This Bond Sale May Solve Wall Street’s $566 Billion Problemby
Wells Fargo issues first CMBS that meets Dodd-Frank rules
Banks depend on debt issuance to fund real-estate lending
Bonds sold on Thursday could determine whether Wall Street banks stay in the $566 billion business of packaging commercial mortgages into securities.
The nearly $871 million issue, from Wells Fargo & Co., Bank of America Corp., and Morgan Stanley, is the first to comply with new rules designed to make commercial mortgage-backed securities safer for investors.
To meet new regulations, the banks are keeping some of the offering. Bankers across the industry are unsure of a crucial piece of information about the assets that they hang onto: Will regulators view them like bond investments or mortgage loans? If regulators treat them like bonds, more underwriters are likely to exit the business, which generates $2 billion of annual revenue for them, according to research firm Coalition Development.
Any exit would be another blow for Wall Street bond businesses, which have already experienced 30 percent drops in revenue in the last three years after getting hammered by litigation, regulation, and shrinking customer volume. The decline of their commercial mortgage bond units could also make it harder for property owners to borrow. Banks already have $1.9 trillion of the real estate loans on their books, and regulators are pressuring them to reduce risk from the assets.
The deal is set to provide “certainty of execution that this structure can work,” said Chris van Heerden, the Charlotte-based head of commercial mortgage-backed securities and real estate research at Wells Fargo.
Banks are the biggest sellers of commercial mortgage bonds, having sold 91 percent of the most common kind of the securities issued this year, data compiled by Bloomberg show. There were about $566 billion of the securities outstanding as of the end of June, according to data from the Securities Industry and Financial Markets Association. New issuance has fallen 43 percent to $32.8 billion from a year ago.
Wells Fargo is issuing the bonds, known as WFCM 2016-BNK1, backed by its own loans plus some from Bank of America and Morgan Stanley. All three of the banks are underwriting the securities. The deal is helping fund projects including a luxury mall in Las Vegas, the Boston headquarters of Vertex Pharmaceuticals Inc., and a Renaissance hotel in Dallas, according to a report from Kroll Bond Rating Agency.
Wells Fargo sold a $267 million chunk of the transaction at a spread of 94 basis points, the lowest premium this year for comparable securities.
Starting Dec. 24, new regulations require issuers of commercial mortgage bonds, and similar securities backed by loans, to hold onto 5 percent of the debt that they sell. That requirement is known as risk retention and was originally part of the 2010 Dodd-Frank financial reform law. It is designed to encourage lenders to make better lending decisions by forcing them to eat losses if loans go bad, and comes after bad subprime mortgages were packaged into bonds and helped inflate a housing bubble last decade.
Banks and other issuers have a choice about which securities they hold onto. They can hold 5 percent of every piece of a deal, or 5 percent of the bonds that will be the first to take losses in tough times. For commercial mortgage bonds, there’s a third choice: selling the 5 percent to a third party. Wells Fargo, Bank of America and Morgan Stanley are taking the first option, each holding part of the 5 percent.
Retaining these securities threatens to reduce banks’ profits because they have to fund any assets they hold. If the portion a bank retains is classified by banking regulators as bonds, they will have to use more capital to fund them, and the accounting treatment is worse.
“There are some really interesting questions that remain to be answered,” said Brian Olasov, an executive director at Carlton Fields Jorden Burt who helps craft the Commercial Real Estate Finance Council’s approach to new legislation and regulation.
"The deck is being shuffled and some people are going to win and some people are going to lose," he said. "Some people are going to be brought into CMBS that haven’t been in CMBS before and others are going to leave CMBS."
Banks have had more than 18 months to scrutinize the final regulations for risk retention. Wall Street firms have figured out how to follow the rules for most kinds of bonds backed by debt, including residential mortgage-backed securities and collateralized loan obligations.
But for CMBS, banks have had more trouble. The loans in these securitizations are often longer-lived than credit card or auto loans, which forces banks to fund them with more capital. Many residential mortgages, meanwhile, meet exemptions from the retention rules that commercial mortgages do not.
Lenders outside the banking system see an opportunity. Ladder Capital Corp., a commercial property finance company, has sought regulatory approval to become a CMBS issuer, Pamela McCormack, the company’s chief operating officer, said at an industry conference in June. Others, such as Ellington Management Group, are looking to partner with banks to meet the retention requirement, according to Leo Huang, a senior portfolio manager at the company.
Issuers can also forgo their 5 percent retention requirement by finding a third-party investor to hold the most junior chunk of their offering. The catch: The issuer is responsible for ensuring the investor holds the securities without hedging -- and is liable if it does not. No issuer has yet tested this structure.
“There are going to be winners and losers,” said Rick Jones, a real estate partner at Dechert LLP. “A year from now, the number of issuers might be the same but I think the composition of that group will be very different.”