Restrictions May Ease Pension Fund CMBS Purchases

During the early 1990s, the commercial mortgage-backed securities (CMBS) market provided an important new source of capital that helped to alleviate the severity of the commercial real estate credit crunch. Since that time, the CMBS market has blossomed into one of the primary sources for commercial real estate finance. However, one of the major impediments to the further development of the CMBS market is a set of tight restrictions that have been placed on pension fund purchases of CMBS issues. With assets totaling $4.2 trillion and more than $160 billion invested in institutional real estate debt and equities, pension funds represent the largest source of potential investment capital for CMBS.

The Employee Retirement Income Security Act (ERISA) strictly governs pension fund investment practices. Under ERISA, pension funds are limited to the purchase of only the most senior tranche of a CMBS issue. It has been a long-standing practice for CMBS to be tranched, which involves dividing an issue into different classes of credit quality that have differing levels of subordination and rates of return.

Generally, CMBS issues are separated into investment-grade and noninvestment-grade pieces. Tranches that receive the four highest credit ratings-AAA, AA, A, and BBB-are considered to be investment-grade securities. Receiving an investment-grade rating indicates a low probability of payment default. Noninvestment-grade tranches, known as B pieces, have a higher likelihood of default, which is compensated for by a higher rate of return. Each lower tranche of a CMBS issue is subordinated to the higher level tranche; therefore, a AA piece is subordinated to a AAA piece. A BBB piece has three levels of subordination: AAA, AA, and A. The cash flow from a CMBS issue cascades downward from the highest to the lowest tranches. If there was an interruption in the mortgage payments of the assets that compose CMBS, the lowest level tranche would be the first tranche (the B piece) not to be paid. Pension funds are not allowed to purchase the noninvestment-grade tranches. Provisions within ERISA restrict pension fund purchases of CMBS to the nonsubordinated tranche, which by definition is the highest rated tranche of a securitization.

Unfortunately, this creates discrepancies in the quality of tranches that pension funds can purchase from CMBS issue to issue. For example, one CMBS issue may have the highest rated tranche of AAA while another CMBS issue has the highest rated tranche of A. In that case, the highest rated security that pension funds could purchase in the second CMBS is A; however, in the first securitization only the AAA tranche could be purchased. Ironically, pension funds could not purchase the AA tranche in the first securitization even though it has a higher rating than the A rating of the second securitization. This restriction locks out pension funds from purchasing major portions of the investment-grade component of the AAA CMBS issues.

Ratings that rating agencies prescribe are universal across all asset categories. Consequently, a CMBS issue with a AAA rating has the same risk profile of a corporate or municipal bond with the same rating. This process allows investors to accurately assess the risk profile of a security without having to take into account the asset category. Corporate and municipal bonds are not subject to the same restrictions as CMBS; pension funds can purchase investment-grade corporate and municipal bonds. This creates a significant anomaly between CMBS and corporate and municipal bonds. For example, a pension fund could purchase AAA, AA, A, and BBB corporate bonds but not AA, A, and BBB tranches of a CMBS issue if the highest rated tranche was AAA. This disparity in the treatment of corporate bonds and CMBS cannot be accounted for in the risk profile of the CMBS because of the universal ratings.

To address this problem with pension fund purchases of CMBS, the Capital Consortium has submitted a class exemption to the Department of Labor (DOL) that would allow pension fund purchases of investment-grade CMBS to be exempted from the ERISA restrictions. The Capital Consortium comprises the National Association of Realtors, the Mortgage Bankers Association of America, and the National Realty Committee. (See CIREJ, May/June 1996, page 8; see also "News Briefs," this issue, page 4.) The consortium started the application process in May 1995 and subsequently has worked with the DOL to address questions and concerns regarding the application. The DOL is expected to issue its ruling on the application in late 1996 or early 1997. Prior to the consortium's application, the DOL has issued exemptions on a case-by-case basis. By issuing the class exemption, the DOL will eliminate a needless barrier to the development of the CMBS market and provide greater access to a multitrillion dollar capital source. This will stimulate the growth of the CMBS market, which will in turn provide greater stability to the supply of commercial real estate capital.

George Green

George Green is a policy representative/senior economist for investment real estate at the National Association of Realtors in Washington, D.C.