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Regulatory Déjà vu All Over Again

posted by Adam Levitin

A new CMBS issuance is set to test whether regulators will treat the 5% retained credit risk under Dodd-Frank as loans or bonds.  The difference matters because there are different capital charges for loans and bonds.  If regulators treat the retained credit risk as bonds (which matches the technical form of the retained interest), then the risk retention requirement will be much more onerous.  If they treat the retained credit risk as loans, it is just as if the bank securitized only 95% of the loans, rather than 100%.  

Here's the thing:  we've been through this issue before.  In the 1980s the Federal Home Loan Bank Board had to decide whether S&L's junk bond investments were to be treated as bonds or as loans.  S&Ls were limited to hoping 1% of their assets in junk bond, but the FHLBB permitted them to count junk bonds as "commercial loans", which had a 10% asset cap, and thus have up to 11% of their assets in junk bonds. Bill Bratton and I documented this in a paper about the development of the synthetic CDO several years ago:  

The Federal Home Loan Bank Board (“FHLBB”) implementing regulations stated that investments in corporate debt securities had to be in securities “rated in one of the four highest grades by at least two nationally recognized investment rating services at their respective most recent published rating before the date of purchase of the security,” meaning that the corporate debt securities had to be investment grade. 12 C.F.R. § 545.75(b)(2) (1984). However, the rule making permitted S&Ls to invest up to 1 percent of their assets in corporate debt securities irrespective of their rating “if in the exercise of its prudent business judgment it determines that there is adequate evidence that the obligor will be able to perform all that it undertakes to perform in connection with such securities, including all debt service requirements.” Id. § 545.75(d). In other words, on their face, the regulations permitted up to 1 percent of S&Ls’ assets to be invested in junk bonds if the S&L believed that the bonds would not default.

In its Federal Register release publishing the regulations, however—but not in the regulation itself—the FHLBB stated that “the Board wishes to clarify that an investment in notes, paper, or debt securities may be treated as a commercial loan to the issuer whether or not they satisfy the rating, marketability, and other requirements of § 545.75.” 48 Fed. Reg. 23032, 23045 (May 23, 1983). This meant that S&Ls could purchase junk bonds and treat them as “commercial loans” for the purposes of investment regulation. Accordingly, the applicable limit for S&L junk bond purchases was the 10 percent of assets limit set for commercial loans. 12 C.F.R. § 545.46(a) (1984).This 10 percent limit could then be added to the 1 percent facially permitted junk bond limit, as S&Ls were permitted to elect the “classification of loans or investments,” namely that the S&L could choose which limit would apply to a particular loan or investment if multiple limits could apply. Id. § 545.31. This should not be confused with regulatory classification of loans for Allowance of Loan and Lease Losses (ALLL) purposes.

Thus, an S&L could opt for the 10 percent limit plus the 1 percent limit to get up to 11 percent of its assets in junk bonds. 52 Fed. Reg. 25870, 25876 (July 9, 1987) (referring to the 11 percent limit).

This story did not end well for the S&Ls...or the FHLBB.  Some S&Ls gorged on junk bonds, seeking higher yield to offset the mismatch between their mortgage assets'  earnings and their deposit funding cost.  Others gorged even more because they were part of the Michael Milken daisy chain.  This all turned out very badly as the junk bonds proved to be, well, junk, and only deepened the S&Ls' insolvency.  The FHLBB paid the price too...it's no longer around, having become the OTS (mainly), which is now (mainly) merged into the OCC.  

Is there a lesson here for regulators regarding the CMBS market?  Perhaps.  There are important differences, but regulators should be making the decision not based on the convenience of the CMBS market.  The story of the S&Ls should be a cautionary tale about taking regulatory actions that favor short-term industry interests without a good free-standing justification for those actions.  There has been incredible convergence between loan and bond markets, but they aren't fully interchangeable.  The covenants and payment structures on the 5% retained interest surely don't match the covenants and payment structures on the underlying mortgages.  Securitization is doing more than a pure pass-through here, and the question is whether the risks created are material enough that they should require treating the retained credit risk as bonds. 



Why not remove just return to the BIC Program?

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