What is Risk Retention under Dodd-Frank? (Pt. 1)

Written by Fernando Martin| September 29, 2018

Anyone who works in or around commercial real estate has probably heard the words “risk retention” at some point, however many people may not fully understand what it is or how it may affect them personally. In order to understand what risk retention is, we have to take a look at where this term actually comes from.

After the market collapsed in 2007, a lot of people lost A LOT of money, including retirees that got completely wiped out from what they were supposed to be living on for the rest of their lives. Needless to say, people were very upset, and demanded that the government do something to protect them from anything like this ever happening again. That’s where the Dodd-Frank Wall Street Reform and Consumer Protection Act comes in, which was passed in July of 2010. This Act created the Financial Stability Oversight Council to identify possible risks to the financial markets in order to avoid another financial crisis from ever happening again. It also gave the FDIC (the regulatory agency the oversees banks) the ability to start regulating non-bank institutions including CMBS originators/securitizers, which previously had very little oversight at all.

In September of 2010, the FDIC enacted the “Securitization Safe Harbor Rule” (revised in October of 2015) which not only outlined when payments of principal and interest should be made to investors, but also established what is now referred to as “risk retention,” which went into affect on December 24^th of 2016. So what exactly does risk retention mean? It means that any financial institution that securitizes a pool of CMBS mortgages and offers the bonds to investors must retain at least 5% of the credit risk associated with those bonds, with an exception for “qualified” CRE loans (which we’ll get into in another segment as the definition may change shortly with a new bill being considered).

“It means that any financial institution that securitizes a pool of CMBS mortgages and offers the bonds to investors must retain at least 5% of the credit risk associated with those bonds, with an exception for “qualified” CRE loans …”

This risk retention can be held in one of three ways:

1) by keeping 5% of each tranche of the bonds (a “vertical strip”);

2) by taking a 5% residual interest in the first-loss position (a “horizontal strip”), where the value of the strips are based on actual deal proceeds as opposed to notional balances (i.e. market value rather than par value); or

3) by taking a “L strip,” which is a hybrid between the vertical and horizontal strips, seeking the ideal balance between risk and returns.

The risk retention strips can be passed to “B-piece” buyers (investors that buy the riskier bonds for a discount), but the bonds must be held for at least 5 years and may only be sold to other qualified “B-piece” buyers, which in reality will result in 7-10 year holds (considering the almost all CMBS loans are currently 7-10 years because of the pricing). However, if residual interest is passed to “B-piece” buyers, they cannot be financed.