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“ONE SIZE DOES NOT FIT ALL” MARGINING DOES NOT ADDRESS MULTIFAMILY MBS RISK; HARMS MARKET Executive Summary After the financial crisis of 2008, Federal regulators and others looked for ways to reduce risk in the residential housing market. One way the regulators have sought to reduce risk is to require margining – the posting of cash as collateral – to back the obligations of parties under a “to be announced” (TBA) mortgage backed security (MBS). While this may make sense for residential MBS, the Treasury Markets Practice Group (TPMG) recommended extending margining to the multifamily market as well. Because of the unique nature, small size, existing risk mitigation factors and stability of the multifamily MBS market, PGIM Real Estate Finance believes requiring margining in this market will do little to reduce risk. Instead, it will have significant negative impacts to lenders, broker-dealers, borrowers and renters. Specifically, PGIM Real Estate Finance believes requiring multifamily MBS margining will increase the costs associated with multifamily loans and reduce overall market predictability and stability. PGIM Real Estate Finance agrees with the recommendation of the U.S. Securities and Exchange Commission (SEC) to exempt the multifamily MBS market from the mandatory margining requirements. The SEC allows broker-dealers to make an internal risk limit determination for each counterparty and, based upon that determination, the broker-dealer is permitted to waive any margining requirement for conforming MBS. We also urge multifamily TBA market participants to give serious consideration to the negative consequences associated with margining when deciding whether or not to implement the practice for multifamily MBS. Key Takeaways • How certain regulations enacted to ensure stability in the residential mortgage market--as a result of the financial crisis—are unnecessarily being applied to the multifamily MBS market • Why there is disagreement among a variety of institutions, including the SEC, on the role margining should play in the multifamily MBS market • How residential and multifamily MBS risk profiles are inherently different • Why mandating margining for the multifamily market could negatively impact the industry and raise costs for lenders, broker-dealers, borrowers and renters Background on the TBA Marketplace How does a lender lock in the interest rate for a home mortgage weeks or even months before closing? Why is it that the rate doesn’t change in response to changing market conditions? If a buyer could not lock in an interest rate early in the home buying process, there would be significant disruptions to the residential market. The TBA market makes it possible to lock in an interest rate and avoid the vagaries of a potentially volatile interest rate environment. While many individuals might not be familiar with this market, it is a critical element of our economy’s infrastructure and one that most homebuyers rely on. © 2017. PGIM, the Rock symbol, and the PGIM Logo are service marks of Prudential Financial, Inc. and its related entities. *Debt Service Coverage, Loan to Cost and Loan to Value vary by property affordability component. Please call PGIM for more details. “ONE SIZE DOES NOT FIT ALL” MARGINING DOES NOT ADDRESS MULTIFAMILY MBS RISK; HARMS MARKET When a residential mortgage lender makes a loan, typically that lender will bundle up a number of loans and sell the loans as MBS. A TBA is a contract between a lender and a securities purchaser, either a dealer or an end investor, where the lender agrees to sell an MBS to the purchaser at a specified price at a specified point in the future. In the TBA market, the lender is confident it will put together the loans in time to deliver the MBS to a buyer based on its view of the market even though, at the time the lender commits to sell the MBS, the loans to back it have not yet been identified. Thus, the moniker “TBA.” Based on the forward contract, the lender is able to set the borrower’s interest rate, giving borrowers assurance of being able to close their loan at a particular rate. The sale of the MBS enables lenders to recover capital and make more home mortgage loans. The MBS buyer gets a fixed rate investment, homebuyers know their interest rate when committing to buy a home, and selers get higher prices because there is no interest rate uncertainty. Under this process, the market has worked smoothly and all participants benefit, but this model is about to change. Why the change? The residential mortgage market disrupted the U.S. economy. However, the disruption did not stem from the TBA market itself; rather the disruption was caused by the quality of the residential loans that backed the securities. Nonetheless, due to its importance to the economy, regulators have been seeking ways to ensure stability in the residential mortgage market since the financial crisis and consequently enacted new regulations impacting the TBA market. Some of the requirements go well beyond the residential market and may disrupt the multifamily market in a major way. PGIM Real Estate Finance, as one of the largest multifamily real estate lenders in the country, enters into forward contracts to sell MBS backed by multifamily loans to lock in interest rates for commercial borrowers on a regular basis. This enables PGIM Real Estate Finance to offer competitive interest rates to its borrowers and give borrowers interest rate certainty in advance of closing, providing predictability for the market and facilitating deal flow by utilizing a liquid and transparent product. The multifamily market is decidedly different and does not present the inherent risks and potential disruptive impact to the U.S. economy, unlike the residential market. PGIM Real Estate Finance has taken a lead role in influencing recent industry discussions around the appropriate regulatory framework for the multifamily TBA market. Although certain changes to the regulation and best practices of the TBA market may be useful in creating greater transparency and safety for residential MBS market participants, PGIM Real Estate Finance believes the multifamily MBS market is fundamentally different and should be treated as such. Regulatory Landscape The TBA market accounts for a significant portion of fixed income trading in U.S. and world markets. Due to the incredible strain imposed on the markets by the collapse of the residential housing market, regulators have been examining methods of reducing systemic risk and increasing overall transparency across all areas of the market, rather than the single area of failure. Reducing counterparty credit exposure is one of the end-goals for policymakers and mandatory margining is one part of that solution. © 2017. PGIM, the Rock symbol, and the PGIM Logo are service marks of Prudential Financial, Inc. and its related entities. *Debt Service Coverage, Loan to Cost and Loan to Value vary by property affordability component. Please call PGIM for more details. “ONE SIZE DOES NOT FIT ALL” MARGINING DOES NOT ADDRESS MULTIFAMILY MBS RISK; HARMS MARKET “Margining” refers to the posting of cash as collateral to back the obligations of parties under a forward contract. It is based on changes in the value of the asset being sold. The idea is that the buyer would be harmed if the value of the asset goes up and the sale falls through, so the seller should post additional collateral to back the seller’s obligation to deliver the asset. In that scenario, the buyer would keep the margin posted if the sale failed. One-way margining refers to the purchaser’s ability to demand margin from the seller of the MBS, while two-way margining requires the seller and purchaser to post a margin, depending upon price movements. In 2012, a group of professionals from a variety of institutions (including, and sponsored by the New York Federal Reserve Bank), known as the Treasury Market Practice Group (TMPG), published a best practices guide recommending margining of TBAs. The TMPG’s best practices are not binding, but are widely accepted by the broker-dealer community. The Financial Industry Regulatory Authority (FINRA), under the auspices of the SEC, proposed Rule 4210, which required margining on TBA transactions. The SEC published partial amendments to that rule and ultimately, in its last amendment in June 2016, exempted the multifamily MBS market from the margining requirements, leaving the requirement for sellers to post margins in multifamily MBS to the discretion of broker-dealers. Despite the SEC’s proposed rule amendments, in July 2016, the TMPG released a statement reaffirming its view that multifamily MBS should not be exempt from margining. Their statement went far beyond the requirements outlined by the SEC in its most recent rule proposal. The TMPG’s best practices could result in the imposition of margining on multifamily MBS market participants, which is contrary to the intentions of Federal regulators. It is our strong belief that, while margining may be appropriate in the residential market, it is not necessary and even potentially highly disruptive for the multifamily market. PGIM Real Estate Finance urges multifamily TBA market participants to give serious consideration to the negative consequences associated with margining when deciding whether or not to implement the practice for multifamily MBS. Margining is not necessary to address perceived risks in the multifamily MBS market. This market does not present the same risks as the residential market, and the multifamily MBS market already utilizes a number of risk mitigation tools. Further, margining will only increase the costs associated with multifamily loans (without any commensurate benefit), reducing overall market predictability and stability, making loans more expensive for borrowers and ultimately leading to increased costs being passed on in the form of higher rents for consumers. Distinguishing between Residential and Multifamily MBS The TBA market is dominated by forward settling agreements relating to residential MBS. A very small slice of the market is made up of forward settling agreements relating to multifamily MBS, which comprise just five percent of the overall annual trading volume of the TBA marketplace. Multifamily MBS forward settling transactions involve loans that are secured by multifamily or health care loans that have five or more dwelling units. Examples of properties that might secure these loans include assisted living, skilled nursing facilities, memory care, cooperative housing projects, student housing, rural housing, military housing, hospitals and conventional and affordable apartments. © 2017. PGIM, the Rock symbol, and the PGIM Logo are service marks of Prudential Financial, Inc. and its related entities. *Debt Service Coverage, Loan to Cost and Loan to Value vary by property affordability component. Please call PGIM for more details. “ONE SIZE DOES NOT FIT ALL” MARGINING DOES NOT ADDRESS MULTIFAMILY MBS RISK; HARMS MARKET The credit and counterparty risks inherent to the residential MBS market are very different than those encountered in the multifamily MBS market for several reasons: A multifamily TBA MBS is not really a “TBA.” The TBA market allows the delivery of MBS backed by a yet-to-bedetermined pool of mortgage securities. Multifamily MBS generally relate to a single, already identified property and the trade is specific to that particular mortgage loan. The terms of that specific loan and the details of the property are known at the time of the trade. Therefore, the trade confirmation letter relates to a specific, already identified loan, rather than generalized terms relating to loans that have not yet been sourced. A rigorous underwriting process has already been completed at the time of the trade. Because of the timing of the trade, there is a lower risk that the trade will not be completed or the MBS will not be delivered as described in the forward commitment because the loan has already been the subject of a rigorous underwriting process making the loan infinitely more likely to proceed to closing. It has been extremely uncommon for these loans to fall through. Good faith deposit already reduces credit exposure. In multifamily loans, a good faith deposit is collected by the lender from the borrower. The good faith deposit typically represents contractually agreed-upon liquidated damages between the buyer and the seller of the security. In the event the transaction fails to close, the MBS purchaser will retain this amount. If the transaction closes as planned, then the amount is returned to the borrower. This already serves as a hedge of the buyer’s exposure to a failed trade overall market for MBS. In addition, multifamily lenders participating in the government sponsored lending programs that typically underly multifamily MBS are subject to intense oversight by the Federal Housing Administration and the Federal Housing Finance Agency. As a result of this oversight, these lenders must submit to regular audits and meet minimum capital requirements. Mark-to-market calculation will be difficult and burdensome. Unlike residential MBS, which are backed by a homogeneous pool of fungible assets, multifamily MBS are backed by unique properties that are more difficult to value. There is no readily available mechanism to make value determinations on a daily basis, which would create great uncertainty as to how to value the actual margining requirements as a practical matter. Lowest common denominator credit analysis. Rather than have the marketplace individually evaluate its counterparties and their creditworthiness, required two-way margining attempts to achieve systemic safety by eliminating the market’s own efficiencies in assigning credit risk evaluations to counterparties. This increases costs for all market participants rather than those that truly require margin to mitigate credit risk. Unfair playing field leads to concentration risk. Some brokerdealers are not required to follow the TMPG guidelines and, therefore, will not require their counterparties to post margin. In addition, Fannie Mae, one of the largest investors of Fannie Mae MBS, is exempt from margining. This unbalanced treatment creates a competitive disadvantage for others in the marketplace, potentially causing a higher concentration of activity in fewer counterparties, thus increasing rather than reducing systemic risks. Small market, small impact. As noted above, the multifamily market is a very small portion of the ©2017.PGIM,theRocksymbol,andthePGIMLogoareservicemarksofPrudentialFinancial,Inc.anditsrelatedentities.*DebtServiceCoverage,LoantoCostandLoantoValuevaryby property affordability component. Please call PGIM for more details. “ONE SIZE DOES NOT FIT ALL” MARGINING DOES NOT ADDRESS MULTIFAMILY MBS RISK; HARMS MARKET Real World Impacts of Margining on Multifamily MBS and the Multifamily Lending Business Multifamily MBS margining sounds esoteric and exotic, but ultimately, imposing a margin requirement on these products can have real life impacts on Main Street as well as Wall Street. The small size and relatively low risk that is present in multifamily MBS must be measured against the significant impact of margin requirements on lending in relation to these multifamily projects. Impact on Lenders. The TMPG’s margining requirements would adversely impact lenders by reducing liquidity and, in turn, the volume of loans that can be made while increasing costs. Small lenders could be squeezed out of the industry altogether. Margining would make multifamily lending less attractive to lenders in an already complex and capital-intensive business. Impact on Broker-dealers. Margining could result in a disruption of the competitive landscape among brokerdealers. For example, broker-dealers who are exempt from the requirements might emerge as the preferred counterparty even in situations where they might not provide the most advantageous execution, which would result in higher costs to borrowers. that are geared towards senior citizens and the disabled. The lending and borrowing costs experienced by market participants would almost certainly be passed on to consumers trying to access these forms of housing in the form of higher rents and more limited housing options. Multifamily rents have already increased significantly over the last five years in the face of already high demand for affordable housing. Introducing additional costs and constraints on liquidity into the MBS marketplace would only exacerbate these conditions. Conclusion While there are no Federal requirements to margin multifamily MBS in the TBA market, risk officers and regulated buyers should consider the impacts of adopting one-way or two-way margining. Unlike the residential market, the multifamily market functions smoothly with very limited failures and was not adversely impacted by the financial crisis of 2008. Further, there are already a number of risk mitigation tools in place for multifamily MBS. Although margining may be appropriate for residential MBS, mandatory margining in the multifamily space is misplaced and results in substantial burdens and costs for almost all participants that negatively impact the daily functioning of lending markets as a whole without commensurate benefits. Impact on Borrowers. Presuming they are able to access financing, borrowing costs will be higher. Borrowers may not be able to develop and construct the same number of multifamily projects in an atmosphere of reduced liquidity and higher costs. Impact on Renters. The multifamily lending business services the development of apartment buildings, hospitals, military housing, student housing, assisted living and other healthcare related dwelling facilities © 2017. PGIM, the Rock symbol, and the PGIM Logo are service marks of Prudential Financial, Inc. and its related entities. *Debt Service Coverage, Loan to Cost and Loan to Value vary by property affordability component. Please call PGIM for more details.