Well, we're all reading it now. I have been mulling this edifice and talking about what it means with many, many people who are very invested in getting this right. Frankly, this thing is a very hard read. Its breadth is quite extensive and its clarity comes and goes. Given the witch's brew of a regulation drafted by a committee of committees, the conflicting goals and guideposts of those regulatory constituencies, the incredibly complex business on which this regulation scheme is overlaid, and the swirl of politics around the issues giving rise to this regulatory construct, figuring this out requires a literary deconstructionist's sensibility to figure out what's wrong and what might need to be fixed.

There is a half dozen trade organizations working on comment letters and Dechert is active on most of these undertakings. With an outside comment date of October 30th (and notwithstanding pleas for more time, little likelihood the regulators will brook any delay), we really have to hustle if we want to make an impact. Here is the lead: There is plenty in this Proposed Rule that strongly suggests to me that what it appears to require may not be what the regulators expect will be achieved as, in some measure, the assumptions about the structure and performance of the securitization industry on which it was constructed may not be entirely valid. Consequently, this is fertile ground for unintended consequences. When they come home to roost, it will not be a good outcome.

Well, we do have the balance of a 60-day comment period, and embracing my sunny optimism, perhaps some of our comments, if well made and convincingly substantiated with facts, may actually affect the form of the Final Rule. And, as we have observed before, this puppy has a two year transition rule which commences on the publication of the Final Rule in the Federal Register. Assuming that happens sometimes early in the new year, its effective date will see the passage of a congressional and a presidential election and God knows what else. In this mad world whether things deemed final in 2014 will still be final in 2016 is anyone's guess.

There will be plenty of room for many, many technical comments to just try to make all of this work better, indeed to work at all. But for cocktail party purposes, here are my preliminary cliff notes on the big issues of the Proposed Rule:

• Resi got a pass. The Qualified Mortgage rules as proposed reflect a victory for the political and policy constituencies in favor of maximizing the ease of capital formation for the residential market place. In that wrestling match, safety and soundness got just plain thrown down. Estimates vary but between the exception for assets guaranteed by the GSEs (but there are going away eventually, right?, right?), and the relatively easy-to-meet underwriting criteria of the QM, perhaps as much as 85 to 90% of all residential mortgages will get a pass on risk retention. One might say that this is good policy for the restoration of our ownership society. One might wonder, however, how the epicenter of the last financial crisis gets a pass from the centerpiece of the regulatory construct designed to prevent a do-over.
• Premium capture is dead. That is an unequivocal good, and we should take a moment to honor its death. Oh, by the way, you are still entitled to use premium capture as an alternate modality for risk retention; a special opportunity for the differently-abled.
• 5% risk retention is now measured by fair value, not par. This means that for a straight, horizontal or first loss risk retention piece, the B buyer would be holding up into the investment grade bonds based on the current structure of publicly offered conduit CMBS product. That's a problem, as it is wildly inconsistent with a business plan of the B buyer community to hold spread product on an unlevered basis for a long period of time. Much is now made of the fact that risk retention can be both horizontal and vertical, the so-called L-shaped retention and that the relative elements of the horizontal and the vertical element can be agreed on by the parties. Terrific. Look, it's better than it was in the original proposal. A traditional B piece buyer can now buy a traditional B piece, which might get you to 2.5% or so on the required risk retention, and the sponsor can construct another 2.5% of risk retention through a vertical strip – that's a good thing. No, really, it's a good thing.
• The document includes some seriously fancy-pants calculations of what 5% means, comparing projected cash flows and projected principal repayment rates, which may be a "gotcha" as drafted. Essentially, the B piece cannot get more cash than an amount in proportion to principal amortization. Apples and oranges – what's going on here? Given the sequential structure of most structured finance products and the securitization of no or slow amortizing loans, it seems many B pieces will fail this test. Maybe this is a mistake. Maybe. If this is an intended feature of the Rule, it is bad and we are in trouble. Could someone just ask the FRBNY and figure out if this is a typo or a gotcha?
• Within this 550 page edifice, there is curiously little said about remedies. Oh, certainly, the relevant agencies will have broad enforcement remedies but the regulation says precious little about what actually to do when something goes awry. If the sponsor uses the B piece modality to meet its risk retention requirement and the B piece buyer either intentionally or unintentionally violates the conditions of risk retention, the document tells the sponsor in the sternest terms to tell the investors. Gotcha. That's it? How can a sponsor be responsible or really even monitor what a B piece does after closing?
• If the sponsor elects to hold risk retention on a vertical or horizontal basis, the general rule is that it must hold it until the later of 2 years or when the pool has deleveraged to 33% of the original deal size. CRE gets a special rule that allows the sponsor or the B buyer to sell the position to another who will continue to meet the risk retention requirements of the Rule. The B buyer has to hold this paper without non-recourse leverage (and without risk specific hedging). As the successor B buyer has to continue to hold that paper on the same basis as the original holder, I am not sure how much good the 5 year exception to the hold period actually is. On the other hand, there's not a lot of rigor around the organization of the B buyer, how it is organized and the financial condition of the B buyer which certainly will provide some opportunities for recourse financing that might feel a bit less so.
• The commercial side version of the Qualified Mortgage called the Qualified CRE Loan, is a very tiny place. Perhaps a few more loans would fit into it now than did when the original proposed Rule was promulgated, but not many. This would be good, as inclusion of such loans could reduce the 5% risk retention to as low as 2.5%. Clearly, the message is the only way you're meeting risk retention in commercial land, boys and girls, is by holding horizontal or vertical risk.
• For reasons which only appear to be mean-spirited, the regulators willfully ignored the compelling arguments the industry made that a standalone which is tranched to investment grade should not have to have risk retention through either horizontal or vertical strips. Give me a break – tell me that a 35% LTV loan on a trophy property in Manhattan is somehow riskier than a pool of brand new minted QMs. With apologies to Evita; Politics, the art of the possible.
• The Operating Advisor: Still with us. Joy. The role of the operating advisor is, on balance, slightly diminished from the original Rule but still greater than in the current version of CMBS 2.0. After the B buyer burns off (assuming there is one), the operating advisor can recommend the removal of the special servicer. While this requires an affirmative vote of certificate holders, it only requires such a vote of a quorum of 5%. As we know, it is almost impossible to get a lot of investors together, but a 5% quorum; that's doable.
• There are some funky disclosure provisions in the new Rule that presumably, although not certainly, can be met as additions to the FWP or OC. One of these provisions requires an analysis of all of the reps, all of the exceptions, and an explanation of why loans that didn't meet the reps were included in the pool. I am sure there are trial lawyers cheering somewhere over that.

So what do we do? We need to focus on the existential issues and not fritter away any chance of credibly getting regulatory engagement which could lead to some important fixes by deluging them with a textual version of "we just don't like this at all." 

For my money, the priorities are: 

• Fixing the cash flow to principal payment ratio test so that the B piece solution actually works. If we don't get this fixed, the B piece solution will largely go away. I do not believe that was the regulatory intent. I hope I'm not being Pollyanna-ish.
• Insuring the sponsors do not get severely penalized for events outside their control when a B buyer does not meet the requirements of the reg. While an obligation to try would be acceptable, a broken B piece buyer cannot trigger draconian damages or loss of access to shelf eligibility or the like.
• A bit of a more reasonable CRE qualified mortgage would be lovely.

Beyond this, we could certainly be helpful on a whole host of technical issues if the regulators will engage, but let's make sure that everyone understands wherein lies the main chance.

For a perhaps more balanced and scholarly analysis of the Proposed Rule, please take a look at our OnPoint. For a laser like look at how this applies to CLOs take a look at our other blog post on how the Proposed Rule applies to CLOs.