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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.