THE REALITY OF

CMBS RISK RETENTION:

A REAL SOLUTION OR JUST ANOTHER ILLUSION
By Joseph Philip Forte
Introduction
Faced with prospect of refinancing nearly $1.4 Trillion of existing US commercial real
estate debt in the next four years, real estate investors borrowers as well as lenders
continue to doubt whether there will be sufficient capital available to the commercial real
estate finance market to avoid a future catastrophic shortfall in the financing of
commercial property. Notwithstanding the anemic and halting recovery of the capital
markets for commercial property finance over the last several months, there continues to
be a high degree of concern whether CMBS 2.0 can eventually restart with sufficient
volume to fuel the recovery in the property markets. Some have held the view that the
retention of risk by the originators/ issuers of the CMBS issuances will help restore
confidence in the CMBS market and dramatically increase its volume; this is believed
just because it is asserted that the lack of such risk retention running up to the crisis
was at the heart of the collapse in the market.
Indeed, legislators and regulators prematurely focused their blame for the crisis on the
failure of the securitized lenders to retain any risk in the loans originated for
securitization, in addition to the rating agencies abnegating their role of policing the
market. The Federal Reserves Board published report on securitization reforms (the
Fed Report), which concluded that
simple credit risk retention rules, applied uniformly across
assets of all types, are unlikely [italics added] to achieve the stated
objective of the [Dodd-Frank] Act namely, to improve the asset-backed
securitization process and protect investors from losses associated with
poorly underwritten loans.
This conclusion is correct and what follows is a brief overview of what went wrong in the
market and what is the most effective form of risk retention appropriate to the
commercial real estate market.
Too much capital, persistent historically low interest rates, excessive leverage, unsustainable
property values and ever declining cap rates have led to booming real estate markets before and
the subsequent collapse and securitized lending was not in this respect an exception. Yet the
trouble was not and is still not with securitization itself, but with originators, issuers and
investors' incredible misperception and mispricing of risk. It is as though they collectively
thought that somehow the securitization process had taken all of the risk out of real estate
financing (or at least was someone elses problem). Clearly, a very erroneous conclusion.
From the inception of the CMBS market until 2 years before the crisis began, the most
cognizant assessor of risk was the purchaser of the lowest tranche of CMBS certificates the
2011 Joseph Philip Forte

first-loss position (the B piece buyer) who paid cash and conducted its own due diligence
of the structure and on the collateral intending to retain the risk. Such an evaluator cannot
afford to ignore risk in its purchase. But in the later period, the difference was that risk was not
being assessed for the term of the loan, but almost at the point of origination as the credo
became: Make it and sell it. The pressure to compete with other lenders - lower rates, more
proceeds - simply overwhelmed the process. Volume was emphasized over properly assessing
and pricing the risk. Although intermediaries always export risk by parceling it to various end
users with different risk appetites, at the time the ultimate purchaser of the risk did not
understand or appreciate the risk because of the credit rating agencies failure to properly identify
and consider in their ratings the risk of new structured finance vehicles being used to package
credit risk assets such as Collateralized Debt Obligations (CDOs).1 Issuers viewed themselves as
exporting risk - it was someone else's risk after it was securitized but the someone else didnt
quite appreciate the risk undertaken. But as we have seen, it does not always work out quite like
that as assets have a way of migrating back to an issuer's balance sheet through the failure of an
investment in an asset by an issuers subsidiary (e.g., structured investment vehicles or SIVs) or a
defaulted financing of an asset sale. Thus were the seeds of the current turmoil planted over the
last few years before the current crisis.
From Storage to Moving
When a lender sells an asset, it does so to remove the asset from its balance sheet to free up
capital and allow the institution to make a new loan as well as collect a new fee. Real estate
lending went from being a portfolio business to a fee business from a storage business to a
moving business. Yet, by financing its purchaser in the sale of an asset, the loan seller is
removing the asset from its balance sheet as owner, but clearly reacquiring the risk of the newly
pledged asset as lender. Hence, the prospect of being able to remove assets from the seller's
portfolio (or its continuing pipeline) without retaining the risk of the assets on its balance sheet
was a very appealing structure for asset sellers.
As the securitized market grew exponentially on the back of the strong and steady increase in
leverage at all levels of the real estate capital stack, competition for loan products heightened
because of relatively stable markets, availability of too much capital and the entrance of new
players many without any tradition of principal investment. Loan underwriters began to ignore
the looming refinance risk of balloon maturities and rely on pro-formas of ever rising rents. As
the process further commoditized, investors looking to improve their returns began to employ
evermore leverage in the acquisition of assets. This required investors to stray out of their
traditional comfort zone and down the credit stack and cash buyers became, or were replaced by,
more highly levered buyers.
Wall Street, in an attempt to avoid retaining any risk whatsoever, now adapted new CDO
technology used in other markets for use in the commercial real estate finance market. In stark
contrast to the traditional warehouse or repo financing of financial assets, the CDO offered a
long term fixed rate without mark-to-market requirements or margin call risk. The availability of
CDO financing led to a further explosion of non-senior loan products, which, because of US tax
1

Unfortunately, the residential mortgage market had earlier made even greater use of CDO technology leading to the substantial issuance of residential
MBS comprised entirely of so-called subprime loans to borrowers whose credit (and lenders whose underwriting) was substandard. The lower
rated tranches of these subprime securitizations, which would be more prone to default than prime residential loans, were perfect candidates (in the
issuer or investors' estimate) to be included with other unrelated, often non-real estate assets in CDOs. Driven by this accelerating ready
availability of financing to subprime MBS investors, the subprime market exploded onto the scene financing otherwise uncreditworthy borrowers in the
acquisition of the American dream a home of their own.

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law limitations could not otherwise be disposed of, by depositing B notes, mezzanine debt and
B-pieces, into a CMBS trust. The mortgage loan origination community was more than willing
to accommodate the ever increasing capital markets investor appetite for subordinate debt
products by increasing loan production as the lenders were able to serially clear their financed
non-senior debt inventorythat would otherwise have been retained in portfoliointo a CDO.
Thus, lending volume of non-senior mortgage components and mezzanine debt grew
significantly supported by the growth of the commercial real estate CDO allowing CMBS
issuance to reach record levels. We began to build financial capital stacks overleveraging
property rather than create physical buildings.
CDOs The Tipping Point
But the critical development which was the worst consequence for the CMBS markets was that
B-piece buyers were also able to finance out of their position through use of CDOs or
resecuritizations encouraging nearly 20 new highly leveraged entrants into that market segment
who did not have the traditional loan-to-own discipline of the original five or six cash B-piece
buyers. With this development the synthetic asset market began to grow and distort the
discipline of the cash market.
Many assumed, including the Federal regulators and the Federal Reserve, that the subprime loan
melt down (as the media coined it) would be a self-contained event of risky overleveraged
residential loans to uncreditworthy individuals. But the interdependence of the global capital
markets and the teetering of major financial institutions led to investors viewing all structured
finance securities, including CMBS, as a single bad asset class to be avoided at all costs. This
was the definitive step in the Perfect Storm that was to develop from the confluence of a series
of seemingly unrelated and disparate events.
As this continued, market turbulence disrupted pending securitizations and purged buyers of
certain bonds from the market completely; it became almost impossible (or at least extremely
risky) to attempt to value an asset or to price a risk. Fearing all real estate collateral, investors
initially demanded higher yields but then withdrew entirely from the market unable to assess
the risk.
Looking for culprits, the investors and the media began to focus on the national credit
rating agencies, accusing them of becoming toll takers instead of gate keepers for the
market place. But many investment grade investors were relying almost entirely on letter
ratings, deal sponsorships and the ever more attractive pricing and almost never read the
offering disclosure documents or if they did, did not fully understand and appreciate the
nature of the risk being described; but neither did the new leveraged B-piece buyers who
purchased to sell the risk in a new financial instrument not to retain it as an investment.
Unlike the recent leveraged B-piece buyers, traditional B-piece buyers (as the most junior
noninvestment grade investors) assured themselves of the prudence of their investment in
the risky first-loss position of the CMBS trust, by requiring full access to information
about the borrower, the property, the leases and cash flow, the loan, all third party and
originator reports on borrower and guarantor credit and the collateral as well as the
lenders underwriting to conduct their own due diligence and evaluation. Because of the
inherent risk of their most subordinate investor position in the CMBS trust, the due
diligence and re-underwriting that they undertook was far greater than most primary
mortgage market lenderssecuritized or portfolioand more similar to the
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comprehensive credit and collateral diligence of a junior mortgagee. This is horizontal

risk retention.
B-Piece Buyers the Real Gatekeepers
Thus, it was not the credit rating agencies who rated the deals but the original cash B-piece
buyers who were the markets real gatekeepers. As a condition to their purchase of the firstloss tranche they, and not the credit rating agencies, regularly and routinely questioned and
demanded documents, information and updates, and even rejected loans that were deemed
substandard to prevent their being deposited in the CMBS trust. The credit enhancement
provided by this first-loss position to the CMBS trust and its senior certificate holders was not
only their existence as a subordination cushion but more importantly the knowledge and
comfort that the B piece buyer had focused its expertise and experience on understanding and
managing the credit risk associated with each asset in the CMBS trust.
Last year, the Congressional Oversight Panels February Oversight Report - Commercial Real
Estate Losses and the Risk to Financial Stability predicted $200-300 billion in commercial
real estate loan losses for the banks alone for 2011 and thereafter. Moreover, regional and local
bankswhich provided substantially more capital to the commercial real estate markets than
the insurance companies or the CMBS lenderswere seen as significantly more overexposed
to commercial real estate as an asset class - being multiples of their capital. These portfolio
lenders are a cause for serious concern for federal banking regulators notwithstanding the
banks retention of 100% of the credit risk in their portfolio. It is a clear cautionary tale about
the illusory value of credit risk retention by loan originators or subsequent whole loan
purchasers.
Clearly, the benefit of the horizontal credit risk retention by the B piece buyer is precisely that it
is NOT the originator (or subsequent whole loan purchasers for securitization) of the mortgage
loan with its own competing motives of compensation, lender competition, borrower
relationships, property envy, industry league table standings, achieving issuance size and
PR/marketing opportunities i.e. bragging rights which daily color or even sometimes
interfere with a clear assessment of the credit risk of a mortgage loan. A truly independent
second review of each loan by a real estate specialist and NOT the credit rating agencies is
what is necessary. If CMBS 2.0 is to restart successfully, we cannot revert to the post-2005
leveraged B piece buyers who collected fees and quickly exported their first-loss position risk
to a CDO. While the debate over the efficacy of different forms of credit risk retention for
different asset classes will continue among the regulators who recognize the Federal Reserves
recommendation to adopt different retention requirements for various types of securitized
assets recognizing differences in market practices and conventions, the regulators have
proposed their new rules.
Dodd-Frank Act
Section 15G of the Securities Exchange Act (newly enacted by Dodd-Frank Act 941 (b))
requires that the Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the
Comptroller of the Currency, and Securities and Exchange Commission (together with Federal
Housing Finance Agency and the Department of Housing and Urban Development for
residential mortgages) promulgate joint regulations governing the risk retention requirements
for the securitization of different asset classes.
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On March 29, 2011, nearly 400 pages of proposed regulations were issued as the regulators
proposed risk retention rule for all asset classesgenerally requiring that securitization
sponsors retain a 5% unhedged economic interest in a portion of the assets pooled in a
securitization for sale to third parties (the 15G Regulation). There are limited specific
exemptions from risk retention for certain loans qualifying under regulator promulgated
conservative underwriting standards for the different asset classes. In addition, a sponsor is
permitted to share its required risk retention with the originator of an asset (but not with
subsequent purchasers from the asset originator). However, under the regulation any type of
retention which sponsor is permitted to allocate to another (including a CMBS B-piece buyer)
requires the sponsor to monitor the other partys compliance with the regulator and must notify
its investors of any noncompliance. There are several variations of risk retention for other
assets classes: eligible horizontal slice of pool assets, a pro rata vertical slice of all classes,
combined horizontal and vertical (L) slices, cash reserve accounts, as well as other
alternatives not significant to CMBS. While the general provisions are applicable to all asset
securitizations, there are specific provisions applicable to commercial mortgage loans.
Dodd-Frank Mandates
While Dodd-Frank requires that a sponsor (i.e. the issuer) retain a risk of 5% on all transactions,
such retained interest can be reduced for CMBS only by (a) risk retention by (i) the loan
originator or (ii) qualifying third-party first-loss position buyers as well as (b) by the regulators
determination that (i) the commercial mortgage underwriting standards and controls are
adequate, (ii) adequate representations and warranties concerning the commercial mortgages
being are made to CMBS investors and (iii) the representation and warranty breach
enforcement provisions are adequate to protect investors in a loan put-back.
While the new regulation recognizes that B-piece buyers have been central to CMBS and
permits their use as a risk retention alternative, it has imposed several new conditions for a
third-party purchaser to be counted as qualifying risk retention for purposes of Dodd-Frank.
Available only in CMBS transactions, the third-party purchaser must:

purchase a subordinated horizontal interest in the securitization in the same form,

amount and manner as a sponsor i.e. it must be the first-loss position with same limits
as sponsor;

purchase the interest at closing for cash without financing, directly or indirectly, from
any party to the securitization (other than another investor);

conduct significant due diligence on the credit, collateral and cash flow of, and
underwriting for, all of the individual assets of the pool in the context of the whole
pool before, not after, CMBS issuance;

have its investment experience and the other material information be disclosed by
sponsor together with the B-piece purchase price and percentage of the pool acquired;

comply with all limitations on sponsor that prohibit hedging (except limited
circumstances), transfer or pledging of the asset; and

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not be affiliated with any other party to the securitization (other than another
investor), nor have any control rights not shared with the other investors.

While the last condition would prevent a B-piece buyer from being, or have its affiliate
appointed, the special servicer, it would be permitted to do so, if the CMBS documents
provided for appointment of an Operating Advisor who was to be consulted on major
servicing decision (material modifications, waivers, foreclosures or REO); and who
would monitor, report and be able to recommend removal and replacement of the special
servicer (subject to majority of investors retaining the special servicer).
The conditions to qualifying as a B-piece buyer for risk retention were clearly aimed at the
recent abuses of the leveraged B-piece buyers immediately prior to the credit crisis. They will
now have to pay cash, do due diligence, and hold their investment for the term of the CMBS
unable to export the credit risk into a financial arrangement like a CDO or otherwise reallocate
its credit risk to another.
Although there is also a risk retention exemption for pools of loans made in accordance
with the regulators promulgated commercial mortgage underwriting criteria, the 33
enumerated separate prescriptive underwriting standards of the so-called Qualified Loan
Exemption should assure that few (but the most conservative loans) will fail to qualify a
CMBS pool for a risk retention exemption (historically less than 1% of CMBS Loans
outstanding). This alternative would, however, require a buy-back obligation by sponsor.
There are several other risk retention schemes that have been proposed by the regulations
such as the sponsor retaining a representative sample of the pool assets which also
includes a sponsor obligation to buy-back loans not conforming to the sample.
Unfortunately, the 15G Regulation fails to provide guidance for dealing with single loan
securitizations or short-term floater securitizations but does impose new obstacles such as
the Premium Capture Cash Reserve Account which will effectively eliminate the
financial incentives for securitization and would disrupt the recovery of the CMBS
market.
SEC Regulation
A regulation of the Securities and Exchange Commission (SEC) proposed before the
15G Regulation (the SEC Regulation), requiring (a) blacklining of representations and
warranties by credit rating agencies which must consider any sponsors sub-standard
representations and warranties in their ratings, (b) sponsor scheduling of loans that are
exceptions to their underwriting or representations and warranties and (c) sponsor
periodic reporting of put-back requests for breaches of representations and warranties for
loans deposited in a securitization and detailing their responses to such requests which
will be published and used by rating agencies in their ratings of sponsor transactions will
better prevent poor underwriting being conducted by originators and condoned by
securitizers and substandard loans being made and deposited if any of the foregoing SEC
requirements lead to serious consequences to an originators ability to sell, or a sponsors
ability to securitize its loans in the future.

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Industry Response
While many real estate finance and securitization industry trade associations and
individual institutions and other market participants have provided extensive comments
as well as alternative recommendations for aligning interests in risk retention among
CMBS participants before the extended August 1, 2011 comment period for the 15G
Regulation expired, the Commercial Real Estate Finance Council (CREFC) provided
the federal regulators with much more than comments. Recognizing the critical
significance of who writes the rules in any effort at market reform, CREFC early seized
upon the opportunity afforded by its reputation as a recognized industry standard setter to
develop industry best practices and standards in direct response to the earlier SEC
Regulation regarding risk retention. Building upon existing standards that it has
developed over the last 17 years for the CMBS industry such as its Investor Reporting
Package (which are well regarded by investors and regulators alike) and to assure that
the views of issuers, originators, investment and non-investment grade investors,
servicers and other market participants were taken into account, CREFC organized
industry participants to produce and adopt a number of new industry standards which it
submitted to the federal regulators in response to their regulatory initiatives. Among
other best practices, it published and submitted to federal regulators: a principles-based
underwriting framework with an annex with disclosures concerning assets underlying a
securitization; model industry representations and warranties; and a new mandatory nonbinding mediation process for related loan sale breaches. As a well-respected senior
investor recently commented on the CREFC effort:
The Model Representations provide a clear benchmark for comparison,
and the need to blackline to the Model Representations is a disclosure best
practice that makes any variations from the Model Representations easy
for investors to evaluate. Use of the [M]odel Representations as a
reporting template is a disclosure best practice that helps investors
understand what underwriting and documentation practices were applied,
and what was found in the underwriting process. This provides investors
with a key tool necessary if they are to police the quality and completeness
of underwriting procedures, and do their part in funding good origination
practices while defunding bad practices that generate risks that can
damage market sustainability.
To jump start CMBS 2.0, the skin in the game conundrum must be resolved to the ultimate
satisfaction of investors investment grade and non-investment gradeand not just the regulators.
Without the investors there is no market regardless of the regulatory scheme put in place. The
recovery of CMBS will be best protected from poor underwriting being conducted and condoned,
and substandard loans being made and deposited if: adequate representations and warranties
encompassing factual assertions about loan attributes, underlying property characteristics and lender
due diligence are made by the originator of the loan when sold and/or deposited in, and by the issuer
at the issuance of, a securitization trust; and the first-loss position is purchased in an arm's length
negotiation by an independent third party for cash. Although a powerful reporting template for
investors in their decision-making allowing investors to actively police their investment rather
than relying on third parties representations and warranties are only as effective as the strength of
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the par buy-back enforcement process for any material breaches; and the B piece buyer must have
adequate financial resources to back losses and conduct significant credit and collateral due diligence
of all of the individual assets in the pool in the context of the whole pool before, not after, issuance.
Thus, while a loan may be sold to a third party, the risk of its underwriting and origination must be
retained by its originator and/or issuer and not reallocated to another. Although it can finance a
proportion of its purchase with an at-risk loan (from other than the originator or issuer's sponsor),
the third-party investor must retain its first-loss position and not export the credit risk into a financial
arrangement like a CDO or otherwise reallocate its credit risk to another.
Rather than rely on an originator and securitizer solely interested in selling loans or CMBS
certificates without effective accountability, CMBS investors will have more confidence in the
securitization process if they are better able to rely: on representations and warranties and
disclosed exceptions if a breach of those representations and warranties carries an enforceable
par repurchase indemnification by the originator/seller or the issuer; and on the purchaser of a
first-loss risk in a specific pool who analyzes and evaluates each individual loan to be
deposited. The analysis of the overall pool risk loan by loan provides a more reliable
assessment of credit risk for the certificate holders than the originator or depositor who have not
assembled the pool based on overall risk but by individual loans with competing motives.
Investor Concern
Accountability of the originator and issuer are crucial to the securitization process, but CMBS
investors also have serious concerns in the alignment of interest of participants in a
securitization. CMBS investors have expressed in letters to, and meetings with, the SEC
specific concerns with the CMBS process in spite of the federal regulators proposals.
Investors want: a full description of the financial strength of a loan seller providing
representations and warranties; the issuer to prepare and disclose a blackline comparison of
loan sellers representations, warranties, breach remedies and exceptions against the CREFC
Model; to receive a loan-by-loan representation exception report identifying loans that do not
conform to representations; adoption of the proposed CREFC Disputes Resolution and
Remedies procedures in all Pooling and Servicing Agreements (PSAs), and for all
prospective investors to receive a copy of the PSAs; and the SEC to support loan resolution
fee rate parity (i.e. compensation) for servicers in the PSAs for successful breach claims
because many PSAs do not compensate servicers for put back activities which clearly acts as a
disincentive for their undertaking the often costly process. And consistent with their continuing
concern with special servicers and B piece buyers not being aligned in interest with CMBS
investors, senior CMBS investors have been strong proponents of Operating Advisors in
CMBS deals and support the 15G Regulations adoption of Operating Advisors (when the
special servicer and the B piece buyer are the same party or affiliates) to oversee the special
servicer and possibly remove a special servicer for breach of an applicable contractual
Servicing Standard. While CREFC supports the appointment of Operating Advisors, it is
concerned with the overbroad reasons for removal of the special servicer absent an investor
veto of removal, and believes a special servicer should be solely removed for willful
misconduct, bad faith or negligence, while senior CMBS investors believe the proposed
required investor quorum and threshold vote to remove a special servicer is too high to be an
effective policing mechanism for senior investors.

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Conclusion
The restaging of CMBS market as CMBS 2.0 has to be a new generation of structures, not a
fancy repackaging of the same old structures. First, structures need to be more transparent and
not overly complex for investors. New originators need to understand their mistakes and the
problems facing servicers as well as investors from the old origination environment. Second,
CMBS cannot be seen as or be a moving business; and although not a storage business, it
will require that there be real skin in the game to foster the confidence of investors in the
new origination process. Ultimately, bridging the current gap between originators/issuers and
investors will best be accomplished by requiring: adequate representations and warranties by
originator and issuer; full disclosure of loan underwriting and documentary exceptions; a
blackline of the particular securitization representations and warranties against a SEC-adopted
template; and an enforceable breach repurchase protocol that investors can have confidence in
as well as returning the B piece buyers to their original role as the gate keepers self-charged
with maintaining discipline in the CMS market. Thus, if a substandard loan somehow is
deposited with adequate representations and warranties, a diligent B piece buyer can reunderwrite the loan and if it is found unacceptable, kick the loan out of the pool but if the
kick-out fails to occur, the breach can be used to compel a par repurchase of such loan. Only
the continuity of this process can provide investors with the degree of predictability and
stability that they seek when they can once more rely with some degree of confidence on truly
enforceable representations and warranties breach buy-back and redundant loan by loan review
of an at risk first-loss holder.
What is not yet fully appreciated or understood by market participants are the potential
enforcement consequences for originators and issuers of the SEC Regulations requirements for
representation and warranty blacklining against an established benchmark (SEC or industry)
and disclosure in mandated originator/issuer quarterly reports of loan put-back requests and
details of resolution (for the last 3 years) both of which the credit rating agencies are required to
consider in their ratings; which investors may use in their loan breach put-back litigation; and
which the SEC may use for its own as of yet unknown purposes.
But what will the federal regulators finally decide is adequate risk retention for CMBS? Will it
be a multi-faced approach? Will investment grade and non-investment grade investors be
satisfied with the federal regulators Final Rule or will they lobby for more market-driven
protections and better pricing of risk to assuage their continuing concerns? Only one thing is
certain in this reform process - the final regulations whatever they provide will not be the final
chapter in the recovery and eventual resurgence of the CMBS market in the future.

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