Senate Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance, and Investment Hearing

Thank you Chairman Crapo and Ranking Member Warner for the opportunity to testify today. My name is Drew Fung. I am a Managing Director and Head of the Debt Investment Group at Clarion Partners. I am testifying today on behalf of the Commercial Real Estate Finance Council, or ("CREFC"), where I am a Member of the Executive Committee.

CREFC is the collective voice of the roughly $3 trillion commercial real estate finance market. CREFC's 300 member firms include balance sheet, Agency and Commercial Mortgage-Backed Securities ("CMBS") lenders as well as loan and bond investors and servicing firms. Our industry plays a critical role in financing properties of all types in all 50 states including apartments, nursing homes, grocery and retail, just to name a few.

My testimony will focus on the CMBS industry. In today's economy, CMBS is an essential financing vehicle for the U.S. economy. However, a plethora of new rules and regulations could dramatically affect CMBS liquidity, and thereby undermine the viability of this critical source of funding.

Introduction

The legislators and regulators had a daunting mission in restoring the health of the financial services sector following the financial crisis and the Great Recession. Eight years later, we have the benefit of empirical data and anecdotal experience about the very real costs of a macroeconomic crisis and also, the costs of regulation. Underpinning this data, it is now also a generally held view that deceleration in growth is likely to be a longer term feature of the national and global economies.

It is within the context of this growth picture that we must revisit our regulatory regime, and specifically its deleveraging objectives. It is critical to note that the Group of Twenty (G20) first added financial regulation to its agenda in 2009, broadening and enhancing the role that the international regulatory bodies played in determining home country requirements. At that time, goals for reducing leverage in the system were based on trends and observations ending with the deepest points of the mark-to-market losses. At the same time, there was little attention paid to the economic effects of regulation. It still remains a challenge to determine the collective effects and costs of the cumulative regulations aimed at the structured finance marketplace, partly because the rules are still being written, partly because some final rules have yet to take effect, and partly because they are so complex. Even so, many countries are seriously reconsidering the burden of the future regulatory agenda, given entrenched headwinds to growth. Some are not only contemplating, but also actively pursuing, relief for securitized products in order to support growth. n1

More recently, the CMBS market has seen excessive and sustained dislocation, also referred to as "illiquidity". To a certain degree, geopolitical events are to blame for some of the distress that many markets experienced in February and March, yet these events do not account for all the distress. While other fixed income asset classes started to trade more normally in recent months, CMBS continued to exhibit numerous signs of relative distress. What accounts for this lagging effect on CMBS?

Market participants are unanimous in their belief that regulation is driving much of the present strategic decisions, and the effects of that regulation are causing the market to grow thinner and more fragile. Despite the fact most participants agree that credit trends in the commercial property market remain healthy, issuers and investors alike have shed staff, cut their budgets and reduced allocations. Some even closed their doors.

Weeks after researchers and other market watchers released their 2016 issuance forecasts (as high as $125 billion), many if not most, reissued forecasts at roughly half of their original numbers. Commercial Mortgage Alert published an estimate of $50 - 60 billion in their most recent issue (05/13/16). In other words, with little to no stress, and despite the fact that many other fixed income asset classes regained their stride after the February pounding of oil prices and other macroeconomic challenges, the CMBS market continued to see record levels of volatility. n2

While the regulators periodically revisit the deleveraging question in speeches and analyses, the U.S. regulators, in particular, seem unwilling to meaningfully investigate the role that regulation is playing in the fracturing of markets, fund flows and the global slowdown. This frustration was felt by CREFC members while submitting comments during the agency rulemaking processes. There are countless instances in which our trade association and others provided well researched and documented analyses of the CMBS and other structured products markets. Yet, the regulators answer with rule requirements that are less tailored than they need to be for each asset-class, let alone CMBS, in order to maintain the organic efficiencies of the market in favor of simplifying the regulatory regime globally. Now that the CMBS market is exhibiting severe distress, and there is evidence of a negative feedback loop between poor liquidity conditions, lending rates and capital raising, the effects of regulation must be addressed, and done so quickly.

A strong contingent of CREFC's members believe that regulatory burden is responsible for reducing liquidity in and weakening the resilience of our market, despite the impact of geopolitical forces. Many believe that liquidity is the CMBS linchpin and that the regulations are causing permanent damage to it. Yet, even buy-and-hold investors, such as the pension fund universe (that is reportedly 6.99% invested in real estate) n3 need market liquidity in order to be able to meet their own regulatory and fiduciary requirements.

CREFC and its members believe that thoughtful regulation can be a net positive and that some of the new regulatory requirements have improved the marketplace and the alignment of interest between issuers and investors. While the broad intent of the regulations is well-founded, the overwhelming burden of rules that lack tailoring to the characteristics of different asset classes provides little marginal prudential improvement, if at all. At the same time, these rules generate significant costs to the end users (i.e., borrowers and consumers) and to savers whose investments are devalued as a result. Consequently, there is a growing chorus of urgent concerns from all ends of the industry that regulation is institutionalizing inefficiencies andmay even severely disable liquidity for the CMBS market permanently.

Moreover, lenders and investors agree that a dislocation in CMBS will travel quickly throughout the commercial real estate ("CRE") debt and equity markets, impacting valuations and fundamentals. Certain aspects of the marketplace are so fragile today -- even before half of the planned regulations come into place -- that CMBS is experiencing severe pricing volatility, a marked contraction in issuance and reduction in capacity. We are working on borrowed time to investigate the solution and to initiate remediation, especially given the current schedule of new rules in the pipeline.

CMBS the Asset Class and Historical Performance

The securitization of commercial mortgages began out of the necessity to clean up the balance sheets of taxpayer-backed depository institutions in the late eighties and early nineties. A combination of excess development in the wake of strong commercial property demand, a subsequent economic downturn, tax reform and loose credit from depository institutions led to a drastic overbuilding of office properties. By 1989, 534 depository institutions had become insolvent due to imprudent loans. Congress created the Resolution Trust Corporation (RTC) in 1989 to dispose of the failed institutions' assets. In turn, the RTC pooled the mortgages and sold them off as diversified bonds, creating the first CMBS transactions. Since then, the market has become much more transparent and investor-centric. n4

Credit retracted nationally across industries in the nineties. Not only had the universe of lenders shrunk dramatically, but the few banks that could lend on property were reluctant to do so, prompting innovative financiers to bypass the banking system for the capital markets. They pooled commercial loans and sold bonds tied to those loans to sophisticated institutional investors from pension funds and insurance companies. By 1998, issuance topped $50 billion per year, and by 2007, issuance topped $200 billion per year. n5

One of the attractive features of CMBS was that institutional investors (entities with monthly, quarterly or actuarially-driven cash flow obligations) could achieve greater diversification across geography and asset class than by purchasing or originating whole loans themselves. Instead of owning a $50 million loan on a single property, the investor could purchase $50 million worth of bonds equally diversified on a pro-rata basis across 40-100 loans in 10-30 individual markets. And importantly, the investor could decide how much risk they wanted to take based on a bond's seniority in the capital structure and the duration of the security. The most secure bonds received cash flow payments first, while the riskiest bonds last. In the event of a distressed sale, bond holders are paid before the borrower who contributed the equity. Typically, these securities offer more yield, transparency and diversification than similarly-rated corporate bonds.

At the asset level, an investor, generally a business entity (a partnership or corporation), seeks to purchase a commercial property and obtain debt financing for that transaction. Each commercial property can be thought of as a self-contained business with an income statement and balance sheet. The rents charged to use a property - including monthly apartment, office, or retail rents - serve as the "sales" or revenue for the business.

Similarly, a property has expenses in the form of third-party property management fees (landscaping, maintenance, etc.), property taxes, insurance, leasing expenses (as in the case of an apartment leasing manager, or a retail leasing agent, who go and find renters for the property), and non-capitalized annual repairs to the property. These expenses subtracted from total revenues represent the property's profit and loss, or "P&L". It is through this number that all applicable underwriting calculations, such as debt service coverage ratio ("DSCR"), whether from the investor or lender, are calculated.

The property owner's ability to pay off debt is not measured (since all CMBS loans are non-recourse), but rather, the property's, or business's ability to service monthly payments is measured. A mid- to long-term holder of commercial property, regardless of property type, buys a building based on how much cash flow, or yield, the asset will generate each year, and considers hundreds of data points (ongoing surveillance of CMBS is reported on a monthly basis via the CREFC Investor Reporting Package (the "IRP"), a monthly report with over 750 data fields and supplemental reports providing insight into asset, loan, and bond level performance, as well as the final disposition of specially-serviced CMBS loans n6, in addition to a business plan that includes market information ranging from demographics, supply and demand factors for the asset type, and relative positioning to comparable products.

Post-financial-crisis (also known as "CMBS 2.0"), there are two distinct CMBS markets: the conduit market and the single-asset single-borrower ("SASB") market. The conduit market pools commercial mortgages ranging in size from $2 million to over $100 million (but generally not more than $100 to $300 million). These loans are collateralized by stabilized, cash-flowing properties with three years of operating history and professional ownership. As thousands of small banks either closed their doors or were purchased by larger firms in the wake of the 2008 credit crisis, conduits remain a substantial source of debt for secondary and tertiary market real estate operators. Conduit financing provides capital for grocery-store shopping centers, strip malls, family owned hotels, shopping malls, and apartment buildings.

The other type of CMBS lending is SASB loans. These loans typically are larger than $250 million and are made on a single, large property or portfolio of properties owned by one borrower such as large, well-capitalized, public and private real estate companies. Last year, SASB made up over one-third of the total CMBS market, up from roughly 10% historically.

Institutional investors enthusiastically invest in SASB bonds. The demand for this market came about as banks and insurance companies were unable or unwilling to offer their balance sheets to finance trophy buildings or portfolios of properties. The credit characteristics of these loans are highly desirable - often many times oversubscribed by investors. Due to the durable nature of CRE's cash flow, and subsequently the CMBS bonds, the asset class as a whole has performed extremely well. The all-time cumulative loss rate for SASB transactions is 0.25%, and 2.79% for conduit transactions. n7

SASB transactions performed better in the depths of the crisis than most fixed income markets perform under efficient market conditions. Due to the structure and transparency of SASB deals, investors were (and still are) able to make informed decisions. With performance characteristics such as these, it is fairly improbable that regulation could benefit the market. Indeed, when members of the regulatory community have been asked this question, often the answer is that it is difficult for the agencies to grant exceptions. CREFC discussed these issues at length with the Agencies responsible for crafting the risk retention, and our list of submissions to the regulators can be found in Appendix B. n8

Why CMBS: Borrower Access to Credit

CMBS provides the most democratic and cost effective method of financing for small real estate assets. While SASB financing makes it possible to spread the risk of a large dollar loan on a single property, conduit financing is an essential component of the main-street CRE market. If traditional credit providers - banks and life companies - service the borrowers who need mid-sized loans, then CMBS serves the ends of the barbell, with SASB transactions that are too big for a single institution to handle on one end, and loans on small, privately owned real estate companies and syndicates that make up 90% of CRE ownership on the other.

In 2015, CMBS provided 21% of all of all CRE loans. This is the sector's largest financing source, followed only by agency debt (18%) and regional banks (16%). Annual originations by banks and life companies ebb and flow, but have generally been steady and limited to specific niches. While CMBS's 50% market share in 2007 was arguably too high, as witnessed prior to the crisis,securitization has proven to pick up a large portion of the slack that portfolio lenders and the Agencies typically eschew.

One of the most popular sentiments expressed by all types of CREFC members (buy- and sell-side) is that the broader CRE market needs CMBS in order to function efficiently and to fill the gap in financing needs posed by underserved borrowers in smaller cities and suburban areas.

For instance, Idaho currently has over $1.1 billion worth outstanding loans distributed across cities including Boise, Twin Falls, and Meridian. Similarly, Virginia and Massachusetts currently have over $26 billion and $17 billion, respectively, in outstanding CMBS financing (please see Appendix G for a breakdown of each state's outstanding CMBS loans).

The CMBS market represents a core source of capital that cannot easily be replaced. When new issuance is halved in a single year, especially one in which there are significant refinance needs, it is realistic to expect a broader market disruption. During liquidity interviews, CREFC members had significant concerns over the impact a declining new issuance market would have on bond values, and more importantly, property values. Members noted that all things being equal, removing 20% of available debt capital from the marketplace would surely depress property values. Members also noted that they did not see a ready alternative to CMBS financing - that is, long-term, fixed rate mortgages. Instead, bank participation will be declining as the regulatory regime is ramped up across all banks, big and small, and as the regulators enforce limits on CRE exposures.

Maintaining availability of CMBS financing is even more critical following regulatory warnings regarding CRE concentrations at banks. Many bank lenders in our membership report intentions to maintain, instead of grow, loan levels, which means that any reduction in the CMBS market should represent a reduction in capital availability across the sector. While some 1Q 2016 data series indicated that loan levels are still growing, the spurt in the first quarter represents loans that were negotiated before the end of the year and the prudential agencies published a warning to the CRE lenders. n9 Indeed, the April 2016 Senior Loan Officer's Opinion Survey reflected a tightening of underwriting standards across the industry for the first time in this cycle,FRB: Senior Loan Officer Opinion Survey on Bank Lending Practices and this is considered to be a leading indicator of future trends. Industry watchers report that the CRE loan pipeline has contracted in 2Q 2016, which should be reflected in the second half of the year.

Evolution of the CMBS Market Before and After the Crisis

The CMBS market is generally viewed in two historical segments - CMBS 1.0, which existed before the crisis, and CMBS 2.0, which commenced after the crisis. The reason that the two phases are delineated is that the CMBS market has greatly evolved in several critical ways since the crisis: 1) pro-forma (aspirational) underwriting is infrequently mentioned and in fact, underwriting criteria have been tightening; n10 2) CMBS deals include much greater levels of subordination, or cushion, to absorb potential losses (see exhibit below); 3) collateralized debt obligations ("CDOs") backed by CMBS are no longer issued; and, 4) even greater transparency and information is provided to investors.

Recent economic conditions were primed to result in a return of aggressive lending and funding. Environments marked by low rates and improving credit trends, as we saw in recent years, are prime ecosystems for higher leverage, because the economics work. However, risky leverage did not return to the CMBS market. In fact, the opposite happened. The levels of loan and deal level leverage remained much lower than in CMBS issued prior to the crisis (CMBS 1.0). Importantly, the double leverage that came with CDO funding seems to be wrung out of the system.

Early regulatory and industry intervention at the beginning of the crisis were indeed the integral in weeding out the most ambitious lending and financing forms from the CMBS industry. The combination of accounting changes and additional requirements of the rating agencies, as well as other rules helped to stabilize the CMBS market starting in 2010. While the Term Asset Backed Loan Facility (TALF) did support several CMBS transactions, the TALF's activities in the commercial market were limited. In other words, the market participants agreed on a new architecture which instilled the requisite confidence from both buy- and sell sides. This caused the market to rebound with little assistance from the TALF facility established to liquefy the market during the crisis.

Indeed, CREFC members played a vital role in this stabilization, as our community contributed a critical new feature of the CMBS 2.0 (post-crisis CMBS) marketplace - additional transparency measures in the form of the IRP, described in detail above, and in Annex A, which is the deal package. (See Appendix A for more details on CREFC IRP). These two transparency measures are proof that through the leadership of CREFC, the CMBS industry has self-regulated over the years as investors demanded standardized deal documents and up-to-date performance data. n11 However, regulators gave the industry little credit for these self-imposed reforms.

In 2009, CMBS issuance had collapsed to almost $0 from a height of $231 billion in 2007. Issuance rebounded to roughly $100 billion in the private label market last year. Until recently, many bonds had excess bidders and the CMBS market enjoyed inflows of capital correspondent with performance. It seemed that despite low interest rates, market participants generally agreed that CMBS was functioning well in the main.

As a result, CMBS 2.0 has continued to evolve. First, more stringent accounting and rating agency rules resulted in greatly reduced economic incentives for CDO structuring. Now that CMBS are not re-leveraged through CDOs, the dollar value of investable capital is lower today than it was when interest rates were higher. Second, the rating agencies have all significantly revised their models and required much greater amounts of subordination. As a result, the bonds at the bottom of the stack that absorb losses have roughly doubled. Third, better transparency in the form of Annex A and the IRP, now in its 8 th version, has reinforced better underwriting standards and more extensive due diligence. While the market is constantly evolving, CREFC believes that these positive conditions are not temporary, but rather more permanent features of the CMBS 2.0 market and the upcoming CMBS 3.0 market.

Regulatory Regime and the Question of Effectiveness

The CREFC community is generally supportive of prudent regulation that appropriately weighs the cost of the requirements with the corresponding benefit it is expected to achieve. In our comments to the various regulators, including the Securities and Exchange Commission ("SEC"), we made this fact known and expressed a desire to work with them in identifying solutions that would enhance positive market practices, including those put in place by the CMBS market itself. Currently, the CMBS market is subject to an extraordinary amount of direct regulation, and many of these measures have the impact of treating CMBS more harshly than other asset classes (e.g., Fundamental Review of the Trading Book and Liquidity Coverage Ratio). Further, there are innumerable rules that indirectly impact the market by greatly changing the conditions under which the entire financial system operates. These rules then drive the conditions in which CMBS functions. Of the subset of these new rules that affect CMBS most directly, there are:

* the accounting changes FAS 166 / FAS 167;

* rating agency rules;

* Regulation AB II (a set of disclosure requirements);

* reporting requirements to the TRACE facility;

* Volcker Rule (which sanctions CMBS market making but presents a set of very high hurdles for compliance);

* Basel III leverage ratio (which affects how market making desks fund themselves with repurchase agreements);

* Liquidity Coverage Ratio (LCR);

* Net Stable Funding Ratio;

* Risk based capital rules; and

* Risk Retention rule (which requires that issuers hold 5% of a securitization).

Last year, CREFC produced a study n12 of the regulatory impacts on the CRE sector overall and found through interviews and quantitative analysis that taken together, regulation has done some good things for our sector, but it has also reconfigured the structure of the markets in such a way that makes it ultimately less resilient in times of stress. These outcomes generally run counter to broader policy goals of maintaining sound functioning markets and supporting sustainable growth. Broadly speaking, the rules under the Dodd-Frank Act and also the various components of Basel III discriminate against longer-term assets and those that are not highly standardized, such as residential mortgages. At the same time, there is little acknowledgment of the unique transparency in the CMBS market or how the market functions differently than other asset classes that tend to be traded on more of a quantitative, and less on a fundamental, basis.

CMBS Liquidity and Market Resiliency

The universal concern of all industry participants is that the constant march of new regulatory requirements will create such a drag on margins that a critical mass of participants will exit. Many CREFC members have commented on this likely end game for CMBS now that they can envision a more complete regulatory timeline.

Starting with the risk retention rule, which goes into effect on December 24, 2016, borrowers, issuers, and investors are keenly analyzing implementation at this time. CREFC gathered estimates last year and found that the regulation would likely add roughly 10% to the interest rate the borrower pays. This number was calculated assuming stable conditions and before CMBS participants started to consider the implementation challenges in earnest. Based on a sampling of issuers and investors more recently, CREFC found that on average, our members believe that much of the current spread widening is driven by regulatory burden, suggesting that the 10% of marginal costs originally estimated will prove to be lower than the actual costs incurred in a volatile trading environment such as the one prevailing for some time now. Given that risk retention is the next piece of regulation to move into effect for our sector, it can reasonably be credited as the greatest driver of costs to the borrower at this time and one of our industry's top priorities. The regulatory factor is often cited as the driving force beyond continued spread volatility at this time, while other fixed income asset classes revert back to more stable trading environments.

CREFC and the majority of its members have often supported differentiated treatment for SASB bonds, because the asset class has performed better than most other fixed income sectors, and in some ways, is simply the best performing sector through the crisis. Yet, the six regulators that were obligated to promulgate the risk retention rule, chose to include SASB deals in the coverage universe, even though there was very little, if anything, more that rules and restrictions could accomplish with the sector. n13 The risk retention rule was written with conduit structures in mind, yet will also be applied to the SASB universe, despite the fact that the requirements cannot be adopted without wholesale restructuring the SASB model and the market with it.

Additionally, it is important to note that risk based capital rules and the LCR are steep for our sector, and, more importantly, they treat CMBS relatively poorly compared to other financial instruments. Additional rounds of Basel capital requirements will make CMBS even less viable. Based on a series of interviews conducted with market leaders since the beginning of 2016, the FRTB, which changes capital requirements for all inventories kept for market making purposes, has been cited as one of the most concerning pieces of regulation, if not the most. n14

Even though the Basel Committee on Banking Supervision (BCBS), reduced the magnitude of the charges applied to CMBS in the final version of the FRTB published on January 14, of this year, these requirements place CRE backed-deals on par with subprime residential mortgages. In turn, it will be even more challenging to allocate capital to CMBS businesses, and ensures increased fragilities. The LCR, which is the first of two new liquidity requirements under Basel III, is also an example of a punitive approach toward all non-sovereign asset classes, but particularly, securitizations and CMBS. The LCR requires that CMBS issuers apply an additional cost to the production of their assets, even after they have been sold. The recently proposed Net Stable Funding Ratio follows the LCR's construction and is expected to additionally disadvantage CMBS relative to other asset classes.

Other Countries Easing Regulatory Treatment of Securitizations

In contrast to the tightening of the regulatory regime in the U.S. anticipated in the near future, the European Union is using the securitization markets to help restart growth. Policy makers across many jurisdictions and throughout legislative and banking authorities have recognized in many ways that the securitization markets can provide safe and alternative funding to the banking system. As such, the European Central Bank (ECB) is utilizing the financial technology as part of its small and medium sized business program.

Additionally, the ECB and other European regulators have begun to consider how to ease the burden on safer securitizations through reduction of risk based capital requirements and other mitigating measures. Importantly, they have noted that compliance and accounting measures have increased the discipline in the markets and believe that an offset in the capital and liquidity requirements would be warranted.

The European authorities are not the only jurisdictions contemplating a reduction in the regulatory burden on structured products. In light of slowing growth globally, other regulatory agencies have considered certain changes too, including China, Japan and Australia.

Regulation and Market Liquidity

In short, these regulations are and will continue to have a significant impact on CMBS. The precipitous decline in CMBS liquidity (e.g., inventories, turnover, trade size), especially the prolonged spikes in swap spreads, are particularly troubling. These trends suggest that the market is trading inefficiently; in the absence of credit concerns, anticipation of the next round of regulation must be driving much of the volatility. Moreover, certain trends suggest that the pattern may be sustained for some time, if not deepened becoming a negative feedback loop as many have warned:

a. The number of market making platforms is declining rapidly, especially those that provide "balance sheet" and that can hold inventories. Based on a partial survey of the market in April, it appears that at least one in five people have been downsized this year, and at least one institution, the number is reversed; of five original market-making staff, one remains. One member investor speculated that there were ten true dealers with capacity to hold inventories and to make markets across a range of new issues last year; that number was halved by year-end 2015 and as of this writing, the number is now down to two or three true market makers.

b. As expected, the investors who relied on liquidity - those who care more about total returns than relative value - have exited en masse in lock step with the liquidity providers, leaving a distinct and troublesome gap at the lower end of the bond stack.

c. Yet, buy-and-hold investors have reacted decisively to the distress in the market too by reducing allocations to the sector and many are actively retreating from the conduit market. All are concerned about the ability to price their investments accurately in a volatile market.

d. The proportion that CMBS represents in the Barclays Aggregate Index, which is the one of most often used fixed income benchmark indices, has declined significantly to 1.2% from a high of 5.7%, meaning that the demand for CMBS will continue to decline.

e. While there were roughly 40 conduit lenders and sellers last year, they too are closing their doors and now number roughly 28.

f. The pipeline of new issues has been moving at a slow pace since April. The SASB deal calendar, especially, seems to be drying up in the summer with a couple of small deals scheduled in June and none in July. n15 Both sides of the business are seeing smaller deal sizes, which also indicates general lack of liquidity and is a concern for both buyers and sellers.

g. The primary hedging instrument for the industry, the CMBX, has begun to trade very differently than the underlying cash bonds, which also indicates inefficiencies in the market and portends a deepening of the dislocation if pricing of the two products, the bond and the hedging instrument, do not become reasonably more correlated in their movements again.

Demand for liquidity relative to market supply is stark. A survey of issuers, traders, investors and other market participants conducted by CREFC in early February suggests that, market-making capacity was already undercapitalized by one quarter to one half. Since then, additional traders have lost their seats, draining further capacity from the system.

Recommendations and Conclusions

Considering all of the perverse impacts of regulations - both individually and in the aggregate - our list of recommendations would be long, and mostly within the regulatory purview. As such, we began this process first by petitioning the regulatory community for correction and clarification. Regulators accepted some of our recommendations but also declined a good number. It is for this reason that we now seek Congressional intervention.

From the legislative perspective, we urge the members of this Committee to work together in a bipartisan fashion to introduce the companion to the bill sponsored by Representative French Hill of Arkansas. H.R. 4620, the "Preserving Access to CRE Capital Act" addresses the challenges posed by the risk retention rule in a targeted, fair and responsible fashion. Though the recommendations in the bill do not affect the core requirements codified in the Dodd-Frank Act, Section 941, n16 they are meaningful and would have a positive impact on the marketplace. The majority of CREFC issuers, investors and servicers support the bill, however, there is a minority contingent of investors who support the final regulation without modification.

Introduce and Report Out of Committee a Companion to H.R. 4620

CREFC strongly supports the recommendations below, which restore the proper balance between protective measures and a healthy, functioning CMBS market for the borrowers and employers in every Congressional district. Specifically, the recommendations would: (1) exempt from the risk retention requirements the highly-sought and extraordinarily transparent SASB transactions; (2) set reasonable parameters for regulating and designating as "qualified" certain high-quality commercial loans (QCRE Loans) under the risk retention rules; and (3) provide flexibility in structuring the retained interest to suit investors without modifying the amount nor relaxing the general restrictions surrounding the retained interests.

First, the recommendations would address the issues related to the transparent and high-performing SASB transactions by making them exempt from the risk retention requirements. As mentioned above, SASB transactions are marked by superior performance -- the SASB segment booked a mere 0.25 basis points in cumulative losses between 1997 and 2013. This financing option is ideal for borrowers seeking to finance apartment complexes, hotels, office buildings, and, of course, gateway market "trophy" properties. Despite this superior performance, current regulations do not include an exemption for SASB transactions, which threaten to raise borrowing costs, decrease borrower choice in this market, and induce them to seek other modes of financing that may be less transparent and low risk (e.g., corporate bond markets).

Second, the recommendations would put in place common-sense parameters for considering which CRE loans would be deemed "qualified" under the risk retention requirements. Currently, only a small percentage of CMBS loans would be considered as QCRE loans, and exempt from the risk retention requirements. Although modeled after the Qualified Residential Mortgage ("QRM") exception, the application of QCRE has vastly different consequences. Surprisingly, private label residential mortgage-backed securities were given a generous set of qualifying requirements under the QRM standard; in fact, it is estimated that nearly all of today's RMBS loans would qualify for an exemption. Yet, conversely, in the CMBS space, the qualifying conditions are so onerous that only 3%-8% of all CMBS conduit loans written since 1997 would qualify for an exemption from the core 5% risk retention requirement. This has little sense of proportion or compelling rationale.

H.R. 4620 would moderately widen the underwriting requirements for QCRE, thus helping maintain credit quality in this space, along with stable pricing and availability of financing for a broad swath of business owners. Specifically, the bill would allow pools of unrelated/unaffiliated, or conduit loans will be allowed to amortize over not more than 30 years (from the current 25-year standard); permit low-LTV interest-only loans to be treated as "qualified" where no authority was granted previously; and permit loans less than 10 years in term as qualifying for exemption under the QCRE rule. We expect that this would raise the QCRE percentage to about 15% of all loans, still well below all the RMBS loans that will qualify under the QRM exception. In other words, the parameters are targeted and responsible. In no way would it allow a blanket carve-out for the CMBS community, rather it would only truly apply to transparent and highly-performing loans.

Third, under the risk retention rules, there are special rules for CMBS that allow a third-party investor to purchase the B-piece (known under the rule as the eligible horizontal residual interest, or "EHRI"). The risk retention rule allows up to two third-party investors to share the 5% retention burden, but requires them to hold their positions pari passu (i.e., horizontally). The proposed legislation supported by CREFC would allow third-party purchasers to share the retention obligation pari passu or in a senior-subordinate (i.e., vertical) structure. H.R. 4620 does nothing at all to change the core retention requirement or any of the other requirements surrounding the B-piece investors. The core 5% retention requirement and all other general requirements (e.g., substantive due diligence, holding the interest for five years, etc.) would remain intact.

The legislation allows for a reasonable amount of flexibility in how the B-piece is held internally by two purchasers. This flexibility will allow the B-piece buyer to match investor capital with the additional capital investment (the retained risk amount) that the rules require. For CMBS, the required amount of risk retained will be about two times that of what is currently invested by B-piece buyers in a typical CMBS deal. That is a massive amount of incremental capital B-piece buyers have to raise in order to be risk retention compliant. And that investment is essentially non-transferable - meaning that the funds raised will be "parked" in a single deal for at least five year. Obviously, this comes with an illiquidity premium that investors will seek - further increasing costs to borrowers. The senior-sub structure will be used to help align investors with this new retained risk requirement. It will not affect at all the amount of risk that must be retained, the underwriting due diligence required by the rules or the holding period requirements of the rules. It simply gives the industry flexibility to achieve the risk retention goals of the regulations and is supported by 14 real estate trade associations. n17

Conclusion

CREFC would like to thank the members of this Subcommittee for providing us the opportunity to submit this statement. CREFC asks that the Subcommittee give serious consideration to the negative consequences of the latest round of rulemaking - consequences far beyond the CMBS markets. More to the point: without a robust and competitive CMBS marketplace our members anticipate a liquidity-driven stress event that could potentially take years to rebalance as market participants leave the arena for other lines of business. This imbalance will have far-reaching and profound effects on communities in a very visible way, by constricting the funding for commercial properties that we all come to rely on daily for our groceries, housing, workplaces, healthcare, education, and goods and services. In short, the roughly $200 billion of maturing CMBS debt in the next two years will need to be financed regardless of the actions Congress takes. In the absence of intervention and continuity of a competitive CMBS marketplace, we fear that buildings currently funded could fall into foreclosure, resulting in blighted, perhaps empty structures and loss of principal for America's pension and other investors and retirees.

We remain optimistic that there is time to correct this looming liquidity crunch, and we are eager to work with members of the Committee, and with Congress, to ensure that the discretely tailored recommendations become law.

n1 The below article discusses some of the measures being considered by the European Union: http://www.wsj.com/articles/eu-proposes-new-capital-rules-to-boost-securitization-1443610493

n2 As measured by the standard deviation of swap spreads, which are the benchmark off of which CMBS are priced. Higher standard deviations indicate lack of liquidity. Current readings in CMBS suggest that the market is undergoing significant stress.

n3 According to a recent survey, U.S. institutional tax-exempt exposure to real estate debt and equity grew to $835 billion. One of the largest Asset Managers, TIAA-CREF, has $82 billion, or 9.4%, in exposure of a total of $866 billion in AUM as of 3/31/2015. http://www.pionline.com/article/20141027/PRINT/310279999/real-estate-managers-back-over-1-trillion-again

n4 Alan C. Garner, "Is Commercial Real Estate Reliving the 1980s and Early 1990s," https://www.kansascityfed.org/publicat/econrev/pdf/3q08garner.pdf (2008)

n5 Sam Chandan, "The Past, Present, and Future of CMBS," http://realestate.wharton.upenn.edu/research/papers/full/730.pdf (2012)

n6 For information on the IRP, please visit: http://www.crefc.org/irp or see Appendix A. This information anticipated by almost 20 years asset-level information now required by the SEC for other asset classes.

n7 As of 08/31/2013, per CREFC's comment letter to regulators.

n8 See CREFC's Letter to various regulators on Risk Retention: http://docs.crefc.org/uploadedFiles/CMSA_Site_Home/Government_Relations/Financial_Reform/Risk_Retention/Risk%20Retention%20Proposed%20Rule%20Comment%20Letter.pdf

n9 https://www.federalreserve.gov/bankinforeg/srletters/sr1517.htm

n10 http://www.federalreserve.gov/boarddocs/snloansurvey/201605/

n11 A full list of these self-regulatory measures is available in CREFC's letter to the Federal Reserve System, the FDIC, Treasury, the SEC, and the OCC: http://docs.crefc.org/uploadedFiles/CMSA_Site_Home/Government_Relations/Financial_Reform/Risk_Retention/Risk%20Retention%20Proposed%20Rule%20Comment%20Letter.pdf

n12 http://www.crefc.org/CREFC/Publications/Regulatory_Impact_Study/CREFC/Resources/Regulatory_Impact_Study.aspx?hkey=47af34d5-3cea-43e1-942f-309fd7508928

n13 With an historical realized loss of 0.25%, SASB deals have performed remarkably well, which explains the spike in investors' demand for these bonds in recent quarters.

n14 Even after the Basel Committee on Banking Supervision reduced the risk weighted requirements for structured products in their final version of the standards published on January 14, 2016, industry participants anticipate that new U.S. rules may require that market makers maintain more capital than the market value of certain CMBS bonds.

n15 Commercial Mortgage Alert, 05/13/16.

n16 Issuers / sponsors must retain 5% of the credit value of the bonds for five years, during which time the bonds cannot be hedged (except for interest rate and foreign exchange).

n17 See appendix B for Industry Support Letter to House Financial Services Committe

Read this original document at: http://www.banking.senate.gov/public/?a=Files.Serve&File_id=40B4851D-B063-4D3D-898B-C5FDE727078E