How Basel III Might Blow Up CMBS

WASHINGTON, DC—The Basel Committee on Banking Supervision is expected to publish a rule change for banks' fixed income trading books (FRTB) that could hurt -- quite significantly in the worse case scenario -- the CMBS market, according to a client note published by JP Morgan Chase.

This rule has been under consideration for a number of years in the Basel III deliberations and the industry had been expecting an increase in capital. A year ago, for example, word on the street was that when it is all said and done, Basel III's capital retention for commercial real estate loans will be as much as 25%. 

However, in recent months Basel has been adding harsher and harsher requirements, which, to be fair, is the general trajectory right now for new standards in the global capital markets.

That said, observers were taken aback by the magnitude of the harshness revealed by the JPMorgan client note.

Capital Reserves as High as 274%

As it stands right now, the rule will call for banks to radically increase the amount of capital held on their books against bonds backed by securitized assets. For commercial mortgage backed securities, capital requirements start at 30% and in the most extreme scenario, goes as high as 274%.

Currently banks must hold some amount of capital against a CMBS bond, however the amount is significantly less, depending on the bank and its internal models. One plausible amount, just to illustrate, is 8%.

This is how the capital reserve requirements pencil out, as of right now, according to an analysis of JP Morgan Chase's client note by the CRE Finance Council.

For a senior bond, or one that is AAA rated, banks may have to hold as much as 30% in capital against the market value of the new issue senior bond.

Non-senior rated bonds could be anywhere from 181% to 274% in capital held against the market value of the issue.

Capital held against the non-rated bonds typically held by the B piece are expected to be 417% of the market value of the issue.

The Road To Implementation

While the final rule is expected to be published in December, the road to actual implementation is a long one as with all standards, JPMorgan Chase explains in its note.

Each country's regulators will modify the rules to fit their country's framework. In the US the Federal Reserve Bank, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency will oversee this particular rule-making process because FRTB would apply to trading books held by financial institutions that they regulated, as well as Systemically Important Financial Institutions (SIFI). There most likely will be a public comment as well. Given all that, the estimated time of arrival for the regulation could be in 2019.

Some Possibility for A Rule Change

To be clear, this is not a done deal. JPMorgan Chase says in a follow up to the client note that its believes there is a very low probability of the FRTB passing as it is currently written. "It is too onerous and would make secondary trading of securitized products unprofitable," it wrote.

Unfortunately, it continued, the inevitable middle ground that is reached in a compromise will still call for an increase in capital. Also worrisome is that these changes may not be fully tested. "This could result in both material and unintended consequences on the securitization market," JPMorgan Chase wrote.

There will be lobbying at the US regulatory level, Christina Zausner, vice president of Policy and Industry Analysis at the CRE Finance Council, told GlobeSt.com. However, it is questionable how much US regulators will be willing to bend, she said.

"The inclination of US regulators is to meet the Basel standards. They want other jurisdictions to comply with [other portions of] Basel," which means the US has to comply as well.

Doesn't Matter That It is Aimed Only At Market Makers

To be clear the rule, in whatever form it takes, is only aimed at the secondary market-makers in the CMBS ecosystem. Non-bank issuers of CMBS, such as Walker & Dunlop and Cantor Fitzgerald, will not be subject to the rule.

However, depending on how onerous the final capital requirements are, the affect could be so dramatic that it could seep through the entire market. "It will affect the non-bank issuers," Zausner said. "They will have to tell their borrowers why they have to pay higher spreads for CMBS financing."

This is why. Only the broker-dealer banks can afford to be secondary market makers. If they have to hold a huge amount of capital against CMBS they will be less and less willing to support this trading, although it is possible they might maintain some sort of activity on a subsidized basis.

Primary issuers will do less business as they will not have any place to resell the paper, Zausner said. And investors will be less inclined to put money in CMBS as well as liquidity in the secondary market dries up.

The Cost of Capital Is Rising Anyway

The rule change comes at a delicate time for CMBS, CREFC President Steve Renna told GlobeSt.com.

The risk retention rule for CMSB required by Dodd-Frank is going into effect at the end of 2016, he noted. While the rule has been written, it is still unclear what its ramifications will be and how the market will handle having to retain an additional 5% of the pool, a requirement that is expected to fall largely on the B piece buyers.

"Over the next year we will know more as companies start to get ready for it, but it is very difficult to say right now," Renna says.

"Maybe we will see new entrants, maybe we will see new participants investing less, or more. We just don't know."

One certainty is that the cost of capital will rise when the rule goes into affect, he said. The Dodd-Frank rule, that is. What will happen to the cost of capital -- or even if there will be any capital -- after the Basel III rule goes into affect is anyone's bet.