CMBS Subordination, Ratings Inflation, and Regulatory‐Capital Arbitrage

Abstract

Using detailed origination and performance data on a comprehensive sample of CMBS deals, along with their underlying loans and a set of similarly rated residential MBS, we apply reduced-form and structural modeling strategies to test for regulatorycapital arbitrage and ratings inflation in the CMBS market. We find that the spread between AAA CMBS yields and AAA corporate bond yields fell significantly following a loosening of capital requirements for highly rated CMBS in 2002, while no comparable drop occurred for lower-rated bonds (which experienced no similar regulatory change). We also find that AA-rated CMBS upgraded to AAA significantly faster than comparable AA-rated residential RMBS (for which there was also no change in risk-based capital requirements). We use a structural model to investigate these results in more detail, and find that little else changed in the CMBS market over this period except for the rating agencies' subordination levels.

The Other (Commercial) Real Estate Boom and Bust: The Effects of Risk Premia and Regulatory Capital Arbitrage

“…The sharp fall in risk premia and capitalization rates in the early-to-mid 2000s coincided with the rise in CMBS issuance. Stanton and Wallace (2012) find that the spread between Aaa-and Aa-rated CMBS and corporate bond yields fell significantly after a loosening of capital requirements for these highly-rated CMBS in [2002][2003][2004]. This evidence is consistent with the argument that regulatory-capital arbitrage contributed to boom and bust in CMBS issuance and CRE prices (e.g., Hendershott and Villani, 2012).…”

“…The final Basel II requirements lowered the risk weight for banks on Aaa-and Aa-rated CMBS to just 20 percent of the eight percent . Although this cut was adopted on an interim basis in 2002 (Stanton and Wallace, 2012) and via an expectations effect altered CMBS spreads that year, the 2002 interim rules did not apply to foreign banks and its provisional nature likely deterred much pre-final Basel II issuance Dodd-Frank restored the risk weight on investment-grade CMBS to 100 percent, raised the minimum capital ratio on CRE assets held to 10.5 percent from 8 percent for most banks, and required higher capital for systemically important banks. 22 Banks could securitize loans to avoid baseline capital requirements on CRE held in portfolio, but Dodd-Frank compels any securitizer to retain a 5 percent first loss position in a securitized CRE mortgage.…”

“…To reflect these broad 20 A-rated securities had a 50 percent risk-weight, below the 100 percent weight on whole mortgages. Stanton and Wallace (2012) estimate this change saved U.S. banks $3.5 billion in regulatory capital. 21 Bear Stearns was acquired by J.P. Morgan Chase, Merrill Lynch was acquired by Bank of America, and Goldman Sachs and Morgan Stanley converted to commercial banks that have access to Federal Reserve liquidity facilities.…”

“…In the late 1990s, financial innovations gave rise to conduits, which helped partially avoid capital requirements on CRE by enabling nonbank investors to buy debt issued by conduits which in turn purchased CMBS. In the mid-2000s there was another surge in CMBS share around the time when interim and final Basel II regulations reduced capital requirements for banks holding CMBS (Levitin andWachter, 2013, andStanton andWallace, 2012) and when the SEC effectively eased leverage requirements on investment banks, which took positions in ABS. These growth rate patterns are consistent with the evolution of the shares of different forms of holding commercial mortgages ( Figure 3).…”

Comparing Securitized and Balance Sheet Loans: Size Matters

“…In the absence of government guarantees, such as those that the GSEs provide in the residential mortgage market, lenders appear to turn to securitization only when the benefits, such as diversification, are large enough to outweigh the agency costs associated with securitization. Although diversification is a benefit to lenders that enables greater loan supply, and is thus often socially beneficial, certain other benefits to lenders, such as regulatory arbitrage (see Stanton and Wallace (2012) and Acharya, Schnabl, and Suarez (2013)), may be socially harmful.…”