SPECIAL STUDY
The Impact of Regulation on Commercial Real Estate Finance Regulatory Design, Real Outcomes By Sameer Chandan, Christina Zausner
900 7th Street, NW, Suite 501 Washington, DC 20001 info@crefc.org
The CREFC Regulatory Impact Study was written by: Sameer Chandan, PhD and Christina Zausner. Special thanks to R. George Abood, Jr. for research and financial modeling. Editorial Support and Design Loquatio
CRE FINANCE COUNCIL REGULATORY IMPACT STUDY • DECEMBER 2015
CREFC
Regulatory Design, Real Outcomes ABSTRACT Now eight years since the beginning of the global financial crisis, the regulators are finishing up the bank agenda and are rolling out a slate of nonbank rules. The CRE Finance Council analyzed the holistic impact of regulations across the commercial real estate (CRE) sector through quantitative and qualitative methods, studying the impact on fund flows, market behavior and structure. Starting with the regulators’ own hypotheses, CREFC constructed a set of analyses to estimate the costs of new regulation. Assuming the regulators adopt final rules that remain close to the requirements discussed in public to date and assuming that a normal market environment prevails, the median ten-year impact on the real economy is estimated to be $209 billion. CREFC analysis also suggests that smaller borrowers, lenders and markets will bear a disproportionate percentage of the costs. Looking at the impact from the bottom up, the addition of a single data point into the reporting framework of a small-to-medium sized firm can exceed $1 million, which is the salary equivalent of 27 bank tellers. As a tool, regulation appears to be relatively more successful at forcing broad change, but it also appears to be a fairly blunt instrument that is difficult to control. Because the regulatory agenda extends out into the next decade, it is too early to fully assess the impact at this time. However, there is emerging evidence that, as vast as this agenda is, it may have transformed risk, instead of reducing it as planned. ■
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CRE Finance Council Regulatory Impact Study
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TOP 25 MSAs (Metropolitan Statistical Area) The CREFC study concluded that on the 10-year impact of regulation applied to CRE lenders and CMBS issuers going forward could reduce GDP over ten years by $168 billion to $938 billion, depending on the details of the rules to come.
Primary
Secondary Tertiary
Chicago, IL Houston, TX New York, NY
Dallas-Fort Worth, TX
Phoenix, AZ
Los Angeles, CA
Atlanta, GA
Detroit, MI
Washington, DC
Philadelphia, PA
Seattle, WA
San Diego, CA
Boston, MA
Baltimore, MD
Las Vegas, NV
Orange County, CA
Minneapolis-St Paul, MN
Riverside-San
Northern New Jersey, NJ
Bernardino, CA San Francisco, CA
Denver, CO Miami, FL San Jose, CA Orlando, FL Austin, TX
Integrating a single new data field into a firm’s systems can cost $2 million or more, which roughly equals the annual average salary of 33 data analysts.
Table of Contents CRE FINANCE COUNCIL REGULATORY IMPACT STUDY • DECEMBER 2015
4 Study Objectives
6 Main Conclusions
Regulatory Design, Real Outcomes Regulatory Burden and Risk-Taking 28 Regulatory Views on Deleveraging versus Growth 34 Rising Costs and Reduced Lending Volumes 36
16 Summary of Quantitative Analysis
24 Summary of Interviews
Cyclical Trends Masking Costs of Regulation 40
8 Executive Summary
Reducing Higher Regulated Institutions’ Competitiveness 44 Larger Impact on Small Borrowers 50
62
Role of CRE Debt in Small – Medium Enterprises 52
Resources
Ambiguous Link to Underwriting 54
Overview of Methodology 62
Drag on Economy 58
Applicable Regulations and Timeline 70 Bibliography + Glossary 78
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CRE Finance Council Regulatory Impact Study
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Study Objectives
THE FINANCING OF COMMERCIAL REAL ESTATE (CRE) INVESTMENT and development is a cornerstone of the US property sector. Construction activity, which depends almost entirely upon the availability of financing from banks and other regulated institutions, accounts for more than 1.4 million US jobs1 and more than $1 trillion per year in domestic investment2. ¶ While commercial real estate investment conditions have improved markedly from their financial crisis lows, the long-term impact of post-crisis regulatory intervention is still being assessed. In many cases, rules are early in their implementation lifecycle and the cost burden is better understood. In other cases, they have
At the time of this writing, international headwinds are gathering strength and U.S. GDP is less robust than it has been in most recovery periods. Though policy makers and market participants are generally optimistic that the U.S. economy is capable of absorbing the unwinding of unusually accommodative monetary policy, there are also credible concerns that the policy
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1.4 Million US jobs from construction activity, which depends almost entirely upon the availability of financing from banks and other regulated institutions
CRE Finance Council Regulatory Impact Study
playbook—including regulatory, monetary, fiscal, trade and tax policy—is inadequate for this new world order. Questions of policy effectiveness and correctness now must be answered against a backdrop of GDP and job growth that lag most post-crisis periods. Today’s economic policy challenges can be summarized in the words of a senior real estate portfolio manager at a large, diversified asset manager:
…To spur economic growth, you must provide more capital, better educate the labor force, reduce the burden
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1) BUREAU OF LABOR STATISTICS, EMPLOYMENT SITUATION REPORT, JULY 2015 2) BUREAU OF ECONOMIC ANALYSIS, NATIONAL INCOME AND PRODUCT ACCOUNTS, JULY 2015
yet to be proposed. The prolonged period of intense regulatory uncertainty is a significant challenge for business strategy and represents a risk to the system in and of itself.
on entrepreneurs and have more people enter the labor force. In many respects, we are 0 for 4. We’ve only reduced borrowing costs for existing borrowers and that’s helped current public and private equity owners but we haven’t accelerated small business formation to employ more people.
Within this historical context, the Commercial Real Estate Finance Council (CREFC) sought to assess the totality of the impact of prudential and securities regulation across the CRE finance sector. In this study, CREFC used both quantitative and qualitative analyses to evaluate how prudential banking, systemic risk and securities regulation are altering the CRE finance landscape.
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$1Trillion Annual domestic investment in commercial real estate
On the qualitative front, CREFC conducted more than two dozen interviews with CRE business leaders and regulatory professionals. Attempts were made to carefully represent a range of opinions regarding the various rules and also the challenges of estimating the financial and economic costs. CREFC also developed a suite of analyses used to estimate 1) direct regulatory costs on the CRE sector and on the economy, 2) the corresponding capital-at-risk (the amount by which loan proceeds would have to be reduced to hold costs constant) and 3) the sensitivity of the CRE loan universe to additional costs. The document and the research herein are intended to support a wider conversation regarding where regulation is effective and where it is less so. They are also intended to provide some clarity about the limitations and potential weaknesses of the regulatory agenda, and to characterize the risks of the regulatory burden and complexity. ■
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Regulatory Design, Real Outcomes Main Conclusions
THIS STUDY IS THE FIRST OF ITS KIND, PROVIDING A HOLISTIC ASSESSMENT of regulatory impact on the future financing of the commercial real estate sector. Because the regulatory environment remains in flux with an implementation timeline that extends through 2019, CREFC developed the below conclusions through a variety of sources: interviews with members, quantitative analyses, participation in regulatory working groups, and academic literature. Taken together, they suggest that regulation is generally most effective when used to achieve broad goals. Like most policy making tools, financial regulation tends to be a blunt instrument that often overshoots its target, and the regulatory agenda should be designed knowing that it is nearly impossible to target discreet outcomes. It is important to continue to assess the effectiveness of the rules to ensure a reasonable balance between economic growth and de-risking, and that markets remain efficient.
Policy measures have not proven to be conclusively useful in achieving behavioral changes, such as improving underwriting standards. Doing so requires a closed, monopolistic system or cartel type coordination across bank and nonbank lenders.
The complexity of the regulatory regime is driving some unanticipated changes in financing products, and by extension, the regulators cannot hope to effectively control the net level of risk in the system.
The fluctuation of regulatory capital requirements means that decisions to fund businesses are conducted in a more volatile manner.
Regulation is most useful in serving the broad goal of moving risk around the system. Rules can recalibrate the costs of doing business in one asset class relative to another and encourage changes in fund flows and capital availability.
In some cases, regulation is leading to worsening standards and outcomes, including an evolving bias against smaller borrowers.
Monetary policy is much more powerful than regulation in raising and lowering the volume of credit creation in aggregate across banks and nonbanks.
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Finally, regulation may not have resulted in a stronger market infrastructure. The volatility in Treasury benchmarks and the dramatic contraction in CMBS turnover are raising concerns about the market’s ability to absorb shocks. ■
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Regulation is a Hammer It is a blunt instrument that is best used in broader changes, and less successful when used to achieve more nuanced goals.
REGULATION’S GREATEST UTILITY
LIMITED EFFECTIVENESS …at moderating the volume of credit creation.
Herd-like shifts between asset classes (e.g., from CRE to other asset classes, including subprime). Transformation in risks (e.g., swapping credit for interest rate risk)
In best case, creates easily arbitraged standards (focuses too closely on certain factors like LTV leaving lenders to relax other parameters) In worst case, can lead to worse practices (e.g., the HVCRE rule which incentivizes lower equity contributions)
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Capital and liquidity requirements seem to be the best policy option for moving risk around the system. However, it still may not achieve a net reduction in risk across banks and nonbanks.
LIMITED EFFECTIVENESS …in achieving better underwriting and other market improvements.
Using a Hammer Can Be a Harsh Remedy Net Benefit not Apparent
Capital Rules
Liquidity Requirements
Underwriting Guidance
Market Restrictions and Disclosure Requirements
In part responsible for dislocations in some of the deepest markets Causing a bifurcation of markets between eligible and ineligible products
Combination of Volcker, reporting requirements and other rules have disrupted secondary market turnover
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Executive Summary
ENHANCED SUPERVISION AND REGULATION OF THE FINANCIAL SERVICES industry remains a policymaking priority eight years after the onset of the Global Financial Crisis. While policymakers have agreed on the broad provisions of the post-crisis regulatory framework, many of the measures mandated by the International Regulatory Framework for Banks (e.g., Basel III) and the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) have not yet come into force. New and, in many cases, overlapping regulations that directly affect CRE market participants are scheduled to be designed and implemented through 2019. In the months and years ahead, the regulators are proposing to revise rulemaking related to banks at the same time they roll that evolving model out to the nonbanks. CREFC studied the cumulative impact of regulation on the broad CRE financing sector and also the tradeoffs related to regulation. It is true that regulation provides certain benefits to the marketplace and to the economy as a whole. At the same time, it comes with certain challenges, including lower economic activity and lost jobs. While the regulators started the process by assessing this balance between higher capital and liquidity costs and economic output, several conditions have changed in the
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Outcomes Ultimately, the outcomes of the combined rules may exceed their original design
CRE Finance Council Regulatory Impact Study
interim. Ultimately, the outcomes of the combined rules may exceed their original design or may exceed the new equilibrium point, given changes in the macroeconomic environment and the architecture of the financial system.
THE COMMERCIAL REAL ESTATE FINANCE SECTOR The Federal Reserve estimated that commercial real estate (CRE) financing stood at $3.4 trillion. Because this series excludes the unfunded commitments related to construction and other types of CRE-based
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How Regulatory Costs Can Outpace Regulatory Intentions Layered Rule Making Different rules can interact and amplify outcomes
Individual Rules Regulators and industry discover true costs and challenges during implementation
Regulation is a blunt instrument – it can achieve broad change, but it often overshoots its target.
Economic Impact If it is difficult to anticipate the true range of regulatory effects on the financial sector, then it is even more difficult to determine and manage its impact on the economy
Added Factors Other market stresses, such as peaking refinance needs and rising rates, can drive capital and liquidity requirements higher
Executive Summary
lending, the CREFC estimates that total committed debt is more than $3.5 trillion. Banks originate more than half of the debt outstanding, followed by Commercial Mortgage-Backed Securities (CMBS) facilities, life companies, Real Estate Investment Trusts (REITs) and other nonbank lenders, including specialty finance, private equity and hedge funds. Nonbank lending as a proportion of the market has been growing.
Effect The cumulative effect of these regulations will be to increase the costs and to decrease the availability of financing
CRE debt finances all property types, starting with multifamily, followed by office and retail, hotel and other. The majority of the debt is senior and underwrites stabilized properties. CRE debt also supports entrepreneurialism, accounting for much of the financing to small and medium enterprises, and often at a substantially lower rate than even government subsidized products generally available to small businesses. Commercial real estate represents a material component of GDP. Construction activity is especially well-correlated with
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economic recoveries. One of the more observable impacts of regulation is that CRE construction volume is significantly lagging levels seen during past recoveries.
CRE Finance Council Regulatory Impact Study
ASSESSMENT OF THE CUMULATIVE IMPACT OF REGULATION The cumulative effect of these regulations will be to increase the cost and to decrease the availability of CRE and construction financing. One study suggests that even in today’s relatively healthy environment, regulation has driven more than 60 bps in cost increases for mid-tier borrowers to date. Other studies that are general and apply to the broad scope of financial services activities anticipate cost increases over the life of this rulemaking cycle of hundreds of basis points. CREFC estimates that future regulation will add additional costs of 10 bps at a minimum for high-quality loan and debt product platforms at lightly regulated institutions to 100 bps or more for lower quality loans, loans made in smaller metropolitan areas, and debt at more highly regulated institutions. To put
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Regulatory Cost Drivers
Riskiness of Product
Considerations for Product Treatment: Structure, concentrations, duration
Considerations for Treatment of Institution: Size, complexity, subject to prudential regulation
Type of Institution Less risk
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Most risk
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Executive Summary
this into perspective, these costs represent as much as 15% of an average coupon. If borrowers decide to reduce their borrowing instead of accepting higher rates and lower net cash flows, CREFC found through loan-level analysis that they would reduce proceeds by as much as 8%. The median ten-year economic impact is estimated at $209 billion. Many readers will be familiar with other estimates of both the costs of the crisis and the costs of regulation. During the deepest points of the downturn, commentators thought that the crisis may have cost trillions. However, it is important to distinguish several things about these earlier estimates: 1) the CREFC estimate is based on a normal market environment; 2) other studies referred to the total economy and the CREFC estimate refers to direct impacts to the CRE sector only; 3) the earlier estimates were using unrealized accounting losses as benchmarks, whereas many financial assets have recovered
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$209Billion The median ten-year economic impact of future regulation is estimated at $209 billion
their value; and 4) the enclosed analysis only addresses new regulations starting in second half of 2015. In addition to the regulatory costs, participants in interviews conducted by CREFC expressed concerns about the qualitative effects of the rules. Interviewees at regulated institutions consistently identified regulatory burden and uncertainty as limiting constraints on their lending activities. In more extreme cases, CREFC members described causal links from regulation to devolving lending standards, fractured decision-making and gaps in capital availability.
CRE Finance Council Regulatory Impact Study
One of the biggest challenges facing regulated institutions is the dynamism and uncertainty of the regulatory capital and liquidity thresholds. Capital allocation is intended to be conducted as part of longer-range planning, yet the banks and others have to work within the boundaries of more than a dozen regulatory thresholds. Market participants cite three measures of capital that generally hold the role of “outer bound”, the most stringent in a given period: risk-based capital, the leverage rule and the Fed-led stress tests. CREFC members have said that the outer bound can change from quarter-to-quarter, suggesting a volatile decision-making environment. It goes without saying that excess leverage can do harm to a market and an economy. A number of interviewees noted that lower leverage – whether achieved through regulation or rising rates – could be healthy for the system. However, CREFC members hold diverging views
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How Decision Making Across The Banking Industry Has Changed HURDLE RATE: The rate of return banks require to cover capital, liquidity and other costs. Can refer to an accounting, regulatory or some proprietary framework.
PRE CRISIS: Capital requirements were well understood and hurdle rates more predictable. Pre Crisis Hurdle Rate
Pre Crisis Cushion
C A P I T A L
TODAY: Myriad capital requirements lead to volatility in hurdle rates and requires a bigger capital cushion. Today’s Hurdle Rate
OUTER BOUND: The hurdle rate that represents the costliest regulatory hurdle rate.
Today’s Capital Cushion
C U
Leverage Ratio
S
POTENTIAL REGULATORY EFORCEMENTS FOR BREACHES: Capital Charges, Regulatory rating downgrades, restrictions on business activities, caps on acquisitions.
H I O N
Stress Tests
RiskBased Capital
CAPITAL CUSHION: Additional capital and liquidity firms maintain to account for uncertainty in the regulatory capital calculations.
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 UNCERTAINTY OVER TIME
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Executive Summary
on the effectiveness of the rules and whether they can achieve the original policy objectives. Across interview participants there was broad consensus that some risk had and would continue to migrate out of the banking system, but that system-wide risk was not necessarily lower. While it had moved to the nonbanks, it was also changing form, suggesting that risk in its new forms is somewhat difficult to identify and measure. Of the interviewees, many said that increased costs and uncertainty were forcing poorer decisions and standards, and that systemic risk was as high now as it was prior to the crisis.
Systemic Risk Many said that systemic risk was as high now as it was prior to the crisis
CALLING THE GAME NOW IS PREMATURE It is impossible to determine the extent of regulation’s impact on the industry as of this writing. The dimensions along which regulation can influence change are vast, but can generally be categorized in one of four buckets: leverage, market behavior, market structure and the real
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CRE Finance Council Regulatory Impact Study
economy. As of this writing, certain trends are emerging that suggest regulation is having a distinct effect on how, when and where CRE transactions get financed. Yet, regulatory impacts cannot be fully assessed at this time, due to the fact that: 1. The rules are still being designed and implemented (2019+): 2. The effects of low interest rates continues to absorb and counteract regulation; and 3. The new market structure, which is still emerging, has not been tested by a downturn or a market dislocation. The CRE Finance Council will continue to monitor regulatory outcomes and may revise the assessments in this study when more information becomes available. â–
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The dimensions along which regulation can influence change are vast, but can generally be categorized in one of four buckets: leverage, market behavior, market structure and the real economy.
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CRE Finance Council Regulatory Impact Study
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Overview of Quantitative Analysis
Smaller Regulatory Costs Can Yield Material Impacts Under Certain Conditions
• USING CONSERVATIVE ASSUMPTIONS, CREFC FOUND THAT REGULATION could add 10 to 100+ basis points of cost per deal going forward, depending on the lending entity and the product. • Assuming that the lenders push costs to the borrowers, then CREFC estimates that as much as 8.3% of the loan population will become difficult to refinance as a result of these additional regulations. • While the headline impact may seem moderate in efficient markets, such a stress could prove to be significant given mounting stresses, such as rate volatility and peaking of refinance demands. In order to evaluate the potential cost impacts of regulation, CREFC created a suite of analyses that 1) calculate the share of CRE loan proceeds that may be affected (“capital at risk”) and 2) the level of sensitivity to cost changes in the CRE loan universe. The first analysis measures the share of loan proceeds that must decrease in order to keep the DSCR levels above a 1.25x constant. The second illustrates the share of loans that would shift from one DSCR bucket to another, if the loan proceeds remained the same. Together these methodologies are referred to as “financial availability analysis.”
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QUANTIFY The sensitivity component of the analysis supported a better understanding of the range of underwriting practices used in the CRE marketplace
CRE Finance Council Regulatory Impact Study
CREFC also developed a set of loan-level regulatory cost assumptions specifically for the CRE sector that are key inputs into these analyses. The assumptions were drawn largely from regulatory sources, industry estimates, academic research and other public information sources. The cost assumptions were framed along two dimensions—class of institution and loan type. Best attempts were made to adjust for the considerable uncertainty that persists around rule writing at the time of this study by cross-referencing CREFC estimates where possible with other third-party estimates, and by building conservatism into
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Capital at Risk Regulatory costs can make financing more expensive, and reduce the capacity of the borrower to repay the loan. In turn, lenders will be unwilling to extend fewer proceeds to borrowers.
TOTAL DOLLAR AMOUNT
Low End
Base Case
High End
$18.0 B
$92.2 B
$198.0 B
TOTAL PERCENTAGES
Low End
Base Case
High End
-0.76%
-3.86%
-8.29%
Capital at Risk: Broken Out by Product PRODUCTS AND THEIR TOTAL DOLLAR AMOUNT
Low End
Base Case
High End
CMBS $2.4 Billion
CMBS $8.5 Billion
CMBS $15.3 Billion
Insurance $3.0 Billion
Insurance $5.4 Billion
Insurance $7.9 Billion
Bank Loans $12.4 Billion
Bank Loans $78.1 Billion
Bank Loans $174.7 Billion
$18.0 Billion
$92.1 Billion
$198.0 Billion
PRODUCTS AND THEIR TOTAL PERCENTAGES
Low End
Base Case
High End
CMBS -0.54%
CMBS -1.87%
CMBS -3.36%
Insurance -1.02%
Insurance -1.81%
Insurance -2.62%
Bank Loans -0.96%
Bank Loans -6.01%
Bank Loans -13.44%
-0.76%
-3.86%
-8.29%
the analysis. The primary ways in which CREFC built in conservatism were: - Backed out any double-counting of cost impacts from overlapping rules;
- Excluded multifamily loans from the analysis, due to the unique features of the multifamily market in the US, and the role of the government-sponsored enterprises in supporting its financing; and
- Assumed minimal impacts to most institutions other than larger banks;
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- Treated construction loans similarly to more stable loans, when in fact trends suggest that construction lending is bearing relatively greater cost burden. Capital at risk, or the loan proceeds affected, is calculated as the amount by which outstanding principal balance would have to be reduced in order to main-
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Estimated Distribution of US CRE DSCR After Regulatory Costs (2005-2015 Vintages)
$1,000 Billion $900 Billion $800 Billion CMBS Volume
$700 Billion
Severe Impact
$600 Billion
Medium Impact
$500 Billion $400 Billion
Minimum Impact
$300 Billion
Underwritten
$200 Billion $100 Billion $0 Billion
1.10x<
1.101.25x
1.251.35x
1.351.50x
1.501.75x
>1.75x
DSCR Projections
SOURCE: BLOOMBERG AND CREFC ANALYSIS
tain a minimum debt service coverage after the regulatory charge is applied. Importantly, CREFC makes no assertions as to what decisions borrowers and lenders will make with regards to the capital at risk and the dynamic response to the funding
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gap. The intent is only to estimate the magnitude of potential impact on the marketplace. The sensitivity component of the analysis supported a better understanding of the range of underwriting practices used in the CRE marketplace and the underwriting parameters that drive vulnerability to pricing changes.
More specifically, it pointed to those loans that would likely need to be restructured in order to maintain a DSCR above the 1.25x threshold. More information can be found in the section entitled â&#x20AC;&#x153;Methodology Overviewâ&#x20AC;?.
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Overview of Quantitative Analysis
AVERAGE OUTCOMES UNDER HEALTHY MARKET CONDITIONS
Transparency The CMBS sector offers the greatest transparency into the CRE sector
Assuming that all costs fall to the borrowers, as the regulators do in some of their own models, it is the borrower, not the lender, in this scenario that makes the decision about how to handle the higher costs. To make matters simple, CREFC assumed that all other parameters remain equal and that underwriting standards would be applied in a manner consistent with greater post-crisis discipline, when lower DSCRs were less prevalent. In this scenario, a borrower may decide to either accept the higher monthly interest payments or to reduce the amount in order to offset higher borrowing costs. . CREFC used a DSCR of 1.25x as the cutoff. The level was chosen based on analysis of the loan data and also on anecdotal information from conversations with members. It represents a midpoint of views about healthy DSCR levels for a generalized pool of properties.
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CRE Finance Council Regulatory Impact Study
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Sensitivity Synopsis Capital at Risk with Regulatory Cost Sensitivity ($ Millions) Regulatory Cost (Using 1.25xDSCR as a threshold) 0.100%
0.150%
0.175%
0.250%
0.300%
0.500%
0.570%
1.000%
Insurance
$3,091
$4,697
$5,484
$7,939
$9,605
$15,968
$18,029
$30,906
CMBS
$2,473
$3,893
$4,534
$6,824
$8,565
$15,389
$18,686
$37,235
Bank Loan
$7,280
$12,480
$17,030
$24,960
$31,070
$67,990
$78,130
$174,720
Total
$12,844
$21,070
$27,049
$39,723
$49,240
$99,347
$114,845
$242,861
Capital at Risk with Regulatory Cost Sensitivity (% Decrease) Regulatory Cost (Using 1.25xDSCR as a threshold) 0.100%
0.150%
0.175%
0.250%
0.300%
0.500%
0.570%
1.000%
Insurance
-1.02%
-1.55%
-1.81%
-2.62%
-3.17%
-5.27%
-5.95%
-10.20%
CMBS
-0.54%
-0.85%
-0.99%
-1.49%
-1.87%
-3.36%
-4.08%
-8.13%
Bank Loan
-0.56%
-0.96%
-1.31%
-1.92%
-2.39%
-5.23%
-6.01%
-13.44%
These tables provide sensitivities of the CRE sector to changes in regulatory costs (10 – 100 basis points)
In the case where a borrower chooses to reduce proceeds in order to maintain monthly costs, the analysis shows that between 0.8% and 8.3% of CRE debt outstanding is at risk, or between $18 billion and $198 billion with a base case scenario of $92 billion in capital-at-risk.
HOW DOES THE PICTURE CHANGE FOR DIFFERENT LENDERS? The financial availability analysis incorporated a wide range of regulatory costs depending on type of institution and applicable www.crefc.org
rules. Additionally, the analysis was geared to reflect differences in loan structure and underwriting parameters. Given assumptions about magnitudes of regulatory cost impacts by institution type, it is not surprising that the output suggests that bank lending would be most affected, with CMBS second and the insurance sector following. CMBS: The CMBS sector offers the greatest transparency into these issues for two reasons.
Loan-level data is available and the major pieces of regulation— Risk Retention, Regulation AB II and shelf registration requirements—are final. Based on industry estimates, these rules will add 10 bps to 50 bps of cost to an average loan, or roughly 0.5% to 3.4% of the current coupon. The CREFC methodology suggests that at the mid-point, 3.9% of the CMBS universe would be affected, translating into $8.6 billion of capital at risk. In our severe impact scenario, regulatory costs could place as much as much
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Overview of Quantitative Analysis
as $15.4 billion of CMBS capital at risk between the time of this writing and the point of implementation (i.e. December 2016). Insurance Companies: Life insurance company lenders are known for longer-duration loans to stabilized properties, generally to high-quality borrowers in gateway and primary markets. Additionally, as a sector, they are facing relatively less regulatory change than other regulated constituencies. However, the systemically important insurers (SIIs) will be subject to changes to capital, liquidity and other requirements that will result in a yet unknown regulatory burden. For the purposes of this analysis, CREFC assumed a relatively minimal change in pricing to borrowers in the life company lenders, due to future SII regulations that may also filter down to the next tier through supervisory pressures more than direct regulation.
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$281Billion $281 billion in outstanding CRE debt can be termed â&#x20AC;&#x153;riskierâ&#x20AC;? and would be relatively more sensitive to cost increases
CRE Finance Council Regulatory Impact Study
A 10 bps â&#x20AC;&#x201C; 25 bps change in costs, the insurance company loan universe could put $3.1 billion to $7.9 billion at risk with a base case of $5.5 billion. Some of the severity of the impact versus the CMBS world can be explained in that life company loans are often thought to be the most pristine and are relatively tightly underwritten. Bank Loans to Stabilized Properties: Given that the banking sector is undergoing the greatest amount of regulatory change, there would be the most variability in outcomes for this sub-sector. For this group, CREFC applied 15 bps to 100 bps of regulatory cost increases, assuming that the large banks would attract at least 25 bps on average. Given these assumptions capital-at-risk could be as low as $12.5 billion and as high as $174.7 billion with a base case decrease of $78.1 billion. Notably, because there was little loan level data available at the time of this analysis, CREFC extrapolated the cost of regulation from
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the CMBS universe by filtering loans that shared similar characteristics with bank and insurance loans respectively. Construction Loans: The High Volatility Commercial Real Estate (HVCRE) rule under Basel III that applies to almost all banks essentially adds another 50% in capital charges and the liquidity coverage ratio (LCR) also affects these portfolios. Though a large percentage of loan proceeds would be affected if CREFC had applied the same financing availability analysis to these loans, the nonbank sector is stepping into this business relatively aggressively. As such, CREFC treated construction loans similarly to loans on stabilized properties in the quantitative calculations, highlighting the poorer underwriting outcomes of the rule, which suggest more of a potential for a cliff function.
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Loans to REITs and Other Funds: Many private and some public funds draw revolving lines of credit or whole loans from banks for the purposes of funding acquisitions and some repositioning. These lines can attract charges related to the LCR; but more importantly, they can be subject to concentration thresholds that can cause banks to curtail new business suddenly. CREFC did not include these loans in the quantitative analysis, though a contraction in this type of lending would not only reduce bank exposures to the CRE sector but would also have the added effect of reducing levered nonbank investments.
sive. Here again, it is important to note that multifamily loans, which are often structured with lower DSCRs, were excluded from the analysis. According to this analysis, nearly 11.7% of the CRE loan universe were executed with underwriting parameters below 1.25x, which is generally seen as the minimum DSCR for a primary mortgage. This means that approximately $281 billion in outstanding CRE debt can be termed “riskier” and would be relatively more sensitive to cost increases. ■
HOW SENSITIVE IS THE CRE LOAN UNIVERSE? The above distribution of CMBS debt by underwritten DSCR indicates the range of more aggressive to more conservative underwriting present and measurable by one metric in outstanding debt. The greater the DSCR, the more conservatively the loan was underwritten. Loans underwritten with DSCRs of 1.25x and less are generally considered to be relatively more aggresCRE Finance Council Regulatory Impact Study
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Overview of Interviews
What CRE Business Leaders Said about Regulatory Impacts
IN ORDER TO GAUGE MARKET PARTICIPANTS’ ASSESSMENTS OF THE RAPIDLY changing regulatory context of commercial real estate finance, CREFC interviewed more than two dozen business leaders and regulatory professionals on both the buy and sell sides of the industry. In order to capture a diversity of viewpoints, the interview pool included individuals at banks, life companies, diversified asset managers, real estate investment trusts (REITs), private equity firms, hedge funds, CMBS lenders and others. ¶ Strictly speaking, CREFC did not conduct a survey, but rather a series of interviews based on similar but tailored questions. From this exercise emerged clear majority and minority views on a number of subjects, which are distilled below. Do the regulations have a positive impact on CRE finance? MAJORITY VIEW: General deleveraging is healthy to a point and the realignment of risk at a high level makes sense.
The majority of CREFC members believed that regulations can and will make a positive impact of some sort. Most of those
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individuals cited general deleveraging, or “sand in the gears” as one executive called it, as a positive result for the system, especially given the sustained monetary policy stance. Another executive explicitly noted that “the general direction of regulatory capital risk weights is right—charging more for riskier products is a good thing to do.” Other interviewees shared similar sentiments, and still others also said that adding a liquidity regime was necessary. CREFC members did raise the question of optimal deleveraging, i.e. how much deleveraging was appropriate for the intended regulatory objective. Some interviewees believed that they
CRE Finance Council Regulatory Impact Study
already saw too much deleveraging in the system, while the majority believed that capital was readily available to CRE borrowers at the time of this writing.
Do regulations have a negative impact on CRE finance? MAJORITY VIEW: Regulation may be too aggressive given the pace of growth; and it may also be embedding certain perverse incentives.
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Interview Statistics CREFC held more than two dozen conversations with industry leaders from a variety of lenders and investors between February 2015 – July 2015. Interviews were conducted anonymously. WHO WE INTERVIEWED
CMBS
Portfolio Lending
IG Investors
Mezz, B-piece buyers
Banks Life Co.s Asset Managers Others
7 1 8
8 1 5
– –
– –
4
4
15 2 22
3
2
–
–
8
Total
18
15
4
4
26
Total
Range of Strategies Removing double counting
Views CREFC reviewed opinions and categorized them by theme and majority/minority positions.
Overview of Interviews
The vast majority of interviewees believed that the regulations were at least partly responsible for a drag on growth that might prove excessive once fully implemented. At a micro level, several bank and nonbank executives found that regulatory burden and uncertainty were responsible for certain trends resulting in a deterioration of standards and practices, as well. While Basel III is generally realigning risk weights better with actual risk, some market participants believe that balance sheet allocation is now or may be skewed toward risk-taking due, in part, to rising costs and higher required yields. Following the implications of greater risk-taking through to their logical conclusions, underwriting practices will deteriorate in these scenarios. In some cases, the rules manifestly though unintentionally promote relatively inferior underwriting outcomes than current standards. The High Volatility Commercial Real Estate (HVCRE) requirements under Basel III are a case in point of flawed policy
26
in that they have the effect of setting a lower threshold for equity contribution than is current practice. Interviewees also offered little to no support for the extension of prudential regulation to nonbank systemically important financial institutions (SIFIs). The issue was raised in roughly half of the interviews, and none of these individuals believed that there was much value for the financial system in the application of banking regulation to insurance companies and other sectors. Some said that as the prudential regulatory perimeter moves outward to non-banks, competition for similar types of borrowers would increase as performance and risk models would naturally begin to overlap across CRE subsectors. At the same time, financing availability would contract for non-conventional borrowers. From a policy perspective, the increased competition might be healthy in a marketplace, but CREFC members also mentioned that the erosion of margin was potentially destabilizing.
CRE Finance Council Regulatory Impact Study
Can the regulations achieve the intended impact? MAJORITY VIEW: On the surface, the banks are relatively safer than they wereâ&#x20AC;&#x201D;but net systemic risk may be just as high as it was pre-DoddFrank, as regulation is an inadequate means to achieving better underwriting.
Several interviewees expressed that rules targeting underwriting would actually achieve the opposite outcomeâ&#x20AC;&#x201D;i.e., inferior lending standards and loan portfolios. Underwriting criteria can only target a few features of a loan. When pressed, most interviewees said that they would prefer a better borrower
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WHAT WERE THEIR VIEWS
Some Positive Impacts
Yes % 53
No% 47
Generally thought that deleveraging in the main is good, especially in a low rate environment.
to tight underwriting characteristics, but many lenders revealed that pricing had increasingly become a determining factor.
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Achieving Intended U/W Impacts
Mostly Negative Impacts
Yes % 89
No%
Yes %
11
19
But only to a point, and largely believe that regulatory benefits will be outweighed by negatives.
A minority of interviewees believed that contraction in capital availability at regulated institutions would lead to better loans, even in the presence of relatively unregulated sources of capital. They rejected the idea that the better borrowers
No% 81
Except in the case of general distribution of RWs, most believe that regulations werenâ&#x20AC;&#x2122;t achieving intentions.
would move to lower-cost products, in favor of the belief that lenders and investors would be relatively more selective as lending capacity tightened. â&#x2013;
CRE Finance Council Regulatory Impact Study
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1 KEY FINDING
Regulatory Burden and Risk-Taking SIX YEARS AFTER THE G20 REGULATORY AGENDA WAS FIRST articulated and five years since Dodd-Frank was enacted into law, regulatory initiatives that bear on the functioning of the financial system and CRE lending are still being designed. Even so, the related regulatory and compliance burdens associated with the implementation of pending regulatory initiatives have become features of the post-crisis marketplace, both for lenders and borrowers. The head of CRE lending at a large bank described the overall burden using the Fed-led stress tests as an example. â&#x20AC;&#x153;The banks are supplying the regulators with tens of thousands of pages of information and data points for just this one exercise, and then there are the living wills, Volck-
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er compliance, all of the many regulatory capital and liquidity ratios, and more.â&#x20AC;? The full impact of new regulation has not yet reached the marketplace. Only a subset of the regulations that relate to CRE lending directly have come into force as of late 2015. Between now and 2019, regulatory de-
CRE Finance Council Regulatory Impact Study
mands will increase materially, reflecting newly implemented provisions of Basel III, provisions of Dodd-Frank relating to securitization and derivatives trading, and other efforts.
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New Rulemaking and Designation Themes for 2016 On the bank side, the regulators are more than halfway through their agenda and are circling back to redesign the standards that are not stringent enough. On the nonbank side, the insurers and the diversified asset managers are more exposed to new requirements, while CMBS will be subject to REG AB II and risk retention conformance.
Large Banks
Small Banks
1) Total capital requirements for largest banks (total loss absorbency capital) 2) Changes to the risk-based capital regime 3) New liquidity rule (Net stable funding ratio)
1) Relief plans are popular target but a long way from adoption 2) Additional reporting requirements
Insurance Companies 1) New capital requirements for systemically important insurers (SIIs) 2) Holding company versus operational company model 3) Potential for new requirements on non-SIIs
Asset Managers and Activities 1) Potential for revival of designations process 2) Other entity and activities requirements
Key Finding #1: Regulatory Burden and Risk-Taking
The regulation falls most heavily on large institutions, especially banks. Jamie Dimon was quoted in 2014 as saying that compliance costs alone (not including the costs of meeting marginal regulatory capital and liquidity requirements, fines or additional risk management activities) will add $2 billion per annum to JPMorgan Chaseâ&#x20AC;&#x2122;s cost base.
+ 10,000 The banks are supplying the regulators with tens of thousands of pages of information and data points for just one exercise
The cost burden of new regulatory requirements falls relatively heavier on small lenders. The market share of community banks has declined significantly since 2010, at double the rate of decline in the previous decade. The new regulatory environment has exacerbated the trend by hastening consolidation through the cost of regulatory compliance, (i.e., regulatory economies of scale are contributing to consolidation). This burden of new regulation is increased by the fragmentation of regulatory authority across a large number of domestic and international agencies, which has allowed for parallel and
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CRE Finance Council Regulatory Impact Study
often overlapping initiatives. Not including their global counterparties, there are eight distinct federal financial regulators in the United States. Assessing the individual impacts of these provisions is made problematic by layering effects, where multiple rules relate to the same set of activities. CRE debt is a diversified asset class in that banks account for much of the lending (50%+) and the nonbanks (life companies, REITs, asset managers, and private funds) and commercial mortgage backed securities (CMBS) account for the rest. Roughly one quarter of the debt outstanding is securitized and traded. Accordingly, the CRE sector is subject to much, though not all, of the evolving regulations hitting banks and securitized products, and that will potentially encompass large life companies, asset managers and other ancillary markets. It is likely that regulatory change will continue apace for several years, winding down into the next decade. As of this writing, however, regulatory
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Number of US Commercial Banks
Overview of Interviews
8000 7500 7000 6500 6000 5500 5000 4500 4000 3500 3000
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
SOURCE: FDIC
capital levels have increased by more than 200 bps on average since 2007. Large US banks hold approximately 12.75% tier I capital today versus roughly 10% at the peak. At the same time, the standards for meeting risk-based capital ratios have become increasingly conservative. The numerator is now composed largely of tangible common equity and
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the calculation of the denominator is moving toward Basel III methodologies, which are more rigorous than Basel II in many respects. In other words, 12.75% tier 1 capital today is greater than it was in 2007 terms. Additional new requirements regarding capital and liquidity at banks and SIFIs will further raise headline requirements and also cause executives to potentially reallocate capital.
One CREFC member placed regulatory uncertainty on the same plane of concerns as rising interest rates and geopolitical risks. While most interviewees viewed regulatory change as a smaller challenge than changes in monetary policy or in world order, the majority did question the consequences of regulation.
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Key Finding #1: Regulatory Burden and Risk-Taking
Regulatory burden and complexity taken together could confuse the incentives and the signals by which lenders and investors operate. In a worst case, regulation could result in greater risk taking, rather than less. While almost every interviewee touched on the fact that uncertainty is leading to conservatism, it is not clear that the resulting form of risk-taking is any more prudent. Business heads need to meet higher hurdle rates as a consequence of greater regulatory costs, which suggests the drive to accept more, not less, risk. â&#x2013;
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BURDEN Business heads need to meet higher hurdle rates as a consequence of greater regulatory costs
CRE Finance Council Regulatory Impact Study
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How Regulatory Complexity can Increase Risk in the System The complexity of the rules coming through the pipeline is unprecedented and the regulatory system is unprepared to manage the industryâ&#x20AC;&#x2122;s questions. Even fundamental questions persist well past implementation.
Complicated Rule Ownership
Implementation Lag
Implementation Timeline
Even after the rules are final, there is a huge lag in terms of understanding the impacts:
Capital and Liquidity rules (Fed, OCC, FDIC) Volcker Rule (Fed, OCC, FDIC, SEC, CFTC) Risk Retention (Fed, OCC, FDIC, SEC, FHFA, HUD) 390 Dodd Frank Rules Tens of thousands of pages of rulemaking â&#x20AC;&#x201C; hundreds of thousands of new data reported by each bank = inconsistencies and questions throughout the process and the system
Phase In
Conformance
Business Line Cost Revisions
Changes to Strategic Decision Making
Implementation requires years before understanding true costs.
Risk Retention (End of 2016) Revisions to Risk Based Capital Rules (not yet known) Liquidity Rules (2018) Total Loss Absorbency Capital (not yet known) Volcker Rule (2019 and possibly beyond) Nonbank SIFI Rules (not yet known)
There is evidence that the variance in interpretation of rules across institutions is so vast that it gives rise to the question of regulation as a source of risk to the system. If banks and other regulated entities cannot understand what the regulators want, and the regulators do not answer, then it must be true that confusion about the rules is leading to inconsistency in reporting and inaccuracy in capital and liquidity measurement. www.crefc.org
The Impact of Regulation on Commercial Real Estate Finance
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Regulatory Views on Deleveraging versus Growth
Regulatory Views on Deleveraging versus Growth The regulators have pressed for higher capital and liquidity levels at banks in order to try to achieve a better balance between financial system risks and long-term economic growth.
Their analysis suggests an optimal level of roughly 8.5% to 10.5% high-quality equity for the banking system globally.
Given that economic growth is mostly sluggish throughout the G20, plans to push past this threshold for the majority of banking assets might be less sound today than they were several years ago when the regulatory targets were first established.
The Taylor Rule, proposed
More accurately, there are
optimal capital levels for
by John B. Taylor of Stanford
many papers that explore this
banks is somewhere between
University, is generally asso-
relationship between capi-
8.5% and 10.5%. Below 8.5%,
ciated with the 2% inflation
tal, liquidity and changes in
excess leverage can cause as-
guideline used in setting US
GDP; but one is fixed in the
set bubbles. On the other side
monetary policy. In the same
regulators’ minds and Fed-
of the threshold, too much
way that this rule establishes
eral Reserve Chairman Janet
capital can dampen growth
a correlation between infla-
Yellen has referred to it during
without achieving an offset in
tion and official rates, there is
Congressional hearings and
marginal risk reduction.
a paper, which establishes a
in open board sessions. The
similar connection between
Basel Committee on Banking
bank capital requirements and
Supervision (BCBS) published
economic growth.
a paper in 2010 “An Assessment of the Long-Term Impact of Stronger Capital Requirements,” in which the authors suggest that the
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CRE Finance Council Regulatory Impact Study
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Rebalancing Risk with Regulations Long-run expected annual net economic benefits of increases in capital and liquidity. Net benefits (vertical axis) are measured by the percentage impact on the level of output.
Increasing Capital and Meeting Liquidity Requirements
Moderate permanent effects No permanent effects
8%
9%
10%
11%
12%
13%
14%
15%
Capital Only
2.5%
2.5%
2.0%
2.0%
1.5%
1.5%
1.0%
1.0%
0.5%
0.5%
0%
0%
-0.5%
-0.5%
16%
8%
9%
10%
Capital Ratio
11%
12%
13%
14%
15%
16%
Capital Ratio
SOURCE: BANK FOR INTERNATIONAL SETTLEMENTS, AN ASSESSMENT OF THE LONG-TERM ECONOMIC IMPACT OF STRONGER CAPITAL AND LIQUIDITY REQUIREMENTS, 2010
Industry and Regulatory Cost Estimates Vary Greatly Basel III Impact on Credit and GDP Growth Basel III Impact
Impact on credit spreads
Impact on annual GDP growth
bps
Credit/GDP
% bps/%
Zone
Europe/Japan/U.S.
Europe/Japan/U.S.
IIF 2012-2019 IIF 2011-2015 OECD 5 years tansition BIS Long-term (capital) 1/ 2/ 3/ BIS Long-term (liquidity) 3/ 4/ BIS Long-term (combined) 3/ 5/
328/181/243 291/202/468 54/35/64 52/N.A./52 25/ N.A./25 22/ N.A./66
-0.40/-0.30/-0.10 -0.60/-0.80/-0.60 -0.23/-0.09/-0.12 -0.07/ N.A./-0.03 -0.03/ N.A./-0.03 -0.08/ N.A./-0.04
Global Impact 281/-0.20 364/-0.70 53/-0.16 52/-0.06 25/-0.03 66/-0.08
SOURCE: SANTOS, ANDRÃ&#x2030; OLIVIERA AND DOUGLAS ELLIOTT, IMF STAFF DISCUSSION NOTE: ESTIMATING THE COSTS OF FINANCIAL REGULATION, SEPTEMBER 11, 2012
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CRE Finance Council Regulatory Impact Study
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2 KEY FINDING
Increases in Borrowing Costs and Reduced Lending Volume RECENTLY IMPLEMENTED AND PENDING REGULATORY initiatives raise banks’ and other lenders’ costs for making CRE and construction loans, reducing their incentives to lend to the sector. One market participant, representing a subsidiary of one of the nation’s largest banks, indicated that higher costs are impacting allocations to CRE across a range of balance sheet lenders, including banks and life insurance companies. Lenders have an incentive to pass these costs to their borrowers and not to bear them alone. As a result, the net impact of the additional regulatory burden includes higher lending costs
36
for lenders, higher borrowing costs for borrowers and reduced volume for both. The head of real estate at one of the most active that CRE bank lenders estimates the lower
CRE Finance Council Regulatory Impact Study
bound on the increase in cost to large borrowers at 10 bps to 20 bps. At the upper bound, other researchers have estimated that costs could be as high as several hundred basis points for certain exposures. Additional regulatory www.crefc.org
How Regulatory Costs Can Translate Into â&#x20AC;&#x153;Capital-at-Riskâ&#x20AC;?: Two Paths REG COSTS INCREASE Transmits to Borrower through higher rates
Lender retains costs
Pressure on underwriting metrics and covenants
Less capital available (less leveragability)
May need to add equity to refi or remain out of technical default
Lower margin and greater possibility that biz becomes unprofitable
Key Finding #2: Increases in Borrowing Costs and Reduced Lending Volume
requirements at banks and other highly regulated institutions will extend across capital, liquidity, disclosures, risk management and other compliance obligations. CREFC members pointed out that more than price concerns, volume will be constrained by further apportioning balance sheets to capital and to liquid
assets. Even an institution that lends exclusively on CRE must make fewer loans if each loan requires a larger allocation of capital. Since allocations to CRE will place greater demands on finite capital reserves, bank lending in other sectors will be negatively impacted as well. Research suggests that cost increases in one segment of the market influence costs in other segments of the sector.
Where the distortions of incentives from new regulation are greatest, we observe the most significant departures from historical lending patterns. Under new risk-based capital treatment, construction loans (even to well-rated borrowers) are assigned the same risk weight as loans that are 60-days delinquent. As such, construction lending bears one of the greatest
Quarterly Change in Construction Loans Held on Bank Balance Sheets (In Billions)
$50 $40 $30 $20 $10 $0 -$10 -$20 -$30 -$40 -$50
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 SOURCE: CALL REPORTS, CHANDAN; IN BILLIONS
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CRE Finance Council Regulatory Impact Study
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Stakeholder and Financing Views While the banks are bearing the brunt of the regulatory reform directly, there are many pathways through which demands for higher standards are transmitted to nonbanks
Shareholders
Debt Holders
Legislators
Banks
Regulators
Compliance Departments
Boards & Executives
Investors (in funds)
Clients
Nonbanks
F INANCING
increases in regulatory capital costs of any class of lending. Seven years after its pre-crisis peak, net construction lending by banks is still only a fraction of its previous high and has increased from its crisis nadir at a markedly slower pace than during previous recoveries. Even if new regulations do not extend directly to nonbanks, they too are subject to www.crefc.org
increasing costs of regulation through many channels. The most direct route is when banks pass along costs through their lending arrangements to nonbanks that are used to purchase and to reposition properties. One head of CRE financing at a REIT described how increased borrowing costs are perhaps
the lesser of the challenge. The greater issue is when a strong banking partner cuts the lending arrangement due to strict concentration limits. Turning that around, a strong lender refused to continue the relationship with a strong borrower in order to avoid higher capital charges, suggesting some room for negative bias in selecting client composition. â&#x2013;
CRE Finance Council Regulatory Impact Study
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3 KEY FINDING
Cyclical Trends Masking the Full Impact of New Regulation NATIONALLY, CRE INVESTMENT AND PROPERTY TRENDS have improved since the sectorâ&#x20AC;&#x2122;s financial crisis nadir. Some of the biggest game changers have been low rates, restraint in new construction, resolution of problem loans, more discipline in underwriting and better disclosures. These and other factors have reversed the net outflows from the sector that extended from 2008 through 2010 to net inflows. The capital accumulating today in the CRE sector is spread across all types of nonbanks and is counterbalancing the pullback in bank lending. Industry participants estimate that tens of billions in capital has been raised by more opportunis40
tic funds in recent months. That availability of capital suggests that valuations will continue to improve, all else being equal. General trends of higher proper-
CRE Finance Council Regulatory Impact Study
ty values and recovering operating income reflect the positive relationship between capital markets and CRE investment as well as between macroeconomic conditions and property fundamentals. www.crefc.org
Property Prices: Major Market Apartment Recovered Most Major Markets’ Price Appreciation Continue to Outpace Non-Major Markets
Peak to Trough
Peak to Current
Percentage Peak-to-Trough Loss Recovered
Peak Month
Peak Year
YoY
Apartment — Major Apartment Office CBD
-23.2% -37.6% -49.3%
47.3% 29.5% 35.5%
304.0% 178.3% 172.0%
Dec-07 Dec-07 Feb-08
Dec-09 Jan-10 Sep-09
19.5% 15.4% 23.6%
Major Markets
-38.5%
27.4%
171.0%
Dec-07
Jan-10
17.9%
Office CBD — Major Industrial — Major Hotel — Major Apartment — Non-Major
-48.9% -33.3% -40.0% -45.5%
33.0% 16.0% 13.0% 14.0%
167.6% 148.2% 132.5% 130.7%
Mar-08 Sep-07 Mar-08 Sep-07
Sep-09 Dec-09 Mar-10 Dec-09
16.9% 27.9% 33.4% 14.5%
National All — Property
-40.4%
11.5%
128.5%
Nov-07
Jan-10
16.4%
Office Retail — Major Core Commercial Office CBD — Non-Major Industrial Hotel
-45.8% -39.7% -41.5% -51.7% -32.9% -42.1%
12.4% 6.2% 5.4% 2.2% 0.7% 0.8%
127.0% 115.6% 112.9% 104.2% 102.1% 101.9%
Nov-07 Sep-07 Nov-07 Sep-07 Oct-07 Mar-08
Jan-10 Jun-10 Jan-10 Sep-09 Jan-10 Mar-10
20.1% 9.2% 16.9% 16.6% 14.0% 33.3%
Non-Major Markets (All-Property)
-42.4%
-1.4%
96.7%
Oct-07
Jan-10
15.2%
Office Suburban — Major Retail Hotel Non-Major Office Suburban Industrial — Non-Major Retail — Non-Major Office Suburban — Non-Major
-46.4% -42.8% -43.8% -46.1% -33.8% -44.6% -45.5%
-6.8% -7.5% -7.7% -10.7% -9.6% -17.4% -19.0%
85.4% 82.5% 82.3% 76.8% 71.5% 61.0% 58.2%
Dec-07 Oct-07 Mar-08 Oct-07 Sep-07 Sep-07 Sep-07
Jun-10 Aug-10 Mar-10 Jul-10 Dec-10 Sep-10 Sep-10
16.4% 12.7% 32.7% 16.2% 12.0% 12.5% 16.7%
Index
NOTE: MAJOR AND NON-MAJOR MARKET BREAKOUTS OF EACH PROPERTY SECTOR ARE QUARTERLY DATA, ALL ELSE IS MONTHLY. PEAKS ARE PRE-CRISIS (2007-08), TROUGHS ARE POST-CRISIS (2009-10). HOTEL INDICES LESS COMAPARABLE TO OTHER SECTORS DUE TO DATA DIFFERENCES. SOURCE: MOODY’S/RCA, MORGAN STANLEY RESEARCH.
Key Finding #3: Cyclical Trends Masking the Full Impact of New Regulation
During the first quarter of 2015, annualized commercial property sales increased to $111.4 billion, up 45% from a year earlier but still well below their peak in the first quarter of 2007. The largest markets, where institutional and cross-border investors are less dependent on the availability of financing, have shown the most robust recoveries in transaction volume and property values. Relatively smaller markets have recovered more slowly. Systematic differences in the cyclical performance of large and small markets, assets, and lenders, mask drags on CRE lending from current and pending regulatory initiatives. Several CREFC members have expressed that the full cost of new regulation, and its impact on real estate market liquidity, will be more readily observable during phases of the cycle characterized by increasing economic and financial stress and reduced liquidity. Considering the regulatory timetable, the full weight of new initiatives may coincide with an environment of higher interest
42
Disintermediation The capital accumulating today is spread across all types of nonbanks
rates and legacy debt maturities. In some ways, refinance spikes offer opportunities to investors. However, supply and demand mismatches have often been found to be drivers of market dislocations. While most CREFC members were concerned about contagion from other asset classes, and
CRE Finance Council Regulatory Impact Study
not so much about weaknesses in the CRE sector itself, unmet refinance demands could weigh on property values and other fundamental metrics. â&#x2013;
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Peaking Refis Driving Need for Capital as Regulation takes Capital Off the Table Commercial Real Estate Debt Maturities (In the billions)
$371.7
$345.3
$342.4
$72.0
$65.2
$23.4
$22.6
$315.7
$300.2
$58.5
$51.1
$23.0
$21.9
$178.6
$123.2
$98.1
$400 $350 $300 $250
$73.9 $24.4 $62.6 $66.7
$200
$101.3 $113.6
$150
$138.8
$43.4 $19.2
$100
$210.8
$183.2
$41.4 $153.3
$120.6
$50
$93.4
$74.6
$34.3 $16.0 $25.8 $47.1
$0 2013
2014
2015
Banks
2016
CMBS
LifeCoâ&#x20AC;&#x2122;s
2017
2018
2019
$25.1 $14.4 $23.3 $35.3 2020
Other
SOURCE: TREPP, REAL CAPITAL ANALYTICS
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CRE Finance Council Regulatory Impact Study
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4 KEY FINDING
Reduced Competitiveness of Highly Regulated Institutions THE DISTRIBUTION OF CRE DEBT IS RELATIVELY EVEN between banks and nonbanks. Policy makers, industry leaders, borrowers and other interested parties typically view the strength of the nonbank market as a competitive advantage of the US capital and credit markets. Indeed, European lawmakers and regulators have been struggling to regenerate their economy partly by widening access to nonbank financing. Their goals are twofold: 1) to extend debt financing to lesser-banked individuals and entities, and 2) to better diversify risk in the system. Comparatively, larger lenders in the USâ&#x20AC;&#x201C;banks and nonbanksâ&#x20AC;&#x201D;tend to serve larger borrowers while
44
smaller banks and CMBS conduits tend to serve the smaller borrowers. Regulation of the US CRE sector has accelerated this balancing of risks between higher and low-
CRE Finance Council Regulatory Impact Study
er-regulated institutions. While banks still remain the lower cost lender in many products and markets, rising costs and restrictions are changing how they do business. Theoretically, advanc-
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Commercial Mortage Debt Outstanding by Holder (Excluding Multifamily Debt)
TOTAL PERCENTAGE
54.4%
Commercial Banks
19.2% CMBS
12.7%
Life Insurance
3.3% REITs 3.0% Federal Government
0.9% Pension Funds 6.5% Other NOTE: AS OF 4Q14. EXCLUDES MULTIFAMILY MORTAGE DEBT; SOURCE: FEDERAL RESERVE AND KBW RESEARCH
Key Finding #4: Reduced Competitiveness of Highly Regulated Institutions
Regulatory Costs Influence Strategic Decision-making If revenues donâ&#x20AC;&#x2122;t clear hurdles then executives may cut balance sheet funding or may defund an entire business line
Revenues need to increase in order to clear higher hurdle rate
Stable Hurdle Rate Means more certainty
Unstable Hurdle Rate Many hurdle rates mean more uncertainty
INCREASE IN REGULATORY COSTS
Even regulation that affects the holding company adds costs to their business lines. Therefore, SIFI surcharges, and other such corporate level assessments are allocated out to CRE lending platforms and other businesses.
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CRE Finance Council Regulatory Impact Study
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Bank Return on Equity by Region (In Percentages) Euro Area
Other Europe
30
30
20
20
10
10
0
00
02
04
06
08
10
12
14
0
00
02
04
North America
20
20
10
10
0 00
02
04
06
08
10
08
10
12
14
10
12
14
Asia-Pacific
30
0
06
12
14
-10
00
02
04
06
08
SOURCES: BLOOMBERG L.P. AND IMF STAFF ESTIMATES FROM OCTOBER 2014 GLOBAL FINANCIAL STABILITY REPORT, PAGE 23
ing the risk culture at banks should engender longer-term decision-making impulses. Yet, in many ways, the opposite may be occurring. As capital and liquidity charges evolve, new behaviors that are different from proven practices become standard. At a high level, balance sheet costs, which are intended to be relatively
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stable, can change substantially on a quarterly basis. This indicates that the benchmark for deal profitability also moves around frequently. One CMBS head described the competition within his bank for balance sheet allocation as a â&#x20AC;&#x153;Dutch auctionâ&#x20AC;?. This suggests that senior bank leaders are not so much making decisions based on a long-term view of fundamental and performance trends, but more on the willingness to reduce margins.
To the extent that banks push those expenses out to their clients, many have expressed concerns about adverse selection of low-risk borrowers. As the cost of financing increases for prudentially regulated institutions, the relative cost of financing declines for nonbanks.
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Key Finding #4: Reduced Competitiveness of Highly Regulated Institutions
Even if the banks remain the lower cost lender, they are choosing or being forced to retreat from certain borrowers and products. A recent American Bankers Association survey of chief compliance officers suggested that 46% of banks had retreated from certain products and services in 2014 versus 22% in 2009. As it is, they are having a harder time covering their costs of capital. Research by the International Monetary Fund suggests that even in the US, where banks have returned to relative health, their returns are just clearing their equity costs.
Retreat Even if the banks remain the lower cost lender, they are choosing to or being forced to retreat from certain borrowers and products
In some cases, the banks are even intentionally turning good borrowers away. The head of CRE lending at a REIT explained that a week after executing a financing arrangement with the firmâ&#x20AC;&#x2122;s primary bank, the institution turned them away for a second loan for fear of hitting concentration limits embedded in newer capital requirements. While lower aggregate lending by banks and systemically important financial institutions will reduce their exposure to the real estate sector, adverse selection works in the other direction, increasing the average risk profile of regulated lendersâ&#x20AC;&#x2122; exposures. â&#x2013;
In turn, banks are forced to raise rates. As they do so, large, lower-risk borrowers may migrate from banks and SIFIs, to more competitive sources of capital, reducing the average quality of mortgage portfolios held on balance sheets.
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The head of CRE lending at a REIT explained that a week after executing a financing arrangement with the firmâ&#x20AC;&#x2122;s primary bank, the institution turned them away for a second loan for fear of hitting concentration limits embedded in newer capital requirements.
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5 KEY FINDING
New Regulation Imposes Greater Costs on Small- & Medium-Size Borrowers IN SECONDARY AND TERTIARY MARKETS, smaller regional and community banks are often the only consistent sources of construction lending and shorter-term financing for cash flowgenerating properties. CMBS lenders dominate the supply of relatively longer-term small-balance mortgages. These are the two sources of financing that will attract the greatest relative regulatory cost burden in the future. Small- and medium-size banks have been regulated historically, but much of the newer regulations are only just going into effect for these institutions. CMBS issuers will have to conform to the risk retention rule in December 2016,
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though the market is slowly starting to evolve toward the requirements already. In addition to the increase in burden at the institutional level, CREFC members believe that
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small-balance borrowers and lenders in secondary and tertiary markets will bear a relatively heavier regulatory burden than their counterparts in larger markets with more diverse capital
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Relativity sources. In part, this reflects economies of scale in meeting the regulatory and compliance burdens; smaller lenders have less scale over which to spread the fixed costs of their compliance activities. This belief is consistent with market analysis that shows that the brunt of higher regulatory costs across a wide range of asset classes will be borne by
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CREFC members believe that smallbalance borrowers and lenders in secondary and tertiary markets will bear a relatively heavier regulatory burden
low-income consumers and small businesses. Historically, they have had less pricing power; and the newer capital rules will further assign charges to borrowers and properties that are less pristine.
By limiting liquidity in secondary and tertiary markets, the impact of regulation on small-balance lending is particularly challenging. Losses in asset values and difficulties in refinancing during downturns will be exacerbated by these new constraints, which may increase the rate of balloon defaults and loss severities in these markets. â&#x2013;
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Role of CRE Debt in Small and Medium Enterprises
Role of CRE Debt in Small and Medium Enterprises Entrepreneurship is constrained by a variety of factors, including inadequate financing options
CRE is increasingly used to secure loans related to small- and medium-sized businesses
Increasing costs to smaller businesses secured by CRE collateral runs counter to critical, national policy objectives
Given the sluggish nature of the U.S.
Access to financing, broadly speaking,
post commercial real estate as security
economic recovery, lawmakers are keen-
may be the most notable economic
for 25% of the loans they applied for in
ly focused on creating jobs and stimu-
policy accomplishment since the crisis,
2011 versus only 20% in 2009.
lating entrepreneurship. In Europe, the
but it has failed to adequately support
International Monetary Fund, the Euro-
small enterprises.
Extending this analysis out to its logical conclusion, smaller commercial real
pean Central Bank and many political leaders have joined hands to jumpstart
John Dearie and Courtney Geduld-
estate loans are integrally connected
the economy through small and medi-
ig’s 2013 book Where the Jobs Are:
with small business enterprise in the
um corporate financing. In most G20
Entrepreneurship and the Soul of the
United States. Given the penetration of
economies, entrepreneurship is tasked
American Economy highlighted the
regional and community banks, as well
with driving innovation and economic
inadequacy of debt and equity financing
as CMBS conduit lending, into second-
growth. Its inverse, the decline in new
as one of the primary reasons for the
ary and tertiary markets, these sources
business formation, has been associated
decline in new businesses. Moreover,
of capital are particularly essential.
with exacerbating the wealth gap.
where lenders are making loans, they are requiring increasing amounts of
Bringing this back to jobs and GDP,
Research suggests that access to debt is
collateral—commercial real estate being
entrepreneurship could prove to be
especially important for entrepreneurs.
a popular form. Results of the Kauffman
sensitive to changes in debt service cov-
According to the Ewing Marion Kauff-
Foundation’s business survey indicate
erage ratios. Whether brought about by
man Foundation’s 2011 Business Survey
that small businesses were required to
changes in regulation, interest rates or
(published in 2013) the proportion of
other factors, data indicate that higher
debt to equity increases dramatically
borrowing costs in the CRE sector will
as the amount of financing increases.
weaken access to financing for an im-
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CMBS Loans Back Wide Variety of Businesses In Gateway and Smaller Markets Total CMBS Universe TOTAL PERCENTAGE
38%
1%
Multi Family Housing
Warehouse
1%
Self Service Storage
1%
Mobile Home Park
15%
Office
SOURCE: BLOOMBERG AND KBW RESEARCH
2%
Healthcare
2%
Other
3%
Industrial
3%
Defeased
3%
Retail Unanchored
4%
Hospitality Limited Service
6%
Mixed Use
7%
Hospitality Full Service
14%
Retailed Anchored
portant component of the US financial
kets continue to languish just above to
er businesses already have less access
system â&#x20AC;&#x201C; small business owners.
significantly below historical highs. This
to financing secured with commercial
While property valuations in gateway
suggests that relatively speaking, small-
properties and that they are relatively
markets have overshot the prior peak,
more susceptible to disruptions in the
those in secondary and tertiary mar-
current market.
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6 KEY FINDING
Ambiguous Impact on Quality of Underwriting WHILE THE MAJORITY OF CREFC MEMBERS interviewed said that regulatory burdens will result in deleveraging the markets, they were divided on the question of whether new regulation would drive improvements in the quality of loans. Taking the risk retention rule, which directs CMBS issuers to hold 5% of the deal in order to align their interests with the investors, views were highly charged about the regulationâ&#x20AC;&#x2122;s potential effectiveness in this regard. Some interviewees looked at the equation as a closed environment, one where the borrowers had limited alternatives to CMBS financing and where they would have to accept
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higher costs and tighter terms. In this world, CMBS loan pools would necessarily improve over time.
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Other CREFC members interviewed for this study viewed the equation more as an open system, where borrowers could migrate to other lending platforms that would offer greater flexi-
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Can Regulation Promote Better Underwriting? That depends on two things: 1) the definition of good underwriting and 2) capital availability. The four C’s below represent the key factors used in underwriting, and depending on perspective, the definition of good underwriting can vary. Capital availability is partially determined by the type of market, whether it is efficient and “open” or inefficient and “closed”. At this time, the CRE sector is an excellent example of an open market where capital flows easily from one segment to another. In turn, borrowers are better able to command their terms by moving from higher to lesser regulated lenders.
Capital
Character
Investment in Property
Borrowers
Regulators
Borrower’s ability and willingness to repay
Investors
Historically care most often about interest rate and terms
Often interested in borrower and location first and foremost
Tend to focus on LTV and DSCR in rules
Capacity Financial capacity to repay
Collateral Security and guarantees
Quantifiable versus Idiosyncratic Underwriting Characteristics Nonbanks are drawing business from the banks, which are historically the low cost provider, because REITs, funds and life companies are able to put deals together more flexibly and quickly.
Key Finding #6: Ambiguous Impact on Quality of Underwriting
bility on pricing. In that model, CREFC members said that higher costs would necessarily drive better borrowers away. Across broad categories of loans, banks face the highest risk weights for construction loans under the new regulatory regime, followed by CRE loans and multifamily loans to stabilized properties. This hierarchy, reflecting a rudimentary assessment of the riskiness of different classes of exposures, will discourage lending on construction projects while increasing relative incentives for commercial real estate and multifamily lending. Some projects that represent net benefits to the economy will face funding constraints.
Deleveraging Members said that regulatory burdens will result in deleveraging the markets
Is this scenario one of lower risk? Lenders with lower exposures to construction lending could be characterized by regulators as having lower risk profiles. However, this approach to risk weighting does not reflect the risk profile of specific collateral. Instead, it largely abstracts away from the scenario where a
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debate about whether macroprudential regulations should attempt to ration credit in specific, fast-growing sectors.
carefully underwritten construction loan might have a more favorable risk profile than a poorly underwritten, multifamily loan. This is not inconsistent with previous regulatory initiatives relating to commercial real estate. In describing the impact of the 2006 concentration guidance, authors of a Federal Reserve paper stated as follows:
… the final guidance indicated that regulators might not be generally concerned about individual loan risk, but in preventing systemic problems that result from buildups of CRE loan holdings over time … the effects of the regulation likely were not limited to the target market and so might have generated potentially unintended consequences. These results could inform the
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Whether in the context of balance sheet regulation or risk retention rules governing the CMBS market, several CREFC members characterized new regulation as a blunt instrument and questioned whether it was the right tool for embedding incentives for improving loan quality.
Divided They were divided on the question of whether regulation would drive improvements in the quality of loans
Expanding on concerns regarding adverse selection across regulated and non-regulated lenders, some market participants described how banks with higher hurdle rates will have an incentive to make relatively riskier loans. Overall, regulation’s impact on loan quality is ambiguous, whereas the impact on lending costs and volume is not. ■
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7 KEY FINDING
Estimating the Economic Costs of New Regulation THE CUMULATIVE IMPACT OF THE CORPUS of new commercial real estate lending regulation on the US economy is estimated between $168 billion and, in the extreme downside scenario, $936 billion over the next ten years. The median of the estimated range is $209 billion. The median estimate represents an average annual decline in construction activity of approximately 1.6 percent as well as direct and indirect impacts on other segments of the economy. Over the long-term, the cost of the property input to firmsâ&#x20AC;&#x2122; production functions increases as a result of lower supply. The upper bound of the estimated range reflects
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a scenario of extreme stress across capital, liquidity, securities and other reporting and disclosure regulations, including a material and persistent reduction in construction lending and investment activity nationally.
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This upper bound represents a subtraction of 0.46% of economic output from its related 10-year GDP projection. (The estimates are centered on scenarios with regulatory costs of 10 to 50 basis
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What is Different about the CREFC Estimate Many readers are familiar with certain trillion-dollar estimates for the cost of the crisis. It is important to know that those estimates were developed in an expansive way, adding more rather than fewer costs, and using certain methodologies that generate bigger outcomes.
Theirs
Ours
Wealth destruction measures seemingly taken at the lowest point in the cycle
Assuming normal markets
Factors in all losses throughout the system, including residential mortgages and derivatives
Used only core regulatory costs, removed double counting for rule overlap, excluded fines and litigation, lost business and other indirect costsÂ
Combined costs of jobs lost and other GDP measures with wealth destruction and costs of government programs and interventions
Only incorporates costs related to CRE markets
Included only traditional costs to real economy; excluded costs of government programs, such as monetary policy, TARP and other remedies
The CREFC estimate is built off of very few variables using stable markets as a basis. The vast majority of potential costs to the CRE sector going forward were not incorporated. Those include fines and litigation costs, overlapping regulations, and the cost of market dislocations in part driven by regulation.
Key Finding #7: Estimating the Economic Costs of New Regulation
points, which is representative of a base case range of costs for senior mortgages to borrowers and for properties across the credit spectrum). The wide range of the cost estimate reflects that the exact implementation of pending initiatives, the subsequent strength of their enforcement, the adaptations of lenders to the new regulations, and the degree of substitution across bank and non-bank financial institutions are not yet fully understood. Even the most narrowly targeted regulations have an impact on the performance of the broader economy. The regulation of CRE lending is no exception. By raising the cost of credit for property investment and development, regulation will have the effect of increasing the cost of a key input to economic activity and will thereby exert a drag on economic output. In that case, why pursue the regulatory agenda? The question is one of magnitude and whether the costs are more than offset by the benefits of the specific regulatory intervention. Whether informed by qualitative
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A Drag By raising the cost of credit for property investment and development, regulation will have the effect of increasing the cost of a key input to economic activity and will thereby exert a drag on economic output
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or quantitative assessments, proponents of a new regulation will argue that it yields net benefits. The economic analysis conducted for this study examines the long-run, post-implementation costs to the economy as a whole from the assemblage of recently implemented and pending commercial real estate regulation. Whether undertaken by the regulatory authority itself or independently, the quantitative estimate of these economy-wide costs is subject to significant uncertainty. Because the details of future regulations are not yet clear estimates of the economic impact are presented as a range rather than a deterministic forecast. The long-run costs of higher capital and liquidity requirements on economic output are evaluated using a wide range of alternative macroeconomic models, including dynamic structural general equilibrium (DSGE) models, semi-structural models and reduced-form models. For the purposes of this analysis, DSGE models have been used. Key assumptions are that the full
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extent of the regulatory costs are absorbed in higher lending spreads, i.e. that the incidence of the regulatory burden falls to the borrower, and that the CRE-specific regulations do not influence the likelihood or cost of financial crises. Higher lender costs are incorporated as an increase in the average cost of borrowing across all capital sources; the models do not explicitly account for substitution from one capital source to another as relative costs change. Abstracting from the technical aspects of the models, the basic path of transmission is from higher capital ratios, to bank costs, to borrower costs, to a reduced supply of credit, and ultimately lower economic output. Studies undertaken by global and domestic regulators and private market participants find observable impact from new banking regulation when evaluated across all asset classes. In a 2011 Federal Reserve Bank of New York staff report, the negative impact of Basel III on long-run output is estimated at 0.09 percent for every one percentage point increase in
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the capital ratio. The negative impact on output from the Net Stable Funding Ratio is estimated at 0.08 percent. A cross-country assessment by the Bank of International Settlements similarly finds that a one percentage point increase in the capital ratio produced a median 0.09 percent decline in the level of output relative to the baseline.
Basel III The negative impact of Basel III on long-run output is estimated at 0.09 percent for every one percentage point increase in the capital ratio
The range of the economic analysis results suggest a significant impact from the new CRE regulations. In part, because of the high concentration of CRE loans on bank balance sheets, the impact of the corpus of new CRE regulation is higher than it would be for industries that are not as dependent upon the availability of debt. As compared to its baseline, the model estimates show a cumulative subtraction from GDP of between $168 billion and $936 billion over the next 10 years. The median is $209 billion, reflecting that the distribution of estimates is characterized by a fat tail where the costliest scenarios have very low probabilities. The upper bound of the cost distribution reflects conditions of highly elevated stress from regulation. â&#x2013;
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Overview of Methodology
IN U NDERTA K ING T HIS ST UDY, CR EFC SOUGHT TO G AT HER A ND analyze as much qualitative and quantitative information as was available. However, many of the industry assessments of regulation are backwards looking. While it is difficult to tease out the regulatory impact even when historical data is available, predictive analyses present additional challenges. As such, CREFC approached the data analysis with several principals in mind: 1. Apply conservatism where possible in developing the inputs and the methodologies; 2. Validate inputs and outputs with other studies and data points; and 3. Work in ranges in order to more accurately represent the level of uncertainty and variability in regulatory treatment across the sector. The viewpoints gathered from the interviews, or the qualitative aspect of the CREFC research, serve to provide context.
QUALITATIVE ASSESSMENT: INTERVIEWS
Over the course of several months in 2015, CREFC conducted over two dozen interviews with the trade associationâ&#x20AC;&#x2122;s members. The majority of interviewees were business heads representing buy- or sell-side businesses, many with several decades of experience. An attempt was made to fully represent bank and nonbank activities
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Two Dozen CREFC conducted over two dozen interviews
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across all kinds of loan products. Roughly 15% of the interviewees were from compliance and regulatory-oriented roles. The interviewees were asked similar questions though they were tailored to the individual. While CREFC could identify a few sets of majority and minority opinions, quotes interspersed throughout the paper are meant to stand as barometers of the marketplace. Though the individuals and their firms have been kept anonymous, their roles and sub-sectors are labeled in order to provide the reader with an understanding of biases and incentives.
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QUANTITATIVE ASSESSMENT: FINANCIAL AVAILABILITY MODELING The anecdotes collected through interviews with market participants were complemented with quantitative analysis. CREFC developed a suite of quantitative analyses to assess financing availability after regulatory impacts and to assess CRE debt’s sensitivity to increases in borrowing costs based on segmentation of outstanding loans by underwriting characteristics. While loan level data is available for the CMBS universe, only industry-wide characteristics were available for other product types. As such, adjustments were made to certain characteristics of the CMBS loans in order to better represent other products, such as bank and life company loans, as well as those made by traditional asset managers, REITs, private equity firms, hedge funds and others.
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Loan Level loan level data is available for the CMBS universe
Where loan-level data was available, it was possible to perform sensitivity analyses based on multiple underwriting metrics, chiefly debt service coverage ratios (DSCR), but also loan-tovalue (LTV) and debt yield (DY). Using a matrix format for the output facilitates a better understanding of the range of loans that may be at risk for default or that may need to be restructured with additional equity before being refinanced. Where loan level data is not available, the analysis is run on DSCRs alone. For the purposes of the analysis, loans with underwritten DSCRs of 1.2x and under are generally assumed to be aggressively structured and are removed from the loan level analyses. The remaining loans are considered to be at risk as their DSCRs are believed to pierce the 1.2x threshold or they come close to the border given a certain regulatory cost shock. This proportion of the universe is termed “Capital at Risk”.
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Overview of Methodology
Regulatory cost estimates were taken from regulatory reports, industry sources, academic research and extrapolations of these data points. The regulatory cost inputs to the model are intended to cover capital, liquidity, reporting, restrictions and other compliance requirements across banking and securities regulations. It was necessary to make assumptions based on the best available information at the time of the writing, though many of the critical rules were in development and will remain so through 2016. Additionally, certain assumptions were made about relative level of cost based on institution size and charter type.
Costs Inputs to the model cover capital, liquidity, reporting, restrictions and other rules
will consider is DSCR, which measures the ratio between the propertyâ&#x20AC;&#x2122;s net operating income (NOI) for the year and the annual debt service (ADS). Though CREFC analyzed the impact of regulatory costs on other key underwriting metrics, such as LTV and debt yield, DSCR was the most responsive. How does DSCR work: When NOI and ADS are equal, the DSCR ratio will be exactly 1.00x. A DSCR of 1.00x implies that there is exactly enough net income from the property to cover only the mortgage payments. DSCRs less than 1.00 indicate that a given property does not generate enough income to pay the mortgage.
CREFC did not make assumptions about the resolutions for those loans, but assumed only that the deal must be restructured, the borrower might have to pay a higher borrowing cost, the lender may retain some of the cost or the deal may not get done.
Implications for refinancing: Most CRE loans have a term of 10 years or less, but the assets are longer-lived. Therefore, there is an expectation of refinancing built into the ownership of commercial property.
USE OF DSCR AS THE PRIMARY THRESHOLD
Most lenders monitor the health of loans and the properties they finance ongoing. However, at a minimum, a lender will examine loan performance in depth at the time of the refinancing. If
When lenders are making a CRE loan, they consider a variety 64
of qualitative and quantitative factors concerning the asset. One of the most fundamental financial ratios that a lender
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Exhibit #1 Change in DSCR after additional regulatory costs
ORIGINAL LOAN Annual NOI
LOAN AFTER REGULATORY COST (25BPS) $60,000
Annual NOI
$60,000
Loan Amount
$1,000,000
Loan Amount
$1,000,000
Interest Rate
5.00%
Interest Rate
5.25%
Annual Payment Debt Service Coverage Ratio
not before a loan matures, then a lender will carefully examine projected DSCR at the time of maturity. The regulators generally look for fairly robust DSCRs too. The risk retention rule set a DSCR of 1.75x as the minimum for consideration for preferential treatment. Generally speaking, 1.20x would be considered an industry threshold, and mostly for pristine properties. The weighted average DSCR based on total balance for CMBS loans issued between 2013 and 1Q15 is 2.16x.
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$50,000
1.20x
Annual Payment Debt Service Coverage Ratio
Increased regulatory costs translate into an increased coupon for the borrower and there will impact the monthly debt payment. Assuming the NOI remains the same, DSCR must decline. The more aggressive the underwriting of a loan, the more likely it will require restructuring prior to or at maturity. As an example, for a loan that is underwritten with an original DSCR of 1.22x, even a modest increase in the interest rate could push the actual DSCR below the 1.20x threshold that most lenders require.
$52,500
1.14x
In order to offset a decrease in DSCR due to regulatory costs, a borrower has a couple of options. The borrower can attempt to increase the NOI of the property by either decreasing expenses or raising rents. The second and more feasible option is to decrease the loan proceeds requested, which in turn, helps to maintain the monthly debt payment at or near the original level.
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Overview of Methodology
As in exhibit #1 (previous page), a decrease of $40,000 in the loan proceeds requested result in a 0.05x increase in the debt service coverage ratio. The financing availability modeling performed for this study estimates the amount of loan proceeds that are affected by a given increase in regulatory costs. Exhibit #3 (subsequent page) illustrates the offset in loan proceeds necessary to maintain the underwritten DSCR. Based on loan level data on over 40,000 loans originated between 2005-2015, the model adds an estimated regulatory cost to the interest rate based on the legal entity that originated the loan. As noted above, many conservatively underwritten loans were well-below the 1.20x DSCR threshold and were therefore excluded from the analysis.
40,000 The data collected represents over 40,000 loans orignated from 2005 to 1Q15
The goal of the financial availability modeling was to analyze the entire commercial real estate lending universe using loan level data, and to project the impact of regulation on future originations. The data collected
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represents over 40,000 loans, originated from 2005 to the first quarter of 2015. As such, we have a large statistical sample that represents all stages of the real estate cycle and varies significantly based on the interest rate environment. One of the issues with collecting loan level data is the varying degrees of transparency provided by different lending entities. In the CMBS segment of the CRE lending market, Bloomberg, Trepp and other databases provide very detailed loan level data. In the bank and insurance company segment of the market, there is less transparency. As such, CREFC assumed certain adjustments to the loan characteristics when extrapolating to the bank and insurance sectors. CMBS securities are issued by large investment and commercial banks that have investment banking subsidiaries. Loans securitized in CMBS are backed by established, income-generating properties, with longer terms than CRE loans held on the originatorâ&#x20AC;&#x2122;s balance sheet. The typical CMBS loan has a
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Exhibit #2 Adjustment to loan proceeds and impact on DSCR
ORIGINAL LOAN REQUEST Annual NOI
$60,000
LOAN AMOUNT ADJUSTMENT Annual NOI
$60,000
Loan Amount
$1,000,000
Loan Amount
$960,000
Interest Rate
5.00%
Interest Rate
5.00%
Annual Payment Debt Service Coverage Ratio
fixed interest rate with a 30-year amortization schedule and a balloon payment after ten years. The typical life insurance loan has a similar structure to CMBS with a fixed or floating interest rate, a 30-year amortization schedule and a balloon payment after ten years. To approximate the life insurance universe, our analysis selected loans within the CMBS universe that would most closely approximate an insurance company loan. The loans that were selected had balloon payments with nine to 11 years and loan proceeds of greater than $5 million. www.crefc.org
$50,000
1.20x
Annual Payment Debt Service Coverage Ratio
Another conventional CRE mortgage source is banks. Bank loans generally have shorter balloon terms than life insurance companies as their capital source (bank deposits) are more easily callable than life insurance policies. To create a proxy for bank loans, loans with less than seven-year terms were selected from the CMBS data pool. To eliminate outliers, the model discarded 1% of the loans with the highest and lowest DSCRs.
$48,000
1.25x
STRENGTHS AND WEAKNESSES OF THE QUANTITATIVE ASSESSMENT Because any research and analysis on regulatory impact is complex and is subject to many viewpoints, CREFC is providing the reader with a set of “strengths” and “weaknesses” of the framework offered in this paper. Strengths • CREFC started with regulatory estimates or with actual estimates from banks and other market participants that are
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Overview of Methodology
exposed to regulation. Where possible, chosen estimates were validated by published sources, as well. • Where possible, the analysis was based on loan-level data, which was cleaned and skewed toward stronger loans.
Validated Where possible, estimates were validated by published sources
• The regulatory cost shocks adjust for rule overlap to avoid double counting, and they do not include secondary or tertiary effects, such as a contraction in secondary market trading liquidity. • Unless specified, all macroeconomic and sector conditions are held constant. Weaknesses • Because regulation is being rolled out in tandem with significant macroeconomic and other shifts, it is difficult to isolate effects that are specific to rulemaking. • As this exercise is designed to estimate future costs, they could not be directly observed.
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• Due to the fact that only roughly 25% of CRE debt is traded, there is less loan level transparency in the sector, resulting in large gaps in data.
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• Many regulations remain in some form of development and the industry is still assessing the impacts of even those rules that have been implemented. ■
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Exhibit #3 Adjustment in loan proceeds necessary to absorb regulatory costs
ORIGINAL LOAN Annual NOI
LOAN ADJUSTMENT DUE TO REGULATORY COST $60,000
Annual NOI
$60,000
Loan Amount
$1,000,000
Loan Amount
$952,400
Interest Rate
5.00%
Interest Rate
5.25%
Annual Payment Debt Service Coverage Ratio
$50,000
Annual Payment Debt Service Coverage Ratio
1.20x
$50,000
1.20x
SUMMARY Annual NOI
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Constant
Loan Proceeds
$47,600
Regulatory Cost
25bps
Annual Payment
Constant
Debt Service Coverage Ratio
Constant
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Appendix
Applicable Regulation and Implementation Timeline
THE GROUP OF 20 (G20) ADDED FINANCIAL INSTITUTION REGULATION TO its agenda in 2009 and designated the Financial Stability Board (FSB) to oversee implementation of extensive remediation that regulators sought in response to the financial crisis. In the United States, much of the regulatory agenda is embodied by the Dodd-Frank Act, though policy makers are rolling out additional planks of the G20 agenda outside of Dodd-Frank.
Much of this regulation applies to the CRE sector, including capital, liquidity, risk retention, Volcker, some asset management requirements, and various reporting and disclosure rules.
Going forward, there are material changes to come for the CRE sector: Basel III remains a work in progress.
Newer elements of the regulatory agenda, especially those extending to the asset management sector and to short-term financing, have not yet been exposed.
Material There are material changes coming for the CRE sector
The question of how regulators will treat SIFIs and how that regulation may impact the flow of funds to and within the CRE sector remains a key consideration for the industry.
to be answered, CRE market participants observe that questions regarding unintended consequences arise and real costs become known during the implementation phase. As the regulatory conformance schedule in the US currently extends into 2019, it is likely that the industry will be absorbing major changes from new rulemaking and implementation into the next decade.
For the CRE bank lending sector, capital and liquidity requirements present the greatest financial challenges of the new rules. For the CMBS sector, the credit risk retention rule is the
While major questions regarding regulatory intent remain
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biggest game changer. As of this writing, Basel III capital and liquidity rules are still evolving, and the credit risk retention (CRR) rule will go into effect late in December 2016. Though the Volcker rule allows CMBS underwriting, it restricts secondary trading to market making. Other meaningful rules, such as Volcker, are in effect or going into effect shortly.
Shifting
sioners have mentioned consideration of requirements relating broadly to portfolio composition.
The regulators are shifting their focus and plotting course on a number of nonbank fronts
Finally, the agencies continue to work slowly through the questions of SIFI designation and treatment. As of this writing, the authorities have decided to pursue regulation of asset management activities instead of designations, though they hold out the possibility of also designating asset managers and subjecting them to prudential requirements. Because the systemically important insurers (SIIs), which have been designated already, and the potential asset manager SIFI designees are prominent CRE lenders and investors, the issue is an important one to the sector. Not only can new requirements influence business strategy at these firms, but they can influence activities across the sector indirectly.
Going forward, the regulators are shifting their focus and plotting course on a number of nonbank fronts. Because much of the crisis can be traced to â&#x20AC;&#x153;liquidity transformationâ&#x20AC;?, or the use of short-term debt to fund longer term assets, the regulators have aggressively addressed these activities within the banking sector already, but intend to extend requirements and oversight to bilateral repurchase agreements (i.e. those that occur outside of the banking system) and possibly to other types of short-term financing. Collectively, the regulators are also in the beginning phases of articulating priorities around the
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asset management industry as a whole, though the SEC did finalize rules related to the money market mutual funds already in 2014. In addition, SEC commis-
SII capital and liquidity treatment has not been proposed here in the U.S. However, for these institutions, rating agency requirements have represented binding requirements, or the outer bound threshold. Until
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Major Changes still Comingâ&#x20AC;&#x201C; Shifting more Focus to Non-Banks Reform
2H14
1H15
B3 - HVCRE
2H15
1H16
Non-advanced approaches banks conform
TLAC + GSIB Surcharge
Proposed TLAC global standards
Final GSIB Surcharge rule and Final TLAC / US adoption
Partial GSIB Surcharge Conformance
B3 - Revisions to RBC Methodologies
Final (Seczn) and proposed (credit/FRTB/ floors) global standards
Final global standards (credit/FRTB/ floors) - Target
US adoption Target
B3 - Liquidity Coverage Ratio
Final rule Adopted
B3 - Net Short Funding Ratio
Final global standards Target
US Proposed rule - Target
Final rule Target
Regulation AB II
Final rule Adopted
Partial conformance
Risk Retention
Final rule Target
Partial conformance
Volcker
Partial conformance
IMPLEMENTATION 12 Months
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Non-Banking standards / regulation
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Final capital standards / SIIs
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2H16
2017
2018
2019
Partial TLAC conformance
Full GSIB Surcharge and TLAC conformance Target
Partial conformance
Full conformance
Full conformance Partial conformance
Full conformance
Full conformance Full conformance Full conformance (trading)
Proposed SEC disclosures / portfolio level
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Proposed liquidity standards / SIIs
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Appendix: Applicable Regulation and Implementation Timeline
new regulatory rules have been rolled out in the US, it is not clear which regime will present the strictest set of requirements. Perhaps the most prominent regulatory Issue at this time is the matter of market making and liquidity. Many rules affect the willingness of bank dealers to support secondary market trading, including Volcker, risk based capital, the liquidity coverage ratio, the leverage ratio (which impacts the repo market), and others. Over the course of 2014 and 2015 public discourse on the nature of liquidity and the sources of its contraction has moved between regulators, Congress, business leaders, and the press. For CMBS, turnover volume remains lower than during the crisis, suggesting that the market is indeed structurally different since rulemaking. Market participants generally cite requirements around capital and repos as the primary drivers of the dealers’ pullback on balance sheet allocation to the business.
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Market Making The most prominent regulatory issue is market making and liquidity
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WHAT FOLLOWS BELOW IS A BRIEF SET OF EXPLANATIONS OF RULES AND OTHER REGULATORY ACTIVITIES: Credit Risk Retention (CRR) The CRR rule, which requires that all sponsors (or B-piece buyers) hold 5% of a transaction for at least five years, was adopted at the end of 2014 and becomes effective at the end of 2016. It is alternately called the “eat-your-own-cooking” rule and is intended to achieve better underwriting in CMBS pools. At the time of this writing, the requirement was expected to add costs of 10 bps to 50 bps under current conditions.
Revisions to Basel III Risk-Based Capital The Basel Committee on Banking Supervision (BCBS) is actively revising the foundational concepts underlying the risk-based capital framework and will likely produce final versions of several new standards late in 2015 and early in 2016. www.crefc.org
Initiatives regarding capital floors, treatment of credit risk (portfolio lending) and securitizations will impact costs across CRE business lines at large- and medium-sized banks in the future. Based on some industry analysis produced in relation to the BCBS document, “Revisions to the securitisation framework”, we believe that for commercial asset classes with maturities of five years or more, higher capital requirements are expected for most tranches. The BCBS is also finishing work on the “Fundamental review of the Trading Book” (FRTB), which applies to all assets held for market making purposes. As of this writing (4Q15), the FRTB work stream is possibly one of the most controversial aspects of rulemaking financial system-wide. On average, the requirements as proposed will more than double capital charges for senior and junior bonds, and will be particularly onerous for CMBS as compared to other asset classes. Based on an informal survey of the dealer community, there is a strong majority view that a material number of dealers would drop
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Double The requirements will more than double capital charges for CMBS
to these requirements after other rules enter the conformance stage. On the portfolio lending side, the BCBS has yet to finalize a proposal exposed in December 2014, “Revisions to the standardised framework on credit risk”. The treatment for CRE loans and CMBS will be aligned with the broad capital floors and other BCBS initiatives.
The Basel III High Volatility Commercial Real Estate (HVCRE) Rule The High Volatility Commercial Real Estate (HVCRE) rule, which assigns a risk weight of 150% to certain acquisition, development and construction (ADC) loans, applies to almost all banks in the US and has been in effect for more than a year. The risk weight is 50% greater than the former risk weight, and applies retroactively.
out of the market, and early estimates of bid-ask spread widening range between hundreds of basis points. Importantly, the industry would have to conform
The rule has been the subject of much controversy. There is relatively wide variation in how banks are viewing application; some banks are using a very
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Appendix: Applicable Regulation and Implementation Timeline
conservative approach and applying the new risk weight to most of their ADC loans and others are applying the rule to a smaller proportion of their portfolio. This variation suggests some confusion about the regulatorsâ&#x20AC;&#x2122; intent.
Disadvantages The rule also disadvantages private-label and some GSE-sponsored CMBS
In addition, the industry has raised issues related to the incentives embedded in the HVCRE rule. Essentially, many believe that the new rule promotes poorer underwriting guidelines than its antecedent.
Basel III Liquidity Ratios Basel III mandates that large banks adhere to two liquidity ratiosâ&#x20AC;&#x201D;the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR was adopted in 2014 and went into effect at the beginning of 2015. Meanwhile, US regulators are expected to propose the NFSR in the second half of 2015. The LCR adds costs to whole loans that have drawdown features, such as construction loans. The rule also disadvantages private-label and some
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GSE-sponsored CMBS. The rule excludes the vast majority of CMBS from the High Quality Liquid Asset (HQLA) designation, which is becoming fairly synonymous with banks’ asset and liability portfolios. Based on the BCBS’s final standards regarding the NSFR, it appears that this rule when adopted in the US will likely add operating costs to balance sheet loans.
Registration and Disclosure Rules
U.S. SIFI Designations and Treatment
New shelf registration requirements and Regulation AB II and other reporting requirements will add costs to CMBS. The new shelf registration requirements will add an estimated $20,000 per transaction, according to a senior partner at a law firm. FINRA reporting requirements are considered to contribute to reduced secondary trading liquidity.
One of the most contentious planks of regulatory agenda is the model for managing systemic risk. At the highest level, the question is whether regulatory objectives would be best served by designating and overseeing nonbank SIFIs, identifying systemically important markets and addressing weaknesses in them, or some combination of both.
Volcker Rule The Volcker Rule is impacting the industry on many levels. While CMBS are generally allowed under the rule, and most whole loans appear not to be subject to the trading restrictions, the Volcker rule will require the support of substantial infrastructure representing an ongoing cost of doing business.
www.crefc.org
Total Loss Absorbency Capital The first international level proposal for Total Loss Absorbency Capital (TLAC) was published by the Financial Stability Board (FSB) at the November 2014 G20 Summit. TLAC essentially acts as a capital floor for large banks and would override risk-based capital at the holding company level, requiring that large banks hold 16% to 18% capital and high-quality debt, not including buffers. Based on analysis performed by The Clearing House, the FSB’s proposal will require that banks establish a cushion that is 2.6x to 5.2x the historical need for capital in a crisis.
Until recently, national and international authorities had been pursuing both paths concurrently. However, the Financial Stability Board agreed to forestall work on the subject until they can discuss the matter at their third quarter 2015 meeting. ■
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