Today’s Salvo is a follow-up to our November 2009 Commentary, released December 9, where we discussed the Financial Stability Improvement Act of 2009. We pointed out that the Act contained a watered down “skin in the game” provision that does not adequately capture the process by which B-piece buyers of mortgage-backed securities (MBS) sell them into resecuritizations. On Friday, December 11, 2009 the United States House of Representatives passed HR 4173 - Wall Street Reform and Consumer Protection Act of 2009, which includes the Financial Stability Improvement Act and contains the inappositely named Subtitle F — Improvements to the Asset-backed Securitization Process, Section 1502-Credit Risk Retention. The language includes that an originator generally retain 5% equity in the original pool of mortgages. It went further and gave an exemption for issuers of MBS to sell those pieces as long as it is to a third party that will conduct “due diligence on all individual loans in the pool prior to the issuance of the asset-backed securities…” Practically speaking, this applies to commercial MBS (CMBS), not residential. As we expressed in our November Commentary, we believe that the legislation is misguided.

Let’s look at commercial mortgage-backed securities. A significant reason for the credit catastrophe was that the investors who were nominally viewed as the holders of the first loss (or “skin in the game”) piece were believed to have actually had their money at risk. While this was true in the CMBS space for a period of time, this relationship began to change in 2004 with the propagation of collateralized debt obligations (CDOs). A significant amount of CDOs were comprised of all those ‘B’ pieces and other first loss pieces. The demand for CDOs fueled transaction velocity and consequently the origination of even more commercial mortgage instruments. Not surprisingly, the exponential increase of both CMBS and CRE CDOs were directly correlated. Consider the chart below (click to enlarge).