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Impacts of Subordination and Ratings on CMBS and Regulatory Capital Arbitrage

This paper discusses the evolution of risk-weighted capital requirements for Commercial Mortgage-Backed Securities (CMBS) since January 2002, highlighting the reduction of subordination levels demanded by rating agencies and the significant upgrades in CMBS ratings. The analysis points to a shift in how these ratings impact capital requirements, potentially facilitating regulatory capital arbitrage by keeping risk concentrated within financial institutions. Important debates include the actions of rating agencies, the issuer-pays regime, and their implications on market stability.

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Impacts of Subordination and Ratings on CMBS and Regulatory Capital Arbitrage

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  1. CMBS Subordination, Ratings Inflation, and Regulatory-Capital ArbitrageRichard Stanton and Nancy WallaceJuly 11, 2011 Comments: Stephen Schaefer London Business School

  2. The Story • Jan 2002: risk-weights on CMBS bonds reduced to 20% • Subordination levels for senior CMBS bonds demanded by rating agencies fell; and • Many CMBS ratings upgraded; resulting in • Reductions in required capital via RBCS However • No change in characteristics of CMBS loans themselves • Implication • rating agencies facilitated regulatory capital arbitrage • “Net result was to keep risk concentrated in financial institutions” Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

  3. Comments • Issues raised are very important • risk based capital requirements • use of ratings in RBCR • actions of rating agencies, issuer pays regime, competition between agencies vs. value of reputation • Evidence • significant upgrading • re-pricing of senior loans • reduction of subordination levels Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

  4. Was the reduction in subordination the result of the change in RBCR? 2002 Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

  5. Price Impact of RBCR? • Did reduction in RBCR push up prices of CMBS bonds? And, if so, why? [Value depends on financing?] • Yields on CMBS relative to corporate bonds fell after 2001 but default rates on corporates at the time very high. Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

  6. Was credit re-pricing in years leading up to crisis unique to the CMBS Market? Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

  7. For corporate debt re-pricing in period leading up to crisis reflected substantial reductions in objective measure of credit risk Source: Moody’s KMV – “Credit Risk matters”, Fall 2007. Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

  8. Does Appear to be some significant reduction in CMBS implied vol. in years leading up to crisis Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

  9. Regulatory Capital Arbitrage • From July 2002 banking regulators in US reduced capital requirements on AAA and AA CMBS bonds by a factor or FIVE • RBCR for BB bonds 10 TIMES that for AAA/AA • What was intention of regulators? • presumably to encourage banks to hold senior debt rather than junior debt (?); and • implicitly to encourage securitization in order to facilitate creation of senior and junior quality CMBS bonds (?) • If this is what actually happened, is it right to call it arbitrage? Discussion: CMBS Subordination, Ratings Ination, and Regulatory-Capital Arbitrage

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