was written? Not likely, but we achieve required risk retention in this model based on a very plain reading of the Rule.
Finally, just a word about the other feature of this particular deal which was noteworthy. That was the use of horizontal cash risk retention. This was novel. The cash reserve mechanic contained in the Rule has received very little attention since the risk retention rule was first promulgated. Why? Probably because its DNA can be found in the late, unlamented premium recapture structure championed by the NY Fed in the early exposure drafts of the Rule. That was such a transparent effort to spike the whole securitization business by the NY Fed that we were so soured on any provision that carried a whiff of premium recapture that we really didn't even look at it. It was just an alternative structure, it didn't need to be done. Forgettaboutit! But lo and behold, the cash reserve mechanic in the final rule actually has utility.
The cash risk retention option is contained in Section 246.4b of the rule. This section requires that the sponsor holds cash in an amount equal to the fair value of the eligible horizontal residual interest and requires that:
- The account is held by the trustee for the benefit of the issuing entity,
- the amounts in the account are invested only in cash and cash equivalents, and
- until the securitization repays in full (note other risk retention requirements go away when the pool amortizes to 33%, that may not be in the case with cash risk retention), the amounts in the account shall be released only to satisfy payments on ABS interest and pay critical expenses of the trust to parties that are not affiliated with the sponsor.
In certain types of SASB deals, this is an intriguing alternative. Whether it has legs or not is entirely TBD. The math is complex; there is certainly a negative cash arb resulting from using a cash reserve as, in effect, lower rated more expensive bonds are sold while an equivalent amount of very low yield cash or cash equivalents are isolated in the trust. On the other hand the cash reserve represents a potential ratings pickup and a positive investor response, particularly in the mezzanine part of the capital stack where there will actually be cash available to satisfy realized losses and extraordinary trust expenses. Think of it this way, in a traditional horizontal risk retention, a 5% loss might entirely be absorbed by the sponsor but an 8% loss will hit significant numbers of investment grade securities. In a cash reserve regime those investment grade securities will be paid first before any funds leak to the non-investment grade certificates.
Will we see this again? I expect so. Will we see a lot of it? I doubt it, but it's hard to tell.
Interesting transaction. Innovation is not dead in our market and as risk retention continues to roil the market and the regulatory state continues to intrude (yes, even under whatever this administration might be called), these and other innovations around risk retention may become viable. These alternate types of transactions might also become increasingly viable if the availability of the third party risk retention capital become inadequate to meet demand. We have talked in the past in this commentary about the difficulty of continuing to refresh the amount of capital necessary to float the CMBS industry in a horizontal risk restructure and that indeed may be the case.
And, in case you're so over worrying about risk retention, Y2K redux, before you entirely move on, consider this: what happens when the GSEs come out of conservatorship? When that happens, GSE securitizations will no longer be exempt from risk retention (See 17 C.F.R. 246.8). Let's see, that's $100 billion, $5 billion of risk retention. Got it covered? One more thing to keep you up at night if you run out of things to worry about.
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