Turning the Corner on Risk Retention

Just as everyone seems to have made the adjustment to life in securitization with Risk Retention, comes the US Treasury’s announcement that they agree with what most industry insiders have been saying for years.  The 5% Risk Retention model for securitizations may not be necessary and very well could be artificially and unnecessarily limiting the size of the marketplace.

The report, which was released on October 6th, focused primarily on Risk Retention in the US CLO market; probably thanks to the steady effort by the LSTA over the last few years to get their views across.  It would appear that a reduction in the percentage, a partial exemption or even a full elimination of the requirement is on the table for serious discussion.  Momentum builds.

Ironically, all the doomsayers that several years ago predicted a complete collapse of the CLO market, particularly the small to medium-sized CLO manager marketplace, due to the burden of Risk Retention, have been proven wrong.  The US CLO market is actually quite vibrant and there have been plenty of recent news stories about numerous third-party risk retention investors being available to smaller CLO managers.  As we expected, smart people found a way to work with the new rule.  However, we would be the first to agree that there has to be some negative impact on market size that is directly attributable to the additional costs associated with 5% Risk Retention.

We have been on the record for several years about how unnecessary the Risk Retention rules are, as all they accomplish is to add an insignificant slice of skin-in-the-game for issuers or managers that already have much more to lose if their program fails.  Risk Retention sounded like a great sound bite during the post-crisis era but we think you would be hard pressed to find an investor (if they were being honest) who would tell you that they base a any significant portion of their investment decision on Risk Retention.

Maybe it has taken longer than we might have hoped but it would appear that we are in the process of turning the corner on Risk Retention.

Momentum for Fintech Sector Continues to Build

Bloomberg just ran an article summarizing the record pace for financing in the Fintech or Marketplace Lending sector.  Surely, there will continue to be some bumps in the road but this asset class continues to push ahead, seemingly no matter the headwinds.  Clearly, some smart people are betting on this asset class.

Here’s a link to the article….

https://www.bloomberg.com/news/articles/2017-07-25/funding-for-fintech-startups-poised-to-hit-a-record-in-2017

Marketplace Lending Securitization Comes of Age

An excellent summary of the fast maturing market for the securitization of marketplace loans, or fintech loans as they are also commonly known, has been prepared by S&P Global Market Intelligence.

Here’s a link to the full article……

http://marketintelligence.spglobal.com/our-thinking/ideas/origination-growth-increases-securitization-opportunity-for-digital-lenders

Important Decision Affecting Safe Harbor for CMBS That You May Have Missed

An important recent ruling by the Northern District of Illinois District Court in connection with a preference claim by a bankruptcy trustee which involved CMBS securities.  Could become a very important standard for the future and ongoing recovery of reputation and legitimacy of securitization structures.  Certainly seems to restore some rationality to what most investors, trustees, bankers and originators thought they were getting into when they put these structures together.

Here is a very good summary of the decision which was handed down in April and posted by The National Law Review earlier today, authored by Mark Salzberg of Squire Patton Boggs……..

 

Commercial Mortgage-Backed Securitization Investors Given “Safe Harbor” Protection

How far do the Bankruptcy Code’s “safe harbor” provisions extend in the commercial mortgage-backed securitization (CMBS) market? Do these safe harbor provisions protect financial institutions that act merely as conduits for CMBS payments? These questions were addressed recently by the Northern District of Illinois District Court, and the court’s decision provides ammunition for CMBS investors in clawback claims brought by a bankruptcy trustee.

In Krol v. Key Bank, N.A., the chapter 7 trustee filed preference and fraudulent transfer claims against Key Bank and LaSalle Bank. At issue were payments made by the debtor on a loan (the “Loan”) extended by a trust (the “Trust”) to an entity related to the debtor. Prior to the bankruptcy, the note evidencing the Loan had been transferred to the Trust as part of a securitization process. Key Bank was the master servicer for the Loan, and held the payments temporarily before transferring them to the Trust. LaSalle Bank was the trustee under the Trust

The defendants moved to dismiss the bankruptcy trustee’s claims arguing, among other things, that the payments were shielded by the safe harbor provisions of section 546(e) of the Bankruptcy Code. Section 546(e) provides a safe harbor from preference and constructively fraudulent transfer claims where the transfers (1) were made by and to a financial institution, and (2) were made in connection with a securities contract. The purpose of these safe harbor provisions is to minimize the displacement caused in the commodities and securities markets by a bankruptcy filing affecting those industries. The safe harbor does not extend to intentionally fraudulent transfers (those transfers made with an actual intent to hinder, delay or defraud creditors).

The first question before the court was whether Key Bank was a “financial institution” for purposes of Section 546(e) since Key Bank acted as a mere conduit for payments on the Loan. The bankruptcy trustee argued that Key Bank’s status as a mere conduit required the court to determine whether the Trust, the ultimate recipient of the money, was a financial institution. The court rejected these arguments and refused to read into the statute an additional requirement that the financial institution receive some financial benefit or acquire the funds for its own use. This reasoning is consistent with the approach taken by most of the federal circuits that have addressed the issue.

The second question was whether payments made to Key Bank on the Loan were made in connection with a “securities contract.” The bankruptcy trustee argued that the payments were made in connection with the Loan which was not a securities contract. However, looking to the economic realities of the transaction, the court found that the Loan had been securitized as a CMBS. In a CMBS, securities are collateralized pursuant to a pooling and servicing agreement (PSA) by a pool of mortgages on commercial real estate in which all principal and interest from the mortgages flow to certificate holders in a defined sequence or manner. Here, the Loan had been transferred to the Trust and that the Trust had issued certificates representing investors’ interests in multiple bundled loans. Writing that “in connection with” as used in Section 546(e) should be construed broadly, the court held that the payments to Key Bank, which Key Bank then transferred to the Trust, were made “in connection with” the PSA. The court rejected the bankruptcy trustee’s “novel proposition” that any two-tiered transaction precludes a finding that a securities contract is involved.

Based on this analysis, the court dismissed the bankruptcy trustee’s preference claims and recommended dismissal of the constructive fraudulent transfer claims.

The Krol decision is an important decision for participants in the CMBS market. First, the decision is further support that Section 546(e)’s safe harbor provisions apply where financial institutions act simply as a mere conduit for funds. Under the majority approach, as adopted by the Krol court, a financial institution does not need to acquire any ownership interest in the funds in order to qualify for the safe harbor protections. Second, the Krol decision recognizes the economic reality of CMBS transactions, and brings within the protection of Section 546(e) loan payments where the loan has been collateralized. Third, the decision provides more security for CMBS investors since it increases the scope of the safe harbor protections of Section 546(e).

A Little Embarassing But Maybe We Didn’t See it Coming Either

A very interesting analysis of what U.S. securitization “professionals” may or may not have known about the coming housing and credit crisis back in 2005 and 2006.  A very good article in Mortgage News Daily catalogues an insightful study into the purchasing habits of mid-level securitization managers and other professionals in the months leading up to crisis.

Conventional wisdom continues to tell us that these industry insiders kept quiet about this pending doom because they were mostly motivated by fat pay incentives attached to how much business they closed.  Seems like a pretty logical conclusion.  Only problem is that until now, no one thought to look deeper, starting with a very basic line of questions.  If the securitization industry was “in on the sting”, how did it affect their own decision-making about purchasing real estate during those heady days.  We think the results may surprise you.

You can link to the article here: http://www.mortgagenewsdaily.com/03252013_secondary_market.asp