    [Senate Hearing 114-388]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 114-388

                     IMPROVING COMMUNITIES' AND BUSINESSES'
                   ACCESS TO CAPITAL AND ECONOMIC DEVELOPMENT

    =======================================================================

                                    HEARING

                                   before the

                                SUBCOMMITTEE ON
                     SECURITIES, INSURANCE, AND INVESTMENT

                                     of the

                                  COMMITTEE ON
                       BANKING,HOUSING,AND URBAN AFFAIRS
                              UNITED STATES SENATE

                        ONE HUNDRED FOURTEENTH CONGRESS

                                 SECOND SESSION

                                       ON

     EXAMINING HOW BUSINESS DEVELOPMENT COMPANIES, COMMERCIAL REAL ESTATE
    FINANCE, AND MARKET MUTUAL FUNDS PROVIDE ACCESS TO CAPITAL AND ECONOMIC
                   DEVELOPMENT FOR COMMUNITIES AND BUSINESSES

                                   __________

                                  MAY 19, 2016

                                   __________

      Printed for the use of the Committee on Banking, Housing, and Urban
                                    Affairs

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                     Available at: http: //www.fdsys.gov/

                                        ______

                             U.S. GOVERNMENT PUBLISHING OFFICE

    22-172 PDF                     WASHINGTON : 2016
    -----------------------------------------------------------------------
      For sale by the Superintendent of Documents, U.S. Government Publishing
      Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800;
             DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC,
                              Washington, DC 20402-0001

                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      RICHARD C. SHELBY, Alabama, Chairman

    MIKE CRAPO, Idaho                    SHERROD BROWN, Ohio
    BOB CORKER, Tennessee                JACK REED, Rhode Island
    DAVID VITTER, Louisiana              CHARLES E. SCHUMER, New York
    PATRICK J. TOOMEY, Pennsylvania      ROBERT MENENDEZ, New Jersey
    MARK KIRK, Illinois                  JON TESTER, Montana
    DEAN HELLER, Nevada                  MARK R. WARNER, Virginia
    TIM SCOTT, South Carolina            JEFF MERKLEY, Oregon
    BEN SASSE, Nebraska                  ELIZABETH WARREN, Massachusetts
    TOM COTTON, Arkansas                 HEIDI HEITKAMP, North Dakota
    MIKE ROUNDS, South Dakota            JOE DONNELLY, Indiana
    JERRY MORAN, Kansas

               William D. Duhnke III, Staff Director and Counsel

                     Mark Powden, Democratic Staff Director

                           Dawn Ratliff, Chief Clerk

                          Troy Cornell, Hearing Clerk

                          Shelvin Simmons, IT Director

                              Jim Crowell, Editor

                                     ______

             Subcommittee on Securities, Insurance, and Investment

                          MIKE CRAPO, Idaho, Chairman

              MARK R. WARNER, Virginia, Ranking Democratic Member

    BOB CORKER, Tennessee                JACK REED, Rhode Island
    DAVID VITTER, Louisiana              CHARLES E. SCHUMER, New York
    PATRICK J. TOOMEY, Pennsylvania      ROBERT MENENDEZ, New Jersey
    MARK KIRK, Illinois                  JON TESTER, Montana
    TIM SCOTT, South Carolina            ELIZABETH WARREN, Massachusetts
    BEN SASSE, Nebraska                  JOE DONNELLY, Indiana
    JERRY MORAN, Kansas

                   Gregg Richard, Subcommittee Staff Director

               Milan Dalal, Democratic Subcommittee Staff Director

                                      (ii)

                                C O N T E N T S

                                  ----------

                             THURSDAY, MAY 19, 2016

                                                                       Page
    Opening statement of Chairman Crapo..............................     1
        Prepared statement...........................................    27

    Opening statements, comments, or prepared statements of:
        Senator Warner...............................................     2
        Senator Toomey...............................................     4
        Senator Menendez.............................................     5

                                   WITNESSES

    Ron G. Crane, Idaho State Treasurer..............................     7
        Prepared statement...........................................    27
    Michael J. Arougheti, Cochairman of the Board of Directors, Ares
      Capital Corporation, on behalf of the Small Business Investor
      Alliance.......................................................     9
        Prepared statement...........................................    43
        Responses to written questions of:
            Chairman Crapo...........................................   103
    Stephen W. Hall, Legal Director and Securities Specialist, Better
      Markets, Inc...................................................    11
        Prepared statement...........................................    65
        Responses to written questions of:
            Senator Brown............................................   108
    Drew Fung, Managing Director and Head of Debt Investment Group,
      Clarion Partners, on behalf of the Commercial Real Estate
      Finance Council................................................    13
        Prepared statement...........................................    71

                  Additional Material Supplied for the Record

    Statement from Lynn Fitch, Treasurer, State of Mississippi,
      submitted by Chairman Crapo....................................   114
    Letter from Richard Johns, Executive Director, Structured Finance
      Industry Group, submitted by Chairman Crapo....................   116
    Letter from Thomas C. Deas, Jr., Chairman, National Association
      of Corporate Treasurers, submitted by Chairman Crapo...........   117
    Letter from Michael Frerichs, Illinois State Treasurer, submitted
      by Chairman Crapo..............................................   119
    Letter from Tom Salomone, 2016 President, National Association of
      REALTORS', submitted by Chairman Crapo..............   120
    Letter from Jim Baker, Deputy Director of Research, UNITE HERE,
      submitted by Chairman Crapo....................................   121
    Statement from the Mortgage Bankers Association, submitted by
      Chairman Crapo.................................................   124
    Statement from the State Financial Officers Foundation, submitted
      by Chairman Crapo..............................................   128
    Letter from J. Christian Bollwage, Mayor, City of Elizabeth, New
      Jersey, submitted by Senator Menendez..........................   136
    Letter from Joseph N. DiVincenzo, Jr., Essex County Executive,
      submitted by Senator Menendez..................................   137
    Letter from John G. Donnadio, Executive Director, New Jersey
      Association of Counties, submitted by Senator Menendez.........   138
    Letter from Abraham Antun, County Administrator, Hudson County,
      New Jersey, submitted by Senator Menendez......................   140

                                     (iii)

     IMPROVING COMMUNITIES' AND BUSINESSES' ACCESS TO CAPITAL AND ECONOMIC
                                  DEVELOPMENT

                                  ----------

                             THURSDAY, MAY 19, 2016

                                           U.S. Senate,
         Subcommittee on Securities, Insurance, and Investment,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Subcommittee met at 10:06 a.m., in room SD-538, Dirksen
    Senate Office Building, Hon. Mike Crapo, Chairman of the
    Subcommittee, presiding.

                OPENING STATEMENT OF CHAIRMAN MIKE CRAPO

        Chairman Crapo. This hearing will come to order.
        This morning, the Subcommittee on Securities, Insurance,
    and Investment is holding a hearing on ``Improving Communities'
    and Businesses' Access to Capital and Economic Development''.
    We want to welcome all of our witnesses here today as well as
    the Members of the Committee.
        I will state at the outset we have a series of votes
    scheduled at 11:15, so we are probably going to be moving
    through pretty fast today. I will just give the Senators and
    the witnesses advance warning of that. And we have had a
    request from just a couple of our Members to give an opening
    statement as well as the Chairman and Ranking Member, so I have
    agreed to that as well, and we will proceed with opening
    statements by myself, Senator Warner, Senator Toomey, and then
    Senator Menendez. And then we will move to the witnesses.
        Today's hearing will provide insights into how business
    development companies, commercial real estate finance, and
    money market mutual funds provide access to capital and
    economic development for communities and businesses.
        There is a growing chorus that pending and existing Federal
    rules and statutory limitations are restricting access to
    capital and restraining economic growth.
        Because it is important for Congress to understand the
    factors that are impacting local communities and businesses, I
    welcome a discussion about specific proposals that would
    improve the current regulatory framework while maintaining
    proper safeguards.
        The House Financial Services Committee has already examined
    proposals to modernize the regulations for business development
    companies and to adjust the risk retention rules for commercial
    real estate loans.
        Senators Toomey and Menendez have introduced legislation to
    restore the stable share price for institutional, nongovernment
    money market funds.
        I look forward to hearing from our witnesses on these
    legislative proposals and learning what specific factors,
    including Federal regulations, are negatively impacting lending
    and borrowing in local communities, for example:
        How a pending regulatory effective date will impact
    commercial real estate financing since almost $100 billion of
    loans in commercial mortgage-backed securities are set to
    mature in 2017, up from $52 billion this year.
        What will be the impact on State treasurers to invest and
    use money market mutual funds when several types of these funds
    will be required to switch from a stable to a floating net
    asset value in October?
        What statutory changes can be made to allow business
    development companies to increase investments in small and
    middle-market companies and enable investors to invest
    alongside with them and still provide adequate investor
    protections?
        These and a number of other questions I believe will be
    dealt with today as we discuss these issues, and I will
    conclude with that and turn to Senator Warner.

                  STATEMENT OF SENATOR MARK R. WARNER

        Senator Warner. Well, thank you, Mr. Chairman, and I
    apologize for being late. I wish I knew somebody who was
    involved in Virginia government to get that traffic moving.
        [Laughter.]
        Senator Warner. I want to thank you for holding this
    hearing on the need to improve access to capital for businesses
    and communities. There is, I think, generally a bipartisan
    interest that we need to do more in this area, but in a way
    that is both responsible to avoid harm to investors and the
    financial system.
        I am particularly interested in the legislation to enhance
    business development company lending. BDCs, as we all know,
    were originally created by Congress to spur investment in small
    and middle-market companies, and since the crisis, actually we
    saw in the Wall Street Journal in 2014 that small business
    lending from the ten largest banks was down 38 percent compared
    to 2006. Clearly, there is a void that other lenders must fill.
        I do have to say in terms of the legislation we are going
    to be looking at, I harbor some reservations about the House
    bill since it allows these BDCs to invest further in financial
    services' assets as opposed to the more traditional funding of
    what I would call more the ``real economy.'' And I am also
    concerned about the proposal to codify an exemption to owner
    registered investment adviser. But I do remain open on the
    question of how we can better use BDCs.
        On the commercial real estate risk retention, I think it is
    important to remember why we have risk retention rules in the
    first place. In the aftermath of the crisis, many financial
    institutions practiced an ``originate to distribute'' model
    with mortgage-backed securities displaying little regard for
    the quality of the underlying asset. This practice saddled
    investors with highly rate but low-quality assets, spurring
    large losses.
        We know on the residential side we started with a 5-percent
    risk retention rule. I know there are some questions we are
    going to be looking at today about potentially lowering those
    risk retention rules' requirements for certain types of CMBS. I
    think it is open to that, but I believe it is important to
    maintain the principle of aligning incentives between the
    sponsors of securitization and the investors.
        I know I have got a couple of my colleagues here who are
    involved with the legislation dealing with money market funds.
    In 2014, the SEC came up with what I believe was a compromise
    in terms of rules, changing the treatment of institutional--and
    I stress ``institutional''--prime money market mutual funds by
    requiring a floating NAV.
        Some of these changes have been controversial, and with
    market participants, including municipalities, municipalities
    in my own State, raising concerns about the effect of a
    floating NAV and the effects that will have on the demand for
    municipality securities.
        In evaluating this rule, though, I think it is helpful for
    us to revisit the financial crisis and what precipitated the
    much-needed reform from the SEC. Again, we could go back and
    reexamine what happened back in 2008 with the Reserve Primary
    Fund that ended up from Lehman breaking the buck and the runs
    on the industry at that point. Clearly, there were efforts put
    in place, temporary at that point, to try to guard against
    further erosion of an instrument that many municipalities used
    for liquidity.
        I would agree that money market funds are an important cash
    management tool, but it is important that we never again return
    to the situation where taxpayers must step in to bail out a
    private entity. That is why the President's Working Group on
    Financial Reform, the FSOC, and many Senators urge this panel
    for the SEC to act in terms of reforming the money market
    industry. There were a series of proposals that the SEC
    considered. I believe that where they came down in terms of the
    floating NAV actually seems to be pretty much in a good spot.
        Today we are discussing legislation that would undo some of
    those safeguards applied to that one-third of the industry
    within the institutional investors. I remain open to hearing
    the arguments, but obviously I have a series of grave concerns
    on this topic.
        So, again, Mr. Chairman, I think these are three serious
    pieces of legislation. They are to some a little bit arcane,
    but obviously all key to the smooth functioning of our
    financial markets, and I look forward again to hearing
    particularly from our colleagues Senator Toomey and Senator
    Menendez because I know they feel quite strongly on this
    legislation.
        Thank you.
        Chairman Crapo. Thank you, Senator Warner, and I appreciate
    your thoughts, our working relationship, and will work with you
    on these issues.
        Senator Toomey.

                 STATEMENT OF SENATOR PATRICK J. TOOMEY

        Senator Toomey. Thank you, Mr. Chairman and Senator Warner.
    Thanks for having this hearing.
        I think it is clear that the American economy has been
    underperforming for a number of years now. There are many
    contributing factors, but one of them, in my view, is the
    overregulation that has been inflicted on the economy,
    including in the financial services space.
        At today's hearing we are going to look at and examine two
    somewhat narrow but, nevertheless, important aspects of ways in
    which excessive regulation can be harmful to economic growth.
    Money market funds are a critical source of short-term
    financing in our communities. They are attractive to investors
    and issuers because they are low cost, they are extremely
    efficient, they are very liquid, and they are very stable. They
    offer modest returns, but they offer also very low risk, and
    that is a suitable combination for many.
        The financial crisis absolutely stressed the financial
    system. We had hundreds of banks and dozens of insurance
    companies that failed. Money market funds went through that
    period, and yet only one broke the buck. And investors in that
    fund recovered 99.1 cents for every dollar they had invested.
        Whatever one thinks of the taxpayer guarantees that were
    imposed during the crisis, the fact is taxpayers never ended up
    having to shell out a penny for investors in these funds.
        Nevertheless, in 2010, the SEC imposed a wave of very, very
    significant regulations on money market funds, including
    stringent liquidity requirements, shorter maturities on assets.
    And then in 2014, without any evidence that the 2010
    regulations were inadequate, the SEC, nevertheless, imposed a
    new set of regulations, including stress testing,
    diversification requirements, additional disclosures, and
    requiring prime and tax-exempt institutional money market funds
    to abandon the $1 stable NAV.
        This is problematic for several reasons which we will
    discuss today. I am grateful to Senators Menendez, Crapo, and
    Manchin for joining me in legislation that would allow funds to
    elect a status which would enable money market funds to use the
    amortized cost and penny rounding accounting, therefore,
    maintain a stable NAV. In that respect, and in that respect
    alone, we would revert back to the way the money markets
    operated from 1971 to 2015 with virtually zero losses for
    anyone during that entire period of time.
        By the way, our legislation would leave in place all of the
    extensive 2010 and 2014 regulations, and as a condition of
    having a stable net asset value, our legislation explicitly
    prohibits the Federal Government from stepping in with any form
    of bailout and requires that all investors in the fund would be
    aware of that legal requirement.
        Also, let me briefly, Mr. Chairman, mention the BDC issue
    which we will discuss today. There is an alarming statistic
    that I would start with, which is that the total number of
    small businesses in America declined between 2009 and 2014. I
    am not sure that there is another 5-year period in recent
    history in which that has happened. But it has happened, and
    part of the reason is the reason is the difficulty of accessing
    financing, conventional financing especially, and bank
    financing. Business development companies have stepped in to
    fill that void in many cases, including the cases in my State
    of Pennsylvania. Pittsburgh Glass is a great story where a
    business development fund operated by Franklin Square Capital
    provided $180 million, and they did it for one reason: because
    for Pittsburgh Glass, it was the best financing option
    available to them.
        The House Banking Committee, the Financial Services
    Committee, has passed legislation that would modernize BDC
    regulation, and I think it is very constructive legislation. It
    would allow a modest increase in the leveraging that is
    available. It would streamline some of their issuing
    requirements. And I hope this Committee will take up
    substantively similar legislation, and I am grateful for the
    fact that we will be able to discuss it today.
        Chairman Crapo. Thank you very much, Senator Toomey.
        Senator Menendez.

                  STATEMENT OF SENATOR ROBERT MENENDEZ

        Senator Menendez. Thank you, Mr. Chairman, for the
    opportunity. Like many of my colleagues who were formerly State
    and local public officials, I have always been concerned about
    ensuring access to capital markets for State and local
    governments, for housing and transportation authorities, for
    small businesses, universities, hospitals. And money market
    funds facilitate that access by investing in short-term
    municipal debt and holding it to maturity.
        In fact, money market funds are the largest investors in
    short-term municipal bonds and hold nearly $6 billion of
    municipal bonds in New Jersey. At the end of 2015, money market
    funds were estimated to hold over $245 billion in municipal
    debt issuances.
        Now, I have heard from elected officials across my State of
    New Jersey, including the mayor of Elizabeth, the Hudson County
    business administrator, the Essex County executive, and the New
    Jersey Association of Counties that represent all 21 counties
    in the State, that access to the capital markets that they
    depend on to get the lowest-cost financing for affordable
    housing, for public infrastructure, and schools appears to be
    at risk due to unintended consequences of the SEC rule
    requiring that tax-exempt and prime money market funds must
    change their method of calculating their net asset value from
    fixed to floating.
        And, Mr. Chairman, I would ask to submit all of those
    letters for the record.
        Chairman Crapo. Without objection.
        Senator Menendez. Thank you.
        In addition, I continue to hear from investors and fund
    managers, including local government officials in my State of
    New Jersey, who are charged with cash management or municipal
    finance. They are concerned that instead of making money market
    funds safer, the floating NAV reporting will significantly
    reduce the viability of the product as a tool to invest money
    on a short-term basis.
        In response to these concerns by county and local
    officials, I am pleased to have joined Senator Toomey in
    cosponsoring the Consumer Financial Choice and Capital Markets
    Protection Act in an effort to preserve money market funds both
    as a critical cash management tool for State and local
    government officials and as a source of liquidity and capital
    to meet the public infrastructure and investment needs of
    communities in New Jersey and throughout the country.
        I have heard concerns that investors are leaving both prime
    and tax-exempt money market funds in anticipation of the
    October 14, 2016, implementation date. And since 2014, several
    tax-exempt money market funds invested in critical New Jersey
    State and local debt issuances to support housing, education,
    infrastructure, and health care facilities have closed or
    announced plans to close.
        The fact of the matter is if investors leave these funds
    and there is less demand for municipal securities, the
    borrowing costs for State and local governments will go up. And
    it is not just them that will feel the effect. State and local
    governments provide very often a key role in facilitating low-
    cost financing for nonprofit organizations undertaking vital
    projects in our State.
        So, Mr. Chairman, let me just close by saying I sat on this
    Committee when we did Dodd-Frank; I was a fierce defender of
    it; I was someone who authored several provisions of it; and I
    have fought those who want to slay it. But I do not think the
    SEC always gets it right, and I do not think they got it right
    this time, and that is why I am pleased to join in the
    legislation.
        Chairman Crapo. Thank you, Senator Menendez.
        Before we move to the witnesses, I would ask unanimous
    consent that the following statements and letters be made a
    part of the record. These have been submitted to the Committee
    by the institutions and individuals noted: the State Financial
    Officers Foundation, the Illinois State treasurer, the
    Mississippi State treasurer, the National Association of
    Corporate Treasurers, the National Association of Realtors, the
    Mortgage Bankers Association, the Structured Finance Industry
    Group, and United Here. Without objection, they will be made a
    part of the record.
        Do any other Senators want to submit a statement for the
    record?
        [No response.]
        Chairman Crapo. All right. With that, we will move to the
    witnesses. Again, we welcome all of our witnesses here.
    Although we have a bit of a tight timeframe, I think we will
    have plenty of time to get through and discuss these issues,
    and I will tell the witnesses at the beginning now, if we do
    not have time for all of the Senators--and some of the Senators
    will not even be able to make it because they have got other
    intervening commitments--we do have a practice of submitting
    questions following the hearing and asking for you to respond
    to those as well.
        Our first witness today is the Honorable Ron Crane, who is
    the Idaho State treasurer. Prior to being elected the State
    treasurer in 1998, Ron served as a State legislator for 16
    years and in that capacity as a member of the House of
    Representatives. I served with him in the Idaho Legislature,
    and he is a very good friend of mine. And, Ron, I appreciate
    you bringing some of Idaho's common sense here to Congress and
    hope you will leave some with us.
        Our second witness is Mr. Michael Arougheti, the cochairman
    of the board of directors and executive vice president of Ares
    Capital Corporation, on behalf of the Small Business Investor
    Alliance.
        Our third witness is Mr. Stephen Hall, the legal director
    and securities specialist of Better Markets, and we appreciate
    having you here with us.
        And our fourth witness is Mr. Drew Fung, the managing
    director and head of the Debt Investment Group of Clarion
    Partners, on behalf of the Commercial Real Estate Finance
    Council.
        Gentlemen, we welcome you all. You will see a little timer
    in front of you. We do have your written testimony, and we
    actually do read it and study it very carefully. We ask you to
    try to keep your oral comments to the 5 minutes, as you will
    see on the timer, and then we will get into some good questions
    and answers.
        With that, Mr. Crane.

            STATEMENT OF RON G. CRANE, IDAHO STATE TREASURER

        Mr. Crane. Mr. Chairman, Members of the Subcommittee, thank
    you for inviting me to participate in this hearing. I serve as
    the chief financial officer for the State of Idaho and oversee
    investment portfolios of about $4.4 billion. In addition, my
    office oversees a number of debt management functions,
    including the issuance of tax anticipation notes annually
        I want to thank you, Mr. Chairman, as well as Senators
    Toomey and Menendez, for sponsoring Senate bill 1802, the
    Consumer Financial Choice and Capital Markets Protection Act.
    This bipartisan legislation will improve access to capital and
    economic development by preserving the stable-value money
    market funds for public infrastructure financing and the
    investment needs of Governments and business.
        Following the financial market crisis of 2008, the
    Securities and Exchange Commission adopted a number of reforms
    to the regulation of money market funds that helped to improve
    their liquidity and transparency while reducing interest rate
    and credit risk in the funds. However, one of those
    requirements is having significant unintended consequences. Any
    fund which is available to investors who are not so-called
    natural persons will be required to transact using a
    fluctuating or floating NAV instead of a stable $1 per share.
    This means two things.
        First, because the implementation deadline for the floating
    NAV requirement is fast approaching, a great deal of money is
    leaving tax-exempt and prime funds right now.
        Second, the funds can no longer use that money to provide
    financing to Governments and other organizations such as
    hospitals and businesses.
        I am going to focus my comments mostly on the impact on
    tax-exempt funds, but it is there for prime funds, too.
        For more than three decades, stable-value, tax-exempt money
    market funds have been a stable source of short-term financing
    for cash-flow as well as important funding for public
    infrastructure and economic development. In Idaho, tax-exempt
    money market funds provide over $600 million in financing for
    the tax anticipation notes issued by my office, as well as for
    projects funded by the Idaho Health Facilities Authority and
    the Idaho Housing and Finance Association.
        Money market funds are the lowest-cost form of borrowing
    for us. As recently as the end of last year, a health care
    facility in Idaho was able to pay 7 basis points for financing
    issued by the Idaho Health Facilities.
        Even if you add the cost of credit enhancement and other
    fees, that financing is significantly less than the 120 basis
    points they might have to pay for a bank loan or 250 basis
    points or more that they might have to pay on a long-term bond.
        Unfortunately, the floating NAV requirement, which takes
    effect in October, is forcing investors to leave and causing
    tax-exempt money market funds to liquidate at a much higher
    rate than the SEC expected. It is simple. All the non-natural
    persons have to leave.
        A survey by Treasury Strategies shows that at least 40
    percent of fund assets are at risk solely because of the
    floating NAV requirement, and the indirect impacts are likely
    to make that significantly higher. Just this year, fund
    sponsors have announced that they have or will be closing 17
    tax-exempt money market funds totaling $14.3 billion in assets
    as a result of the SEC's requirement. This is reducing our
    choice for funding sources and driving up the cost of
    financing.
        I also want to mention the impact it is having on my
    ability to invest and manage Idaho's cash. Prime money market
    funds remain an important cash management tool for
    approximately 50 percent of the State and local governments'
    cash that is invested outside of local government investment
    pools. Since Government entities will no longer be permitted to
    invest in stable-value prime money market funds, this will
    limit our investment options to bank deposits and money market
    funds that invest solely in U.S. Government securities. This
    means that at the same time as our financing costs are going
    up, our investment income is going down, and taxpayers have to
    fill in the gap.
        Senate bill 1802 offers a reasonable solution. It enables
    State and local governments and other non-natural persons to
    continue to invest in stable-value money market funds across
    the municipal, prime and Government spectrum. At the same time,
    it leaves all of the other money market reforms adopted by the
    SEC intact.
        Senate bill 1802 is consistent with the decision of the
    Government Accounting Standards Board, GASB, to restore the
    stable NAV for local government investment pools and the recent
    decision by the European Union regulators to preserve the
    stable-value money market fund in Europe.
        Many of my State treasurer colleagues actively support
    Senate bill 1802, including the treasurer from Illinois,
    Treasurer Frerichs; the treasurer of Massachusetts, Treasurer
    Goldberg; the treasurers of Alabama and Mississippi; and
    Treasurer Perdue from West Virginia. Their statements, as well
    as those of many other individuals and organizations
    representing State and local governments and Main Street
    issuers and investors, can be found on the Web site of the
    Coalition for Investor Choice, Protectorinvestorchoice.com.
        Again, thank you, Mr. Chairman, for the opportunity to
    testify on this important issue, and I will be happy to answer
    any questions that you or Members of the Subcommittee may have.
        Chairman Crapo. Thank you, Mr. Crane.
        Mr. Arougheti.

     STATEMENT OF MICHAEL J. AROUGHETI, COCHAIRMAN OF THE BOARD OF
      DIRECTORS, ARES CAPITAL CORPORATION, ON BEHALF OF THE SMALL
                       BUSINESS INVESTOR ALLIANCE

        Mr. Arougheti. Chairman Crapo, Ranking Member Warner, and
    Members of the Subcommittee, thank you. I am Michael Arougheti,
    and I am the cochairman of the board of directors of Ares
    Capital Corporation, an SEC-registered business development
    company, or BDC, and we are one of the largest nonbank
    providers of capital to small- and medium-sized businesses in
    the U.S., or as we like to call them, SMEs, which we believe
    are the backbone of the U.S. economy.
        I appreciate the opportunity to testify today on behalf of
    the Small Business Investor Alliance, the SBIA, a trade
    association which represents a majority of the Nation's BDCs.
    SBIA's BDC member provide vital capital to small- and medium-
    sized businesses nationwide, resulting in job creation and
    corollary economic growth.
        Ares Capital Corporation is publicly traded on the Nasdaq
    and is currently the largest publicly traded BDC by both market
    capitalization and assets. And since our IPO in 2004, we have
    invested more than $20 billion in over 650 transactions
    involving hundreds of SMEs in America, and in the process we
    have created tens of thousands of new jobs and provided capital
    to growing businesses that were unable to access capital
    through commercial banks or other traditional financing
    sources.
        Congress created BDCs in 1980 in a period similar to what
    we saw following the Great Recession. Specifically, Congress
    created BDCs to enhance capital access to SMEs. Uniquely,
    though, the BDC model gives ordinary investors the opportunity
    to finance these small companies themselves, effectively
    funding Main Street.
        BDCs make direct investments in smaller, developing
    American businesses, providing access to capital for companies
    that may not be able to access capital from banks. Yet despite
    what we believe is an outdated regulatory regime, which has
    been in place since the early 1980s, the number of BDCs has
    grown, and this growth accelerated following the economic
    downturn after the 2008 and 2009 recession, where BDCs came in
    to address the unique needs of these small companies that were
    starved for capital. Currently, there are over 80 BDCs in the
    United States, and BDC loan balances have more than tripled
    since 2008.
        While the scope of BDCs' investments may vary, all BDCs
    share a common investment objective and a common purpose of
    improving capital access to small- and medium-sized companies.
    Today the middle-market sector of the economy is responsible
    for one-third of private sector GDP, and BDCs have grown as
    commercial banks have withdrawn from lending to this sector.
        BDCs now find themselves at the forefront of the effort to
    address the unmet capital needs of these companies. But the
    dramatic decline in bank financing for middle-market loans is
    not a new issue; it is a long-term trend. Middle-market
    borrowers have historically depended on smaller regional banks
    for financing, and the number of these banks has been shrinking
    since the 1990s. In order to continue to provide sufficient
    access to capital for small- and medium-sized companies,
    modernization of the BDC regulations is essential. Indeed,
    modernization will permit BDCs to meaningfully grow and serve
    these SME clients.
        SBIA's BDC members have invested in numerous SMEs
    throughout the United States. According to AdvantageData, as of
    March 31, 2016, BDC aggregate loan commitments in the U.S.
    equaled over $82 billion. To provide an example of the types of
    investments that we make, Ares Capital Corporation invested in
    OTG Management, which was a founder-owned operator of full-
    service restaurants and shops within large airports across the
    country. Recently, OTG was awarded a contract to build out and
    operate the food and beverage concession at JetBlue's new
    Terminal 5 at JFK International Airport and needed to raise
    capital to complete the construction plan. However, OTG was
    unable to access financing from traditional sources. It was a
    small company with a limited operating history, and at the time
    the only providers of that capital were BDCs. Ares stepped in
    to fill the voice and provided OTG with much-needed capital as
    well as management support and expertise to help that business
    continue to grow.
        Ares has also helped fund the growth of many minority
    owned-and-operated businesses, including ADF Restaurants, which
    is the second largest Pizza Hut franchisee in the country, with
    over 250 locations in the Northeast.
        Similarly, Main Street Corporation, an SBIA member BDC
    based in Houston, has funded two of the fastest-growing tech
    companies in Eugene, Oregon; the largest privately owned
    jewelry chain store in the Rocky Mountain region; and the
    leading fixed based operator at the Indianapolis airport.
        BDCs are heavily regulated by the SEC and, appropriately,
    the activities of BDCs are fully transparent to regulators,
    investors, and portfolio companies. Specifically, publicly
    traded BDCs are subject to the disclosure requirements of the
    Securities Act of 1933 and the act of 1934 and are also subject
    to additional regulations imposed by the Investment Company Act
    of 1940. These disclosure and other regulatory requirements are
    extensive and include, among other things, a requirement that
    BDCs publish a quarterly summary of each investment held by a
    BDC and the fair value of those investments, which I believe is
    a significantly greater degree of transparency than we find in
    other financial services models.
        So while we certainly believe in the importance of
    appropriate regulation, many of the challenges faced by BDCs in
    increasing the amount of capital that they can lend and deploy
    are a consequence of where BDCs sit within the regulatory
    framework. BDCs are more akin to operating companies such as
    banks and other commercial lenders, yet we are regulated as
    mutual funds.
        So recognizing some of these challenges, the House
    Financial Services Committee recently passed H.R. 3868, the
    Small Business Credit Availability Act, with a strong
    bipartisan vote of 53-4. And I believe that this bill was
    specifically designed to modernize the BDC sector precisely to
    enhance our ability to provide capital to growing SMEs as banks
    continue to retreat from the sector, at the same time ensuring
    significant and appropriate investor protections specifically
    requested by the SEC.
        Currently, most BDCs maintain an average leverage ratio of
    0.5 to 0.75, reflecting a desire and a practical need to
    maintain adequate cushion in the unprecedented and unlikely
    event of a sudden and steep drop in asset values. The
    maintenance of this cushion has the unintended effect of
    reducing the ability of BDCs sometimes to raise and invest
    capital, thereby frustrating the original intent of Congress to
    provide capital to small- and mid-sized businesses.
        H.R. 3868, in addressing this specific issue, would permit
    a modest increase in leverage from 1:1 to 2:1, much less than
    the typical 10:1 ratio found in traditional banking
    institutions and on par with the 2:1 ratio under the current
    SBIC Debenture Program, but without Government guarantee or
    implied taxpayer subsidy. Importantly, the legislation also
    includes significant investor safeguards for accessing
    additional leverage, including a shareholder vote or
    independent board of directors vote within a 12-month cooling-
    off period.
        The legislation also includes other reforms. These include:
    allowing for the issuance of multiple classes of institutional
    preferred stock; permitting BDCs to own registered investment
    advisers; and allowing for additional investments in financial
    corporations. With respect to this last point, let me be clear
    that the modest amendments being proposed do not increase a
    BDC's ability to invest in securities of private equity funds,
    hedge funds, CLOs, or other private investment funds.
        So, in closing, we believe that the time is right to
    modernize regulations governing BDCs and to pass legislation,
    which would allow BDCs to increase capital flows to America's
    SMEs, spur economic growth, and create jobs. And it is clear
    that the banks have left this space and are unlikely to return.
        SMEs are the engine of our economy, and, unfortunately,
    many traditional sources of capital are no longer available to
    them. This bill, in my judgment, represents a strong and
    necessary effort to modernize the BDC sector so that it can
    maintain and grow its participation in a growing small and
    middle market without reducing investor protections.
        I apologize for going over. I am happy to answer questions
    about the bill or any other matters, and on behalf of the SBIA
    and the BDC industry, I want to thank the Committee for its
    commitment to increasing capital for growing businesses, and
    especially its interest in the contribution of BDCs to the
    overall economy and job growth.
        Thank you.
        Chairman Crapo. Thank you, Mr. Arougheti.
        Mr. Hall.

      STATEMENT OF STEPHEN W. HALL, LEGAL DIRECTOR AND SECURITIES
                    SPECIALIST, BETTER MARKETS, INC.

        Mr. Hall. Good morning, Chairman Crapo, Ranking Member
    Warner, and Members of the Subcommittee. Thank you very much
    for the opportunity to testify today. I am Stephen Hall, and I
    serve as the legal director and securities specialist for
    Better Markets, which is a nonprofit, nonpartisan organization
    that promotes the public interest in our financial markets.
        We believe in capital formation as a means of generating
    economic growth and prosperity for all Americans. However,
    deregulation is the wrong way to achieve these goals. The bills
    at issue here today would actually undermine capital formation
    in two very important ways:
        First, they would expose investors to a greater risk of
    loss, eroding the confidence that is essential for thriving
    capital markets;
        Second, they would increase the likelihood of another
    financial crisis, which poses the single greatest threat to
    capital formation and economic growth in this country.
        The 2008 financial crisis proves the point. It destroyed
    millions of jobs, triggered a tidal wave of home foreclosures,
    and wiped out the savings of countless American households. The
    costs have been staggering, and they are still mounting. That
    includes $20 trillion in lost GDP and untold human suffering.
        The lesson is clear: Without effective regulatory
    safeguards, our financial system is vulnerable to crisis, which
    can inflict widespread damage on our entire economy, including
    businesses of all sizes.
        Turning to the individual bills, S. 1802 would allow all
    money market funds to maintain a fixed net asset value. This
    provision would repeal the SEC's 2014 rule mandating that
    certain institutional money market funds adopt a floating net
    asset value. The bill is a step in the wrong direction.
        We know from the financial crisis that money market funds
    are susceptible to runs. When the Reserve Primary Fund broke
    the buck in September of 2008, a run ensued. It quickly spread
    to all prime money market funds, and it froze the credit
    markets. The run subsided only after Treasury took the
    unprecedented step of guaranteeing, for the first time in
    history, the entire money market fund industry.
        Floating the NAV is necessary to ensure that money market
    funds remain stable. It reduces an investor's incentive to
    withdraw from a fund, the first sign of stress. It promotes
    fairness among investors, and it corrects the basic
    misconception that money market fund investments cannot lose
    value. This reform should be allowed to take effect, and it
    should not be repealed.
        H.R. 4620 would weaken the risk retention safeguards
    applicable to securitizations of commercial real estate loans.
    This, too, is a step in the wrong direction. The financial
    crisis again illustrates the point. Before the crisis, the
    originate to distribute model became pervasive in the
    residential mortgage market. A similar pattern took hold in
    commercial real estate where underwriting standards sank to
    meet demand for loans that could be securitized. When the
    crisis hit, the toll on these markets was huge. Risk retention
    requirements are among the most important reforms in this area.
    They help protect investors, and they inhibit the accumulation
    of systemic risk.
        H.R. 4620 would make two counterproductive changes in the
    risk retention rule. First, it would create a blanket exemption
    for the securitization of a single commercial real estate loan
    or a group of related loans. Second, it would dilute the
    criteria for qualified commercial real estate loans, which are
    also fully exempt from the risk retention rule. These changes
    will weaken important investor safeguards and systemic
    safeguards in a market prone to systemic risk.
        Finally, H.R. 3868 would undermine multiple safeguards that
    govern the operation of business development companies. Two
    provisions raise especially strong concerns. One would allow
    BDCs to double their leverage. This change would expose retail
    investors to additional risk of loss. Another provision would
    allow BDCs to invest greater amounts in financial companies,
    thus diverting capital away from the businesses they were
    intended and designed to assist. These and other provisions in
    the bill are simply unwarranted.
        In conclusion, I want to thank you again for the
    opportunity to appear today at this hearing, and I look forward
    to your questions.
        Chairman Crapo. Thank you, Mr. Hall.
        Mr. Fung.

      STATEMENT OF DREW FUNG, MANAGING DIRECTOR AND HEAD OF DEBT
    INVESTMENT GROUP, CLARION PARTNERS, ON BEHALF OF THE COMMERCIAL
                      REAL ESTATE FINANCE COUNCIL

        Mr. Fung. Thank you, Chairman Crapo, Ranking Member Warner,
    and Members of the Committee, for the opportunity to testify
    today. My name is Drew Fung. I am a managing director and the
    head of the Debt Investment Group at Clarion Partners, and I am
    here today testifying on behalf of the Commercial Real Estate
    Finance Council, or CREFC, where I am a member of the executive
    committee.
        CREFC is the collective voice of the $3.1 trillion
    commercial real estate finance industry. Our 300-plus
    membership includes balance sheet, agency, and CMBS lenders as
    well as loan and bond investors and servicing firms. Our
    industry plays a key role in financing properties of all types
    in all 50 States, including apartments, nursing homes, grocery
    stores, retail, just to name a few.
        So my testimony today will focus on commercial mortgage-
    backed securities, or CMBS, as they are commonly known. CMBS
    has been an essential financing tool in real estate for
    decades. But in recent years, there have been a plethora of new
    rules and regulations that have evolved that have dramatically
    undermined the viability of this important funding source.
        So a little bit of background. A conduit, commercial-backed
    security is a set of bonds that is collateralized by a pool of
    between 50 and 100 individual commercial mortgages with each
    loan averaging around $14 million in size. Institutional
    investors buy these CMBS bonds, and the principal and interest
    payments due to them are funded by the cash-flows from the
    mortgaged properties. And the estimated size of the CMBS market
    today, $500 billion, give or take, so quite sizable.
        CMBS plays a key role in commercial real estate lending
    because it provides much-needed real estate debt capital to
    markets and properties, particularly in secondary and tertiary
    markets.
        Balance sheet lenders, such as community banks and
    insurance companies, do not have the capacity on their own to
    cover the full range of these needs. In fact, in 2015, CMBS
    provided over 20 percent of all commercial real estate
    financing, which is over $100 billion of mortgage capital
    flowing into the markets. CMBS provided 34 percent of all
    commercial real estate loans to tertiary markets like Boise and
    Bloomington, and 24 percent of the financing that was put in
    place in secondary markets like Richmond. No other lender
    source comes close to serving all these so-called Main Street
    markets to that extent.
        Earlier this year, the CMBS markets were roiled by
    volatility. Some days it was very near impossible to sell a
    CMBS bond. Other days the interest rates on bonds that may be
    bought or sold in the markets was moving up and down by 20
    percent. This volatility has translated into CMBS borrowers
    paying nearly 100 basis points or 1 full percent more for a
    loan than they would have been required to pay for a loan
    originated maybe 9 months ago, and this is in an environment
    where nearly all the economic indicators have remained stable
    or improved and the delinquency rates in these securities have
    actually dropped.
        But the greater concern, though, is that the availability
    of CMBS capital to these borrowers could diminish over time if
    the growing liquidity issues are not addressed. Liquidity is
    essential to investors who buy these bonds, such as insurance
    companies, pension funds, and institutions that purchase CMBS
    bond. Excessive volatility and the resulting loss of liquidity
    threatens the viability of the CMBS business, thereby reducing
    borrowers' access to the mortgages provided by the CMBS
    industry.
        So what role does the regulatory environment play here?
    Well, today bank-affiliated broker-dealers are the primary
    liquidity providers for the CMBS secondary market. They provide
    liquidity by maintaining an inventory of bonds that already are
    in circulation in the marketplace to sell to or buy from
    investors. So those are market-making activities, and these
    market-making activities are being burdened by increasing
    regulation and expanding obligations to hold more capital
    liquidity and cushion for these loans.
        There are eight new or revised accounting capital rules,
    liquidity rules, including the new Dodd-Frank risk retention
    rules, which will take effect in December, that are directly
    impacting CMBS right now, and there are four more on the way.
        Each of these new capital requirements increases the cost
    of issuing and holding CMBS for broker-dealers and, when taken
    together, poses a serious threat to the CMBS capital flows to
    borrowers on Main Street. So as new regulatory requirements are
    finalized and as rules already in place are reevaluated going
    forward, I think it is very important that the overall impact
    on the CMBS business and on the economy overall are factored
    into the evaluation. And it is actually my understanding that
    policymakers and regulators abroad have already begun to do
    this.
        In closing, a bill that is moving through the House, H.R.
    4620, warrants serious consideration. It would improve three
    elements of the CMBS retention regulations, and contrary to
    what Mr. Hall said, I believe that by adjusting these three
    criteria for loans to be deemed qualified, we will actually
    improve the bond's performance over time while allowing more
    borrowers access to a qualified loan. On a relative basis,
    nearly all residential loans made today qualify for the QRM
    exemption; whereas, conduit CMBS, commercial loans, only 4
    percent of the loans qualify.
        So, in closing, although CREFC's membership is not always
    unified in its public policy views given our different roles
    and interests in the sector, we are unanimous in our support
    for a stable CMBS marketplace and our growing concern that the
    increasing lack of market liquidity threatens that stability.
        So thank you, Committee, for the opportunity to testify.
    CREFC looks forward to working with the Committee to address
    the liquidity concerns I have discussed today, and I would be
    happy to answer any questions.
        Chairman Crapo. Thank you, Mr. Fung.
        I am going to take my question period at the end, so I am
    going to move first to Senator Warner, and then we will go to
    Senator Toomey and Senator Corker. Senator Warner.
        Senator Warner. Very generous, Mr. Chairman. Thank you for
    that. I am going to try to run through these fairly quickly.
        On the BDCs, Mr. Arougheti, Mr. Hall, I do believe the
    business development companies play an important role in the
    middle markets. I think we have seen a lot of the banks move
    out of this space. I am sympathetic to expanding your market
    share and expanding your opportunities, but it seems like the
    legislation you are proposing is a bit of an overreach. You
    know, I would like you both to comment on the question. Not
    only are you looking to increase your leverage ratio from 1:1
    to 2:1, which arguments could be made; but at the same time,
    you are also talking about increasing the percentage of the
    ability for these BDCs to invest in financial institutions,
    from 30 percent to 50 percent, and being able to actually buy
    registered investment advisors.
        It seems like one of the two--I would actually be more
    inclined to be supportive of increasing the leverage ratio, but
    why would it be in the best interest to both increase your risk
    profile both in terms of leverage and increase your ability to
    purchase more financial institutions in and itself, which was
    never part of the original intent of the BDCs?
        Mr. Hall. Thank you, Senator. A couple of points in
    response to your question.
        First of all, in our view, these are indeed--they represent
    an overhaul. They are not modest adjustments to the regulatory
    regime. They encompass fundamental aspects of BDC oversight,
    ranging from leverage, as you noted. They divert money from the
    companies that Congress intended them to serve. Their ownership
    of financial institutions is now going to be expanded
    significantly, and there are even corporate governance
    provisions and shareholder provisions that are material.
        Fundamentally, we come at this from two perspectives. One
    is: Is there really a need for these kinds of weakenings in the
    regulatory regime, number one? And, number two, even if there
    is some sense that adjustments are necessary, what are the
    consequences of doing do? And here, just as a threshold matter,
    the BDC community has actually been thriving over the last 10
    to 12 years. Measured by assets under management, I believe
    they have grown by a factor of 10.
        At the same time, there are recent reports indicating that
    their current leverage levels, which are already preferential
    under the Investment Company Act, are posing pretty serious
    challenges to them.
        It, therefore, strikes us as an inappropriate time to
    actually weaken oversight of these entities, especially where
    it runs directly counter to what Congress intended.
        Senator Warner. I guess, Mr. Arougheti, what I would say is
    I fully agree with Mr. Hall. But, on the other hand, the notion
    of you are both looking for an increase in leverage and you are
    looking for further expansion into an area that was not where
    the original intent of the legislation was headed.
        Mr. Arougheti. I will try to tie all three of them together
    because I think there is a prevailing conception that each of
    those work hand in hand, and they actually do work independent
    of each other.
        I would just quickly say with regard to the leverage, while
    the BDC industry has been thriving, we are not capitalized well
    enough to meet the capital needs of the middle-market borrowers
    that we serve. And I think we could grow more to meet this
    need.
        Number two, as we talk about leverage and the concept of
    leverage in any financial institution, I think it is important
    to anchor on other financial services companies as we think
    about leverage. And as I referenced in our prepared remarks,
    the SBIC Debenture Program, which has been a very successful
    Government-sponsored program, currently allows for leverage up
    to 2:1.
        And then, third, with regard to Mr. Hall's commentary on
    hearsay in the market about challenges of the leverage ratio, I
    think he is referring to a recent report that was published by
    the rating agencies that were highlighting not the risks of
    incremental leverage, but the very challenge that we are
    discussing today, which is, because of the leverage constraint,
    management teams who are managing BDCs are having difficulty
    growing, which I think speaks to the policy.
        With regard to the 30-percent basket, I think this is an
    issue that requires further discussion. This piece of
    legislation has been talked about collaboratively with the
    Commission, with the Democrats and the Republicans, for over
    4\1/2\ years, and the current legislation reflects, I think,
    some of the concerns that you have raised, which is why there
    is a prohibition and direction exclusion of investing in funds
    like private equity funds, hedge funds, CLOs, et cetera.
        But, importantly, there are many financial services
    companies as our economy continues to evolve that have mandates
    that are consistent with the policy mandate of a BDC. As an
    example, we have an investment in a small-ticket equipment
    leasing business that is providing a form of capital directly
    to the same middle-market borrowers that are borrowing from
    us----
        Senator Warner. Let me just--because my time is gone. I am
    sympathetic to potentially leverage. I am not sympathetic to
    both. I would simply make one quick comment, Mr. Fung, as well.
    You know, I can understand your concerns on CMBS. There are
    some of us on the Committee, Senator Corker and I, who believe
    strongly in risk retention. I would point out that there are
    major institutions who are being able to close deals operating
    under the new procedures.
        And, finally, Mr. Crane, since I am not going to get to you
    as well--and I know my colleagues feel strongly the other way,
    there was a compromise here. The floating NAV, I think, did put
    across the notion that these are not--there are risks involved
    in money market funds, and I would simply point out that many
    of your colleagues in the money market industry were
    desperately interested in making sure they were not viewed as
    systemically important and subject to all the FSOC rules. I
    think if we were to go back from this reform, that might reopen
    that debate.
        Thank you, Mr. Chairman.
        Chairman Crapo. Thank you, Senator Warner.
        Senator Toomey.
        Senator Toomey. Thank you, Mr. Chairman.
        Mr. Crane, do you have a preference between prime funds and
    Government funds for your investment purposes?
        Mr. Crane. Mr. Chairman and Senator Toomey, I would tell
    you that I will draw greater yield from the money market funds
    than I will from the Government securities.
        Senator Toomey. And if prime funds became unattractive,
    unusable for you, it seems to me you have a few options: You
    could set up shop in-house and invest directly, which would be
    an extremely cumbersome process for which you may not be well
    suited. You could just deposit the money in a bank, although
    banks do not seem to want deposits these days. Or you could go
    with the Government fund, which you just said--is it true that
    all of those options offer you less yield or a higher cost or
    both?
        Mr. Crane. Mr. Chairman and Senator Toomey, you are
    absolutely correct. We are in the cash management business
    because we have to keep our funds liquid for expenditure
    purposes at the ready. So we are looking for vehicles to invest
    in, but at the same time as being safe, we also want to
    maximize yield so that taxpayers are not making up the
    difference. Money market funds offer us that opportunity, and
    so they are a very good vehicle.
        In our case, I have about $4.4 billion under management;
    probably $230 million of that is in money market funds.
        Senator Toomey. Thank you, Mr. Crane.
        Mr. Hall, in your testimony you state that floating the
    NAV, first and foremost, is because it reduces the incentive of
    any investor to expedite withdrawals from a stress money market
    fund in hopes of redeeming at the dollar price as opposed to
    something lower, and that ``Eliminating this first mover
    advantage substantially reduces run risk.''
        We have operated since 1971 with the risk of a first mover
    advantage. The Reserve Fund is held up as the worst disaster
    that has ever occurred in the history of money market funds,
    and that disaster resulted in investors getting 99.1 cents for
    every dollar that they had invested. And then, subsequent to
    that, we had a huge wave of new regulations in 2010 and in 2014
    which imposed new, more stringent liquidity requirements,
    diversification requirements, maturity shortening, stress
    tests, more disclosures, and, importantly, gates and fees which
    are designed precisely to reduce the risk of first mover
    advantage in an early run.
        My question is: What data do you have to share with me that
    indicates that that entire wave of new regulations imposed on
    what had been an extremely safe and secure product prior even
    to that wave of regulations, what data do you have that shows
    that the new regulations are inadequate and we need to, in
    addition, have this floating NAV?
        Mr. Hall. Senator, the first point I would like to make is
    in reference to your sort of review of the history of the
    performance of the money market funds. It indeed is true that
    the breaking of the buck by the Reserve Primary Fund was the
    most significant, dramatic, headline-worthy breaking of the
    buck in history--and unique in a sense, but it was not unique
    in another sense, because studies indicate that on hundreds of
    occasions over the last couple of decades, money market funds
    have, in fact, teetered on collapse, and but for sponsorship
    support, they would have actually broken the buck. So there is
    more vulnerability here than many people seem to acknowledge.
        With respect to the underpinning of the floating NAV, I
    would simply say that the analysis, both economic analysis,
    regulatory analysis, that supports that measure is amply set
    forth in two sources. One is, of course, the SEC's rule
    release. The other is the set of proposed recommendations that
    the Financial Stability Oversight Council developed. And one of
    the leading reforms that they recommended to the SEC was
    floating the NAV for all money market funds, not just a subset
    of those funds.
        So I would suggest that there is ample support for that
    move----
        Senator Toomey. Well, there is no question there are people
    who agree with that, but I would question whether there is data
    that actually supports the necessity. I would point out the
    Government Accounting Standards Board has ruled that local
    government investment pools could continue to use the amortized
    cost accounting and the penny rounding.
        But let me just move on--I am running out of time--to a
    quick issue. Mr. Arougheti, is it the case that in the
    legislation, H.R. 3868, any increase in leverage would be fully
    disclosed to investors?
        Mr. Arougheti. Yes, it would be fully disclosed. There are
    two provisions that would require a vote of the independent
    board of directors to move forward or a cooling-off period
    after that for shareholders to effectively vote with their feet
    if they were not comfortable being invested in a BDC that
    elected to----
        Senator Toomey. OK. So investors would know that the BDC
    had a leverage of 2:1 ratio if the legislation permitted that.
        My question for Mr. Hall is: Isn't it awfully paternalistic
    for the Government to say, ``We are going to forbid you, Mr.
    Investor, from having this opportunity to take this leverage in
    this particular vehicle''? Or is it your view that we should
    forbid leverage in other cases, too? For instance, it is my
    understanding that an ordinary investor could use a margin
    account and buy stock in a bank and achieve many, many
    multiples of leverage. Would you advocate eliminating margin
    for ordinary investors also? Or why are we singling out this
    particular vehicle as one that cannot exercise really what is a
    modest amount of additional leverage?
        Mr. Hall. I think the answer, Senator, lies in two sources.
    One is the 1980 statute that actually acknowledged or created
    the framework for these companies. They were created for a very
    specific purpose, and it was acknowledged at that time that
    their very business model that is one that caters to companies
    that are less creditworthy than others is inherently risky in
    certain respects. The idea was to help the middle-tier and
    small-tier companies get capital that they could not otherwise
    get.
        The other thing is that the amendments that are being
    sought here, they are not as simple as just doubling leverage.
    It is actually more than that when you factor in the indirect
    increase in leverage that comes from the ability under this
    bill, if it is enacted, to expand investment into financial
    companies that are themselves leveraged.
        So to get to your question, it is not about being
    paternalistic at all. It is about respecting the judgments that
    have long been made about how to strike the right balance
    between helping these companies on the one hand and protecting
    investors on the other. And the history of securities
    regulation is replete with examples of limitations on the
    nature of the investor who is permitted to actually put their
    funds at risk through the accredited investor concept. There
    are loads of protections that can be characterized in some
    sense as paternalistic, but they are not. They are protecting
    investors, and they are in many cases safeguarding our system
    against systemic risk.
        Senator Toomey. I see I have run out of time and gone over,
    so thank you for the indulgence, Mr. Chairman.
        Chairman Crapo. Thank you.
        Senator Menendez.
        Senator Menendez. Thank you, Mr. Chairman.
        Treasurer Crane, you pointed out in your testimony that,
    according to statistics released on April 20th by the SEC,
    gross yields on tax-exempt money market funds increases from 8
    basis points in February to 35 basis points in March. With this
    significant jump in tax-exempt yields, how is this going to
    impact the ability of State and local governments to finance
    infrastructure and economic development projects?
        Mr. Crane. Mr. Chairman and Senator Menendez, my guess is
    it is going to have a dramatic impact, and it is already having
    an impact on the markets. For example, in the State of Idaho,
    we have the Idaho Housing and Finance Association that provides
    low-income housing. We have the Idaho Health Facilities
    Authority that builds hospitals. Those bonds are sold to the
    money market funds. And if there are less money market funds,
    then the cost is going to go up, and the person that is going
    to pick that up is the taxpayer.
        Senator Menendez. Let me ask you this: In your testimony
    you highlighted that the Government Accounting Standards Board
    acted to permit you to offer your local government investment
    pools with a stable unit price. Can you tell us a little bit
    about the Government Accounting Standards Board and its
    decision?
        Mr. Crane. Well, Mr. Chairman and Senator Menendez, they
    recognized that the floating NAV was not good for accounting
    purposes as far as the LGIPs were concerned, and so they
    repealed that rule and allow us to amortize our costs and our
    increases from an accounting standpoint, and rightfully so.
    They recognized it was a mistake and reversed themselves. I
    think they did the right thing.
        Senator Menendez. Let me ask you this: If State and local
    government are faced with impeded access to the capital markets
    through the closure of tax-exempt money market funds, what
    other options exist for low-cost financing of critical
    community and infrastructure projects?
        Mr. Crane. Mr. Chairman and Senator Menendez, I am not
    probably the best one to answer, but I can tell you that if you
    are going to go out and go into the bonding market and sell
    bonds, you are going to pay probably 120 basis points more,
    maybe 250 basis points more. You have got the banks that you
    can use. That is going to be a significant increase in cost. Or
    you can go out and bond for it, and it is going to be much more
    expensive than it currently is.
        Senator Menendez. Thank you, Mr. Chairman.
        Chairman Crapo. Thank you.
        Senator Corker.
        Senator Corker. Thank you. Thanks for having this hearing,
    and I thank all of you for testifying.
        Mr. Arougheti, BDCs are something that in the past I have
    not spent a lot of time on. When you invest in these companies
    or provide capital, is it in the form of equity, mezzanine
    loans, direct loans? Is it all three of those?
        Mr. Arougheti. It is all three of those. The BDCs have the
    flexibility--and I think it is an important point to discuss--
    to make common equity investments, mezzanine investments, or
    senior loans, all with the goal of providing growth capital. As
    the capital markets have evolved and banks have left, it is
    actually the exact opposite of what Mr. Hall said. We are
    actually seeing larger companies come to the BDC market to
    access financing and more senior secured types of investments.
        The knock-on effect of that is when we are talking about
    access----
        Senator Corker. I have got 5 minutes. So the investors that
    invest--you know, it is a public company--is there any lockout
    or can they trade daily, they can get in and out of it?
        Mr. Arougheti. Daily trading.
        Senator Corker. Yeah. And, you know, you all have operated
    for 36 years with a 1:1 debt-to-equity ratio. It is modest, but
    it is doubling. What is actually driving--well, first of all,
    what kind of return on equity did your company have last year?
        Mr. Arougheti. About 10 percent.
        Senator Corker. So with the additional debt, there will be
    some costs there. You could drive that up to 18 percent or so?
        Mr. Arougheti. I think it would be the opposite. So what I
    expect will happen with the increase----
        Senator Corker. Well, now, wait a minute. How could that--
    that is not possible.
        Mr. Arougheti. What would wind up happening is we would be
    investing in lower-yielding senior secured debt. The way the
    BDCs are structures now is if they invest in mezzanine or
    equity, the capital markets, be it bank or bond markets, will
    not actually leverage those assets. So the choice as a
    management team is invest in, quote-unquote, riskier illiquid
    assets with no leverage to drive a 10-percent ROE or invest in
    higher-quality, lower-yielding senior securities with leverage
    to generate the same----
        Senator Corker. So the additional leverage would allow you
    to be more involved in prime-type loans. Is that----
        Mr. Arougheti. Yes, it would broaden the product set, and
    it would give us another tool to bring into the middle market,
    absolutely.
        Senator Corker. And the interest in investing in financial
    institutions, what is driving that? That does seem, just for
    what it is worth, somewhat odd as it relates to this
    legislation?
        Mr. Arougheti. Yeah, I think it is a recognition that the
    face of the economy has changed in the 36 years since the
    legislation was passed, that financial services companies in
    and of themselves are a larger part of the GDP; they are job
    creators themselves. I think this is a relevant conversation.
    As I said, the legislation has tried to identify those types of
    financial instruments that cause concern.
        Senator Corker. So if you were going to--if your ceiling
    was increased from 30 to 50 or whatever, as it relates to
    financial institutions, would you envision then--that would be
    more of an equity investment, would it not, not a lending type
    situation?
        Mr. Arougheti. Each BDC is different, but when people are
    investing in financial services in that 30-percent basket, it
    does tend to be an equity investment. And back to my earlier
    comment, those in and of themselves are not leverageable. So I
    think the concern of leveraging leverage by investing in
    financial services companies is probably----
        Senator Corker. So an investor today in your company would
    have a year, there would be a cooling-off period. They can get
    out of the stock after this testimony if they decide, and then
    they would be investing in a company that they understand has
    got additional leverage and is probably going to be more
    focused toward using that money for lending, not for equity
    itself. Would that be a fair assumption?
        Mr. Arougheti. Yes, that is my view.
        Senator Corker. Let me ask you, Mr. Fung, on the conduit
    lending, I have participated in that in the past and understand
    it somewhat. What is the 4-percent box you are talking about?
    What are the limitations on a qualified mortgage that make that
    box so small?
        Mr. Fung. Well, the QCRE, qualified commercial real estate,
    loan box is smaller now because there are limitations on
    interest-only, there are limitations on loan-to-value. And what
    they are effecting is actually they are applying equally across
    all the different type of loans, including the absolute most
    safe, lower leverage, high debt service coverage loans.
        So this, frankly, is about a very modest change----
        Senator Corker. What I did not hear in your testimony was
    what the limiting factors are that are keeping the box so
    small. I am out of time, but can you quickly lay out what is
    causing only 4 percent of the conduit loans to----
        Mr. Fung. To not qualify.
        Senator Corker. That is right.
        Mr. Fung. Yeah, basically those loans are not qualified
    because they have either too high loan-to-value or a debt
    service coverage ratio that might not meet this broad-brushed
    test. But it is about an overall credit picture of each loan,
    and so, you know, the one or two factors that are being
    considered are probably not absolutely appropriate.
        Senator Corker. Well, I would like to talk to you in more
    detail. You know, having had some experience, I will say
    conduit lending typically has had much--they have been far more
    aggressive, if you will, than life insurers and others. I mean,
    I think that is a fact. And so I would like to understand----
        Mr. Fung. That is true.
        Senator Corker. You agree with that, right?
        Mr. Fung. I do.
        Senator Corker. So if you would, I would love for you to
    come into our office and explain. I am just having difficulties
    understanding what those limiting factors are, and I really
    would like to understand.
        Thank you all for your testimony and for being here today,
    and thank you, Mr. Chairman, for having this hearing.
        Chairman Crapo. Thank you, Senator Corker.
        Senator Warren.
        Senator Warren. Thank you, Mr. Chairman. Thank you for
    having this hearing today. Thank you all for being here.
        In 1980, Congress created these business development
    companies, or BDCs, as special investment vehicles with the
    goal of giving small businesses more access to capital. And
    Congress required BDCs to invest at least 70 percent of their
    money in small businesses. And as an incentive to attract
    investors to BDCs, Congress put a big carrot on the table and
    exempted BDCs from corporate income taxes.
        Now, I know a lot of BDCs focus on small business
    investments and fill a hole in the market. I know a lot of
    companies in Massachusetts and across the country get
    investment money from BDCs. But I am concerned that some of the
    largest BDCs have turned this into a raw deal for investors,
    and the bill before us today would take a bad deal and make it
    worse.
        Mr. Arougheti, you run the biggest BDC in the country, Ares
    Capital, and I took a look at some of the disclosures your
    company submitted to the SEC, and, frankly, I have got to say
    they are pretty shocking. Over the last decade, your management
    and incentive fees have risen by over 35 percent annually. They
    have nearly doubled every 2 years. Meanwhile, total returns to
    shareholders in that same time period have risen by only about
    5 percent. And because of lousy numbers like these,
    institutional investors are bailing out of BDCs, leaving behind
    a lot of mom-and-pop investors who may not realize that they
    are getting fleeced.
        Mr. Arougheti, you have been pushing for legislation that
    would allow your company to borrow more money and increase your
    leverage. In fact, your company alone has spent $1.5 million
    lobbying on this issue in the last few years, and you say that
    is because you want to be able to invest in more small
    businesses. But it seems to me that is something of a
    misdirection.
        If you really want to have more money to invest, why don't
    you lower your high fees and offer better returns to your
    investors? Then you get more money, and you can go invest it in
    small businesses.
        Mr. Arougheti. Thank you for the question, Senator. I think
    when we talk about ROEs on entities that are required by law to
    distribute 90 to 100 percent of their income, it is not a
    corollary to look at other operating companies to talk about a
    5-percent increase in shareholder value because effectively----
        Senator Warren. So you are saying that, in effect, you have
    doubled the return every couple of years to your investors?
        Mr. Arougheti. Right. The way I would encourage people to
    look at the math is you have to actually look at the
    reinvestment of those dividends because BDCs do not have----
        Senator Warren. So I have watched your fees nearly double
    every 2 years. What I am trying to get at is if you are saying
    the return is also doubling nearly every 2 years, then I do not
    get why the market has not just solved this? Why aren't people
    flocking to you wanting to invest more money and you have got
    plenty of money----
        Mr. Arougheti. Well, I think that they are, so----
        Senator Warren. ----to put into small businesses?
        Mr. Arougheti. I think that they are. We IPO'd in 2004 with
    an equity market capital----
        Senator Warren. Well, if you have got plenty of money, then
    why are you coming to Congress asking for a shift in the
    allocations so that you can attract even more money?
        Mr. Arougheti. Sure, so it is somewhat circular. So when
    we----
        Senator Warren. Yeah, it is.
        Mr. Arougheti. When we IPO'd in 2004, we had an equity
    market capitalization of $165 million and 11 people. Today we
    have an equity market capitalization of $4 billion and hundreds
    of people who are in local markets making middle-market loans.
    So----
        Senator Warren. And yet the institutional investors seem to
    be leaving you and leaving only the mom-and-pops behind.
        Mr. Arougheti. I do not think that that is true. Sixty
    percent of the investors in Ares Capital Corporate are large
    mutual fund complexes. There are actually some constrains that
    we----
        Senator Warren. You are saying that in the industry
    institutional investors are moving in to BDCs?
        Mr. Arougheti. Institutional investors are about 50 to 60
    percent----
        Senator Warren. Are you saying they are moving in, what the
    slope looks like?
        Mr. Arougheti. Well, I think they are stable. I think that
    there are----
        Senator Warren. That is not the data I am seeing, but let
    me get to another issue here. I also want to focus on an aspect
    of the BDC bill that you are pushing. BDCs right now can invest
    up to 30 percent of their money in things other than small
    businesses, including hedge funds or other financial firms.
    Ares has taken full advantage of this to funnel money into
    financial firms. At the end of last year, it had about 26
    percent of its money in financial services companies.
        Now, this bill would let BDCs dedicate another 20 percent
    of their investments to financial companies rather than to
    small businesses, which means that BDCs could invest half of
    their money in financial firms and still get all of the no-
    taxes break that was offered to get them to invest directly
    into small businesses.
        If the goal of this bill is to promote investment in small
    businesses that make things and provide services to their
    communities, then why does it allow BDCs to divert even more
    money, up to 50 percent of their portfolio, away from small
    businesses and into other financial firms?
        Mr. Arougheti. Sure. So I will use Ares Capital Corporation
    as an example because you referenced 26 percent of our balance
    sheet in financial services firms. Back to my comments earlier
    about transparency, if you were to look at our filed financial
    statements, you would actually see that those are not financial
    services firms, but it is an investment in two joint ventures
    that we have with a large insurance company, a large specialty
    finance company that make middle market loans.
        Senator Warren. Look, let us be clear. We are talking--
    sorry. We are talking about an amendment here that says that
    you can go up to 50 percent of your investments, not in small
    businesses, and still get all the tax breaks that Congress
    created so that you would invest in small businesses.
        I am out of time here, but I have got to say I am very
    concerned about the business model that big BDCs like Ares are
    using, essentially imposing private equity-like fees on mom-
    and-pop investors without any of the same kind of potential
    upside. And I am very concerned about aspects of this bill
    which would allow firms like Ares to borrow a whole lot more
    money, divert billions of dollars away from small businesses to
    hedge funds and other financial institutions, and collect even
    more management fees, all while preserving special tax breaks
    and not doing anything to help either small businesses or BDC
    investors.
        As this bill is currently written, it is a giveaway to BDC
    executives, and it is masquerading as a small business bill. If
    Congress decides to act on BDCs, it should focus on the best
    interests of investors and on small businesses, not on BDC
    management.
        Thank you, Mr. Chairman.
        Chairman Crapo. Thank you, Senator Warren.
        The vote has been called, or the beginning of the series of
    votes has been called. Senator Donnelly, you and I are the only
    two who have not gone. I will give you your shot now, and then
    I will try to wrap up real fast, and maybe we can----
        Senator Donnelly. Thanks. I will try to abbreviate it a
    little bit, too, then, Mr. Chairman. Thank you.
        Mr. Crane, what impact will a floating NAV rule have on the
    ability of municipal governments to obtain affordable
    financing?
        Mr. Crane. Mr. Chairman and Senator Donnelly, I think it
    will have a negative impact. I think it already is having a
    negative impact. For example, I borrow about $500 million in
    tax anticipate notes annually as a bridge loan for the State of
    Idaho from November 15th to April 15th when the bulk of our
    revenues come in. And the cost that I paid last year was 29
    basis points. This year, we just did a market study. We will go
    into the market in about 2 weeks. That will be between 58 and
    60 basis points, so it is doubling our cost to our taxpayers.
    That is happening not only in the situation where Idaho borrows
    short-term notes, but also in other borrowing that occurs as
    well.
        Senator Donnelly. The reforms that were put in place in
    response to the financial crisis of 2008, do you think the
    floating NAV reform improves financial stability and reduces
    systemic risk or not?
        Mr. Crane. Mr. Chairman and Senator Donnelly, I think that
    probably this was a mistake that the SEC made. This particular
    legislation does not really repeal anything as far as Dodd-
    Frank is concerned. But I think there were unintended
    consequences by the rule that was proposed, and I think it is a
    reasonable fix and will assist.
        Senator Donnelly. Mr. Arougheti, the bill changes leverage
    guidelines for BDCs, and increased leverage can be
    extraordinarily dangerous. Why would those changes not be
    risky?
        Mr. Arougheti. I articulated it again. I will try to say it
    in----
        Senator Donnelly. I appreciate it. I apologize that I have
    other obligations around here, too.
        Mr. Arougheti. No, I think you were here when I said it, so
    I apologize if I am repeating myself. But the way that the BDCs
    are structured, we actually access our leverage from banks
    themselves and from the unsecured debt markets. And if you look
    at the existing credit facilities that govern BDC leverage,
    they articulate in very great detail what assets are
    leverageable or not. And this is all publicly files, so if you
    were to look at Ares Capital Corporation's financial
    statements, you would see that we could borrow 2\1/2\ to 1 on a
    senior secured loan but 0 on an equity investment.
        So the Governors are already in place within the market to
    allow BDCs to borrow based on asset composition. So as I said
    earlier, if we were to leverage in excess of the current
    regulatory limit, it would by definition require that we were
    investing in senior secured loans and lower-risk assets;
    otherwise, you could not access the leverage.
        Senator Donnelly. Thank you, Mr. Chairman.
        Chairman Crapo. Thank you, Senator Donnelly. Actually, you
    asked a couple of my questions, so you will help me be even
    more brief.
        I have just a couple of things to wrap up, and then we
    might actually make it to the vote.
        I again want to thank you, Mr. Crane, for coming and
    bringing Idaho's common sense here to Congress, and I
    appreciate you having done that. You just went through the
    numbers I wanted you to with Senator Donnelly, so I am going to
    move over to Mr. Fung.
        Again, referring to the floating NAV issue, my
    understanding is that there are about $100 billion of loans in
    commercial mortgage-backed securities that are set to mature in
    2017. Is that correct?
        Mr. Fung. Ye, that is the current estimate.
        Chairman Crapo. What would be the expected increase in
    borrowing costs on those loans if we do not resolve this
    floating NAV issue?
        Mr. Fung. It is probably in the neighborhood of 30 to 50
    basis points, is our best guess. It could be as high as a 1-
    percent increase. It is still a bit of a question until the
    first securitization hits the market, subject to the current
    risk retention rules. Nobody knows exactly what the increased
    cost will be to pass along to the borrowers. But what is clear
    today is that there are a number of issuers who are already
    leaving the market, so less capital flowing through to the
    secondary and tertiary markets I discussed in my testimony, as
    well as increased volatility causing decrease interest in, on
    the investor side, people buying the CMBS bonds, and that, you
    know, increased volatility makes it difficult to price the rate
    that we pass along to the borrower. And so you will see
    somewhere along a 30- to 50-basis-point increase, is our guess.
        Chairman Crapo. All right. Thank you very much. I do have a
    whole bunch of questions here for the rest of the panel, but we
    also only have 5 minutes to get over to the Capitol. So at this
    point, I want to thank all of the witnesses for the time and
    effort that you have put into this to bring this information to
    us. You may get a few questions from some of the Senators. We
    would appreciate you responding to those timely. These are
    important issues, and I appreciate the input that you have
    provided to us today.
        The hearing is adjourned.
        [Whereupon, at 11:27 a.m., the hearing was adjourned.]
        [Prepared statements, responses to written questions, and
    additional material supplied for the record follow:]
                   PREPARED STATEMENT OF CHAIRMAN MIKE CRAPO
        Today's hearing will provide insights into how business development
    companies, commercial real estate finance, and money market mutual
    funds provide access to capital and economic development for
    communities and businesses.
        There is a growing chorus that pending and existing Federal rules
    and statutory limitations are restricting access to capital and
    restraining economic growth.
        Because it is important for Congress to understand the factors that
    are impacting local communities and businesses, I welcome a discussion
    about specific proposals that would improve the current regulatory
    framework while maintaining proper safeguards.
        The House Financial Services Committee has already examined
    proposals to modernize the regulations for Business Development
    Companies and adjust the risk retention rules for commercial real
    estate loans.
        Senators Toomey and Menendez have introduced legislation to restore
    the stable share price for institutional, nongovernment money market
    funds.
        I look forward to hearing from our witnesses on these legislative
    proposals and learning what specific factors, including Federal
    regulations, are negatively impacting lending and borrowing in local
    communities.
        For example: How a pending regulatory effective date will impact
    commercial real estate financing since almost $100 billion of loans in
    commercial mortgage backed securities are set to mature in 2017--up
    from $52 billion this year.
        What will be the impact on State Treasurers to invest and use money
    market mutual funds when several types of these funds will be required
    to switch from a stable to a floating net asset value in October?
        What statutory changes can be made to allow business development
    companies to increase investments in small- and middle-market companies
    and enable investors to invest alongside with them and still provide
    adequate investor protections?
        Thank you.
                                     ______

                       PREPARED STATEMENT OF RON G. CRANE
                             Idaho State Treasurer
                                  May 19, 2016
        Chairman Crapo, Ranking Member Warner, and Members of the
    Subcommittee, I appreciate the opportunity to provide testimony on
    legislative proposals to improve access to capital and economic
    development for communities and businesses.
        As the statewide-elected Treasurer of Idaho since 1998, I am
    responsible for the State's debt management, including the issuance of
    both short term debt, such as Tax Anticipation Notes, and bonds. My
    office oversees a number of debt management programs that support
    public infrastructure investment, including the Idaho Bond Bank
    Authority, the Idaho School Bond Guaranty Program, and Tax Anticipation
    Notes. Also established in statute are the Idaho Health Facilities
    Authority, which provides financing to nonprofit health care providers;
    the Idaho Housing and Finance Association, which issues revenue bonds
    to finance affordable housing; and the Idaho State Building Authority,
    which functions as the capital financing arm of the State.
        Also, on the cash management side, I am responsible for investing
    all general account and pooled agency cash, as well as managing Idaho's
    $3.2 billion local government investment pool (LGIP).
        I direct receipt of all State monies, and the accounting and
    disbursement of public funds.
        In particular, I want to focus my comments today on S. 1802, the
    Consumer Financial Choice and Capital Markets Protection Act.
        This bipartisan legislation is important to protecting the
    financing and investment options of Governments, businesses and
    communities in Idaho and throughout the country. I want to express my
    gratitude to Senators Toomey and Menendez, as well as to you, Mr.
    Chairman, for your sponsorship of that legislation.
    Background
        The Securities and Exchange Commission (SEC) has taken important
    actions since the financial crisis of 2008 to strengthen the resiliency
    of money market funds, reduce systemic risk, and protect investors. In
    2010, the SEC imposed new liquidity and transparency requirements on
    money market mutual funds that have proven successful through several
    market stresses, including the European debt crisis of 2011, the U.S.
    debt ceiling impasse and concerns about the downgrading of U.S. debt
    that same year, and the debt-ceiling standoff in 2013.
        Then in July 2014, the SEC adopted additional obligations on money
    market funds, including enhanced disclosures, stress testing, and
    increased, portfolio diversification requirements, among other things.
    Like the 2010 reforms, these are welcome changes that have strengthened
    the ability of money market funds to safely meet the cash management
    and short-term investment needs of businesses, State and local
    governments, and other institutions.
        However, as part of the July 2014 amendments to Rule 2a-7, the SEC
    also adopted a requirement, effective on October 14 of this year, which
    in effect eliminates the utility of any money market fund to investors
    who are not ``natural persons'' (in the terminology of the Rule) unless
    the fund invests exclusively in U.S. Government securities.
        Under this new requirement, any tax-exempt or prime money market
    fund accepting any investor other than a ``natural person'' will no
    longer be able to offer and redeem shares based on amortized cost
    valuation of its portfolio to produce a stable, $1 net asset value
    (NAV). Instead, such funds will have to apply a fluctuating or
    ``floating'' NAV using market-based estimated values. Simply, again,
    the floating NAV goes beyond regulation of the money market fund to
    just kill it as a cash management tool. I do not believe cash
    investors, such as myself, want, or will use, a floating NAV fund for
    cash investments.
        Thus, by October 14, all investors other than ``natural persons''
    are forced to leave any stable value, dollar per share, prime or tax-
    exempt money market fund. Since these investors are managing cash, they
    will be looking to move to a different, stable-value cash management
    vehicle. As a practical matter, this means most will either put their
    cash in a money market fund investing exclusively in U.S. Government
    securities or deposit their cash in the bank.
        In either case, that money will no longer be available in the
    portfolio of a prime or true-exempt fund to loan to businesses or
    invest in tax-exempt notes and bonds of Idaho, other State and local
    governments, and other nongovemment issuers such as hospitals and
    universities.
    Treasury Strategies Survey
        Attached as an Appendix to this Statement is a survey and analysis
    of the extent to which the assets of tax-exempt money market funds are
    from ``non-natural persons'' performed by Treasury Strategies, an
    economic consulting firm, for The Coalition for Investor Choice.
        Treasury Strategies' work to document the impact of the SEC's new
    requirement forcing out ``non-natural'' person investors provides
    accurate data to underlie your support of S. 1802. To my knowledge, no
    one else has undertaken to discern this impact, including the SEC. \1\
    ---------------------------------------------------------------------------
         \1\ In its Release adopting the 2014 amendments to Rule 2a-7, the
    SEC asserted that ``institutional'' investors likely held less than 15
    percent of tax-exempt money market fund assets. Money Market fund
    Reform, Amendments to Form PF, www.sec.gov/rules/final/2014/33-9616.pdf
    at p.244; 79 FR 47736 (Aug. 14, 2014). However, the SEC was relying on
    data differentiating ``institutional'' and ``retail'' funds by criteria
    such as minimum account size; not the distinction in its rule of
    ``natural'' vs. ``non-natural'' persons. In addition, the SEC asserted
    that such data overstated ``institutional'' assets because omnibus
    accounts likely consisted of retail investors. Thus, the SEC assumed,
    without comparable data or performing its own study, that its action
    would not significantly impact the assets of tax-exempt money market
    funds. The present impact is an unintended consequence.
    ---------------------------------------------------------------------------
    How S. 1802 Supports Economic Development
        Treasury Strategies has concluded that this one SEC requirement, by
    itself, will reduce the assets in tax-exempt money market funds by at
    least 40 percent.
        Further, as Treasury Strategies' Report shows, in anticipation of
    this loss of assets, many funds lose viability and are simply
    liquidating, in total, now. Those who are not liquidating, but remain
    uncertain as to the extent of the loss of assets they will experience
    by October, are actively shortening their portfolio maturities.
        At the end of 2015, tax-exempt money market funds held about $263
    billion in assets. \2\ That is about 6.5 percent of the total tax-
    exempt debt market. But it's about two-thirds of the short-term
    municipal debt market, and that has varied between two-thirds and 80
    percent over the past 5 years.
    ---------------------------------------------------------------------------
         \2\ https://www.sec.gov/divisions/investment/mmf-statistics/mmf-
    statistics-2016-3.pdf
    ---------------------------------------------------------------------------
        This is all money that is invested in funding State and local
    government. The Treasury Strategies' Report shows you how those
    investments span the country, both in absolute and per capita terms.
    While States such as New York, Massachusetts, Illinois, Pennsylvania,
    New Jersey, Indiana, and Ohio \3\ stand out as among the largest ten
    issuers in absolute dollar terms, the impact on Idaho is very
    significant on a per capita basis, along with every other State,
    including Virginia, Rhode Island, Montana, Tennessee, Louisiana, South
    Carolina, Nebraska, and Kansas.
    ---------------------------------------------------------------------------
         \3\ Many supporters of S. 1802, in addition to myself, have
    acknowledged their support or made their letters available to the
    Coalition for Investor Choice. See www.protectinvestorchoice.com. For
    example: Letter of Massachusetts Treasurer Deborah B. Goldberg to
    Senator Warren (February 26, 2016); Letter of Carole Brown, Chief
    Financial Officer, City of Chicago to Senator Kirk (April 13, 2016);
    Letter of David J. Gray, Treasurer, Penn State University to Senator
    Toomey (December 14, 2015); Letter of Ann M. Cannon, President, New
    Jersey Association of Counties, to Senators Menendez and Booker; Letter
    of David Bottoroff of Association of Indiana Counties and Nancy Marsh,
    Indiana County Treasurers' Association, to Senator Donnelly (June 5,
    2015); and Letter of Matthew A. Szollossi, Executive Director,
    Affiliated Construction Trades of Ohio, to Senator Brown (October 24,
    2015).
    ---------------------------------------------------------------------------
        We in Idaho, including both State and local government directly, as
    well as other Idaho issuers, benefit from over $600 million of money
    market fund investments. If tax-exempt money market funds lose, at a
    minimum, half of their assets because ``non-natural persons'' are no
    longer permitted to invest in them, that implies that Idaho could lose
    at least $300 million of its present financing from this source at the
    present rates.
        What, then, will my choices be for an alternative funding source?
    There will be two options. First, I will likely have to pay higher
    interest rates in order to place my debt. This is the most basic
    principle of supply and demand in the auction process of the market.
    When the assets available for investment go down, but the demand does
    not, the cost will go up.
        This impact is occurring right now. For example, each year I take
    approximately $500 million in Tax Anticipation Notes to market--and
    these notes have always been purchased by an array of different tax-
    exempt money market funds. There are substantially fewer bidders this
    year, and I've already been told my cost is going up.
        All issuers of municipal debt and nongovernment conduit borrowers
    are already beginning to feel the impact of the shrinkage in tax-exempt
    money market fund assets as a result of the floating NAV requirement.
    According to statistics released on April 20 by the SEC, gross yields
    on tax-exempt money market funds increased from eight basis points in
    February to 35 basis points in March. \4\ This is not good news for
    State and local governments, school districts, port authorities,
    hospitals, universities, and others that have to pay more for working
    capital or to finance infrastructure and economic development projects
    that support local businesses, including contractors and engineering
    firms.
    ---------------------------------------------------------------------------
         \4\ https://www.sec.gov/divisions/investmentlmmf-statistics/mmf-
    statistics-2016-3.pdf
    ---------------------------------------------------------------------------
        My second option is to borrow the money in a different form, or
    from a different source, than a money market fund. For example, I can
    go seek a loan from a bank.
        Short-term borrowing in the capital markets has always been the
    lowest cost form of funding. This is the fundamental notion of the
    yield curve: short-term borrowing costs less than long-term borrowing.
    I would add that tax-exempt borrowing is normally less expensive than
    taxable loans. Thus, borrowing in the capital markets, such as from
    money market funds, costs less than borrowing from a bank.
        For a State or local government with a good credit rating, its
    financing authorities could expect to pay approximately 110 basis
    points more to borrow from a bank than to issue debt held by a money
    market fund. This would be at prevailing rates of LIBOR plus 40 to 50
    basis points. For example, an entity that regularly borrows $10 million
    short-term through the issuance of Tax Anticipation Notes (TANs) would
    see its borrowing costs rise more than $100,000 per year if the debt
    could not be placed with money market funds and bank credit was needed
    as an alternative. Other, less credit worthy borrowers who need credit
    enhancement could see their cost of debt increase 200 to 300 basis
    points.
        These disruptions to financing by money market funds are occurring
    on top of other regulatory actions that are impacting liquidity and
    cost for municipal borrowing; including the Basel III bank capital
    rules and the SEC's proposed liquidity standards for bond mutual funds.
        I would note that total tax-exempt assets held by money market
    funds were over $500 billion as recently as 2009 and, through October
    of last year, most of that decline was the result of the Fed's zero
    interest rate policy.
        As an aside, to return to my point that cash investors do not want
    a floating NAV money market fund:
        At a time when money market funds are offering annual yields of
    only a handful of basis points to invest on a dollar in-dollar out
    basis, the stable value is a big reason why money market funds continue
    to hold, and attract, nearly $2.6 trillion in assets. Again, as the
    Treasury Strategies' Report shows, regulators cannot force investors to
    invest in floating NAV funds and the Fund Sponsors themselves are not
    anticipating that investors will stay. Fund Sponsors are simply
    liquidating their tax-exempt funds, and converting the prime funds, and
    expecting those assets to move to Government funds or elsewhere.
        Now, back to the $500 billion peak. It would be fair to assume
    that, absent the floating NAV requirement, once short-term rates begin
    to rise again, investors would flood back into tax exempt money market
    funds and assets could exceed $500 billion again. That's a lot of
    potential liquidity for building and maintaining hospitals, schools,
    roads, public transportation systems, airports, and other
    infrastructure projects. This implies that ample, low-cost funding
    would remain available to Idaho issuers, and your States' issuers, from
    tax-exempt money market funds.
        There's an indirect negative consequence of the floating NAV that
    will also be averted by enactment of S. 1802. As funding options become
    more limited, the credit ratings of States and municipalities will come
    under pressure and potentially lead to additional costs. Rating
    agencies use access to capital as an important variable. When tax-
    exempt money market funds close and municipalities have fewer buyers
    for their debt, it becomes a risk factor that could lead to ratings
    downgrades .and even higher borrowing costs.
        Although I am responsible for the investment and financing
    activities of the Idaho State Government, I think it is also important
    to mention the fact that money market funds do more than just support
    public infrastructure investment in our State. Prime money market funds
    currently invest in billions of dollars of short-term commercial paper
    issued by Idaho businesses to finance their payrolls and inventories,
    as well as the purchase of new equipment. JPMorgan Chase estimates
    that, as a result of the SEC's 2014 actions, at least $400 billion in
    prime money market fund assets will be converted to funds the invest
    solely in U.S. Government securities. \5\ The net result will be to
    reduce the Federal Government's borrowing costs at the expense of main
    street businesses that are the backbone of our local economies.
    ---------------------------------------------------------------------------
         \5\ See ``The $400 Billion Money-Fund Exodus With Banks in Its
    Crosshairs'', Bloomberg Business, Feb. 23, 2016.
    ---------------------------------------------------------------------------
    Local Government Investment Pools
        As Idaho State Treasurer, I am both a manager of, and investor in,
    money market funds, as well as being a borrower from them.
        First, here is how the SEC floating NAV requirement impacted me as
    the manager, in Idaho, of an investment pool that is equivalent to a
    prime money market fund.
        I am responsible for the management of our LGIP, which we offer to
    Idaho municipalities and other local government subdivisions for their
    cash management. It has a daily balance in excess of $3.2 billion.
    LGIPs use amortized cost valuation to operate similarly to money market
    funds and offer their participants a stable, $1 unit price.
        Although LGIPs are exempt from registration under the Investment
    Company Act, and therefore not directly subject to Rule 2a-7, they are
    still subject to Government Accounting Standards Board (GASB)
    accounting principles. GASB sets accounting and financial reporting
    standards for external investment pools and pool participants. Until
    recently, GASB principles required LGIPs to follow 2a-7 like
    procedures. Thus, when the SEC said that ``non-natural persons'', such
    as Idaho local governments, can no longer benefit from amortized cost,
    our Idaho LGIP was faced with the prospect of not being able to comply
    with the GASB accounting principle.
        This past December, GASB acted to restore amortized cost to LGIPs
    by issuing accounting statement No. 79. \6\ It requires LGIPs to meet
    many of the requirements of Rule 2a-7, such as portfolio duration and
    maturity, quality of portfolio assets, diversification of investments,
    and portfolio liquidity, but ``de-links'' from Rule 2a-7 to permit
    LGIPs to continue to use amortized cost valuation and penny rounding,
    and thereby transact with participants at a stable NAV per unit or
    share.
    ---------------------------------------------------------------------------
         \6\ http://www.gasb.org/cs/
    ContentServer?c==Pronouncement_C&pagename=GASBo/
    o2FPronouncement_C%2FGASB SummaryPage&cid=1176167863852
    ---------------------------------------------------------------------------
        Your enactment of S. 1802 restores the stable, $1 per share of the
    money market fund by enabling any money market fund to elect to
    continue to use the amortized cost method of valuing its portfolio.
    How S. 1802 Supports Liquidity Management
        Although, thanks to GASB, our LGIP is not subject to the pending
    floating NAV requirement of the SEC's Rule 2a-7, we are still impacted
    by that requirement. Like in other States, apart from LGIPs, we also
    invest public cash in financial instruments that meet the investment
    policies of our State code, as well our investment objective priorities
    of safety, liquidity and yield. Eligible instruments include
    Treasuries, U.S. Government agency securities, and stable value
    Government and prime money market funds.
        Safety of principal is the foremost objective of our investment
    program. That is why, in addition to Idaho's LGIP, State agencies and
    local municipalities also use money market funds where appropriate for
    specialized cash management applications. For example, at any point in
    time, Idaho agencies and public entities will have between $300 and
    $500 million invested in prime money market funds.
        If stable value prime money market funds are no longer a permitted
    investment option, Treasurers will have limited choices for using
    pooled investment vehicles to invest in financial instruments that meet
    the needs of their investment programs. Further, with over $400 billion
    in prime money market fund assets converting to Government funds, rates
    on U.S. Treasuries are being driven even lower.
        Even in the absence of the SEC's floating NAV requirement,
    liquidity management is an enormous challenge for State and local
    government entities. This makes enactment of S. 1802 doubly important.
    It will allow our liquidity management programs to continue to hold
    money markets funds in their portfolios that invest in assets other
    than U.S. Government securities. In addition to capital preservation,
    it will allow us to earn market rates of return throughout budgetary
    and economic cycles, which benefits our citizens.
    Conclusion
        S. 1802 will do much to preserve Idaho's access to capital and
    economic development for our communities and businesses. It will
    preserve stable value money market funds as a safe, liquid, market-rate
    investment for our State's cash management needs, and as a source of
    capital for public infrastructure investment and businesses growth. At
    the same time, this legislation protects the positive changes adopted
    by the SEC in 2010 and 2014 that have mitigated risk in, and
    strengthened the resilience of, money market funds without disturbing
    the authority of the SEC to regulate money market funds in its
    discretion. In S. 1802, Congress properly exercises its discretion to
    draw the policy line between regulating money market funds and killing
    them by imposing a floating NAV requirement.
        I appreciate your leadership on this issue, Mr. Chairman, and
    encourage the full Senate to support S. 1802 and protect the liquidity
    and investment options of State and local governments and all other
    investors.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                   PREPARED STATEMENT OF MICHAEL J. AROUGHETI
      Cochairman of the Board of Directors, Ares Capital Corporation, on
                 behalf of the Small Business Investor Alliance
                                  May 19, 2016

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                     PREPARED STATEMENT OF STEPHEN W. HALL
         Legal Director and Securities Specialist, Better Markets, Inc.
                                  May 19, 2016
    Introduction
        Chairman Crapo, Ranking Member Warner, and Members of the
    Subcommittee, thank you for the opportunity to testify today on behalf
    of Better Markets. Better Markets is a nonprofit, nonpartisan
    organization that promotes the public interest in the domestic and
    global capital and commodity markets. Its goal is to help establish a
    stronger, safer financial system that is less prone to crisis and the
    need for taxpayer bailouts. Better Markets seeks to achieve these goals
    through regulatory comment, public advocacy, independent research, and
    litigation. Through these channels, we serve as a counterweight to the
    financial industry to help ensure that policy makers and regulators
    prioritize the interests of hardworking Americans over special
    interests.
        Better Markets supports the goal of promoting and protecting
    capital formation for the benefit of the real economy but has serious
    concerns about all three of the bills that are the subject of this
    hearing. They would remove or weaken regulations aimed at protecting
    investors and maintaining financial market stability in the areas of
    money markets funds, real estate securitizations, and business
    development companies.
        In my testimony, I'll describe the perspective that Better Markets
    brings to these issues; offer a general assessment of the deregulatory
    approach reflected in these measures; and highlight specific provisions
    in each of these bills that we believe would be harmful.
    The Better Markets Perspective
        Better Markets firmly believes that vibrant, fair, and stable
    capital markets are crucial to generating economic growth and
    prosperity for all Americans. We also believe that achieving these
    goals requires a strong regulatory framework. That framework must be
    capable of protecting investors to sustain their confidence in our
    markets and preserve their willingness to participate in capital
    formation. And above all, our regulations must limit systemic risk in
    our markets to avoid a recurrence of the type of devastating financial
    crisis that nearly destroyed our economy in 2008.
        That crisis was the worst financial disaster since the Great Crash
    of 1929, and it produced the worst economy our Nation has seen since
    the Great Depression of the 1930s. It nearly destroyed our financial
    system, obliterating millions of jobs, triggering a tidal wave of home
    foreclosures, and wiping out the savings of countless American
    households. Small businesses were particularly hard hit. In 2008, for
    the first time in history, more businesses failed than were started.
    The costs have been staggering: tens of trillions of dollars in lost
    GDP and inestimable human suffering. \1\
    ---------------------------------------------------------------------------
         \1\ Better Markets, ``The Cost of the Crisis: $20 Trillion and
    Counting'', (July 2015), available at http://www.bettermarkets.com/
    sites/default/files/Better%20Markets%20-%20Cost%20of
    %20the%20Crisis.pdf.
    ---------------------------------------------------------------------------
        And the crisis is still being felt today. Underemployment remains
    at almost 10 percent, 6.7 million homes are still underwater; median
    wages remain stagnant; and middle class Americans still struggle with
    $3.5 trillion in nonmortgage consumer debt.
        The lesson is clear: Without effective rules, our financial system
    is susceptible to financial crisis, and financial crisis poses the
    single greatest threat to capital formation and economic growth,
    especially among small businesses. Strong regulation is thus essential
    for protecting and promoting capital markets that support the real
    economy and ensure long term economic prosperity.
    General Concerns
        The deregulatory approach in these bills raises a number of
    concerns. First, we question whether these measures will really help
    businesses and municipalities access the capital they need to expand
    and contribute to economic growth. Throughout its history, members of
    the financial services industry have opposed regulation based on
    confident predictions that regulatory safeguards applied to their
    activities will limit access to capital and stifle economic growth. In
    fact, however, these claims tend to be speculative, anecdotal, and
    ultimately unfounded. In this case, we haven't seen credible evidence
    that these bills will materially benefit our financial system or the
    larger economy.
        Second, if enacted, these bills will come with a heavy price. They
    will expose investors to an increased risk of loss. Inflicting harm on
    investors doesn't fuel the real economy, and it ultimately undermines
    the investor confidence that is so essential to a well-functioning
    capital market.
        Of greatest concern, these bills would also lead us in the
    dangerous direction of increased systemic risk and a greater likelihood
    of financial crisis. For example, we know for a fact that money market
    funds and the securitization of real estate loans contributed heavily
    to the 2008 financial crisis. The floating net asset value (NAV) and
    the risk retention, or ``skin in the game,'' requirements that will
    soon take effect are key regulatory reforms designed to reduce the risk
    that our financial system--and these markets in particular--will once
    again be thrown into chaos. The bills at the center of this hearing
    would repeal or weaken those reforms before they have been given a
    chance to work. As result, these bills would increase the prospects for
    another devastating financial crisis that would destroy our economic
    growth.
        Perhaps the Financial Stability Oversight Counsel (FSOC) said it
    best when it issued its proposed recommendations on money market
    reform. At the top of their list was the floating NAV. The FSOC
    observed that by reducing the risk of runs on money market funds, their
    recommendations would decrease both the likelihood and severity of
    future financial crises. \2\ It explained that because financial crises
    have such a profoundly damaging impact on economic activity and
    economic growth, ``reforms that even modestly reduce the probability or
    severity of a financial crisis would have considerable benefits in
    terms of greater expected economic activity and, therefore, higher
    expected economic growth.'' \3\
    ---------------------------------------------------------------------------
         \2\ Proposed Recommendations Regarding Money Market Fund Reform,
    77 FR 69,455 (Nov. 19, 2012), at 69,481 (FSOC Release).
         \3\ Id. at 69,482 (emphasis added).
    ---------------------------------------------------------------------------
        The bills we're discussing today are at odds with this approach.
    They would weaken regulatory safeguards, thereby increasing the
    probability of another financial crisis, while putting investors
    needlessly at risk. We believe they would be counterproductive.
    S. 1802--Deregulation of Money Market Funds
        S. 1802 would allow all money market funds (MMFs) to maintain a
    fixed net asset value. This provision would effectively repeal the
    SEC's 2014 rule requiring institutional prime and institutional
    municipal money market funds to adopt a floating NAV. But to ensure
    that money market funds remain stable, we actually need to apply more
    regulation in this area, not less. The bill is a step in the wrong
    direction.
    MMFs Are Vulnerable to Destabilizing Runs
        MMFs are susceptible to runs and when they do occur, the financial
    system can experience major disruptions that cripple the short-term
    credit markets. MMFs do not come with any form of reliable capital
    buffer or Government insurance that can mitigate the effect of a run.
    In addition, the MMF market is large, amounting to $2.7 trillion, and
    relatively concentrated. MMFs are highly interconnected with other
    financial institutions, and they are widely used by individuals,
    institutions, and businesses as cash management vehicles or as sources
    of credit. By virtue of these characteristics, MMFs present an ongoing
    risk of runs that can spread widely and rapidly throughout the
    financial system.
        The financial crisis of 2008 made this threat painfully clear. In
    the most compelling example of run risk, the Reserve Primary Fund broke
    the buck on September 16, 2008, due to losses on debt instruments
    issued by Lehman Brothers Holdings, Inc. Although that debt was only
    1.2 percent of the fund's total assets, a run ensued when the fund
    sponsors declined to provide support. Within 2 days, investors sought
    to redeem $40 billion from the fund. This required the fund to dump
    tens of billions of dollars in assets immediately so that it could pay
    for the flood of shareholder redemptions. This fire sale in turn
    depressed asset values, further weakening the fund.
        The run quickly spread to the entire prime MMF industry, and during
    the week of September 15, 2008, investors withdrew approximately $310
    billion (or 15 percent) of prime MMF assets. This industry-wide run
    caused immediate havoc in the short-term funding markets, triggering a
    vicious cycle of asset fire sales, falling asset prices, and mounting
    redemption requests. The run abated only after the Treasury, on
    September 19, 2008, established the Temporary Guarantee Program to
    guarantee money market funds, and the Federal Reserve established a
    variety of facilities to support the credit markets frozen by the MMF
    crisis. \4\ The entire $3.7 trillion money market fund industry was
    backstopped, putting taxpayers on the hook for any losses.
    ---------------------------------------------------------------------------
         \4\ See SEC Division of Risk, Strategy, and Financial Innovation,
    ``Response to Questions Posed by Commissioners Aguilar, Paredes, and
    Gallagher'', at 12 (Nov. 30, 2012), available at http://www.sec.gov/
    news/studies/2012/money-market-funds-memo-2012.pdf.
    ---------------------------------------------------------------------------
        The collapse of the Reserve Primary Fund was not the first time--or
    the last--when MMFs faced significant stresses and potential collapse.
    During the crisis, other money market funds experienced significant
    stress levels requiring their sponsors to provide support. Going
    further back in time, one study found 144 cases from 1989 to 2003 in
    which MMFs would have broken the buck had it not been for sponsor
    support. \5\ Another survey revealed 78 instances between 2007 and 2011
    in which sponsors provided support to their MMFs in the form of either
    cash contributions or purchases of securities from the fund at inflated
    prices. \6\ Relying on sponsors to maintain a stable NAV is an
    unreliable approach, as we learned from the financial crisis.
    ---------------------------------------------------------------------------
         \5\ Moody's Investors Service, Special Comment, ``Sponsor Support
    Key to Money Market Funds'' (Aug. 9, 2010), available at http://
    www.alston.com/files/docs/Moody's_Report.pdf; see also Release at
    69,462 n. 28.
         \6\ See Steffanie A. Brady, et al., Federal Reserve Bank of
    Boston, Risk and Policy Analysis Unit, ``The Stability of Prime Money
    Market Mutual Funds: Sponsor Support From 2007 to 2011'', Working Paper
    RPA 12-3, at 4 (Aug. 13, 2012), available at http://www.bos.frb.org/
    bankinfo/qau/wp/2012/qau1203.pdf; see also SEC Press Release, supra
    note 10, at 4 (citing over 300 instances since the 1980s of sponsor
    support necessitated by the diminished value of holdings or
    extraordinary redemptions).
    ---------------------------------------------------------------------------
        As the SEC and the FSOC have concluded, requiring MMFs to maintain
    a floating NAV is one the most important reforms we can adopt to reduce
    this run risk. Under this approach, instead of being fixed artificially
    at $1.00, the price of shares fluctuate and reflect the actual market
    value of the assets in the fund portfolio.
    The Floating NAV Mitigates Run Risk
        Floating the NAV offers several benefits. First and foremost, it
    reduces the incentive of any investor to expedite withdrawals from a
    stressed MMF in hopes of redeeming at the $1.00 price as opposed to
    something lower. \7\ Investors who withdraw first no longer benefit
    from a ``first mover advantage,'' since they receive the actual market-
    based value of their shares. Eliminating this first mover advantage
    substantially reduces run risk.
    ---------------------------------------------------------------------------
         \7\ Money Market Fund Reform; Amendments to Form PF; Proposed
    Rule, 78 FR 36,834 (June 19, 2013), at 36,850.
    ---------------------------------------------------------------------------
        Second, the floating NAV also promotes greater fairness among
    investors. \8\ As a result of the artificially stable NAV, an investor
    that succeeds in redeeming early in a downward spiral may receive more
    than they are due by liquidating at $1.00 per share even though the
    underlying assets are actually worth less. Without a sponsor
    contribution or other rescue, that differential in share value is paid
    by the shareholders remaining in the fund. Early redeemers receive a
    windfall and later redeemers pay the cost. The floating NAV eliminates
    this disparity and unfairness.
    ---------------------------------------------------------------------------
         \8\ Id.
    ---------------------------------------------------------------------------
        Finally, floating the NAV also enhances transparency. A fluctuating
    NAV helps correct the basic misconception among many investors that
    their MMF investment cannot lose value. Instead, investors see plainly
    that they bear the risk of loss as to MMFs, just as they do with other
    investment vehicles. Acclimating MMF investors to share price
    fluctuations would further mitigate their tendency to run in panic at
    the prospect that their MMF will ``break the buck.'' \9\
    ---------------------------------------------------------------------------
         \9\ Id. at 36,851.
    ---------------------------------------------------------------------------
    Prospectus Disclosure Is Insufficient
        S. 1802 includes a provision apparently aimed at preserving the
    transparency benefits of the floating NAV. The bill would prohibit
    bailouts of money market funds and require prominent disclosure of that
    fact in all fund prospectuses and sales literature. It thus seeks to
    correct the widespread misimpression that MMFs cannot sustain losses or
    that they carry bank-like deposit insurance. However, we do not believe
    that disclosure alone would alter investors' inflated confidence in the
    stability of MMFs. Demonstrating the truly variable nature of MMFs on a
    day to day basis through transparent price fluctuations would be far
    more persuasive than simply stating the fact in fine print disclosure
    forms. More importantly, this provision in the bill would do nothing to
    mitigate the powerful incentive to redeem shares that arises directly
    from the fixed NAV. Nor would it eliminate the unfair advantage that
    some investors can gain by redeeming shares early in times of stress
    under a fixed NAV.
        The concerns expressed by opponents of the floating NAV are
    understandable but not persuasive. The operational changes required by
    the SEC rule appear to be manageable, in part because the SEC
    established a 2-year compliance period. Most of the large fund
    complexes have made the necessary adjustments to implement the rule.
    And Treasury and the IRS have addressed the tax and accounting concerns
    previously raised.
    Loss of Institutional Investment Will Not Be Significant
        Perhaps the single greatest lingering concern is that institutional
    investors will migrate away from floating NAV Funds, especially the
    municipal MMFs, raising the cost of credit for local governments. Under
    the SEC rule, however, the impact is not expected to be significant. As
    it is, institutional investors account for a small percentage of
    municipal debt in the money market space, and at least some
    institutional investors will continue to seek the tax benefits that
    municipal funds provide. In addition, municipal MMFs that serve retail
    investors will not be subject to the floating NAV requirement, so the
    feared reduction in investment will not occur in that sector.
        In any case, even if the cost of credit rises to some degree for
    businesses or municipalities, the gains in terms of systemic stability
    will be worth it. Policy makers responsible for mitigating systemic
    risks must at times face the need to ``accept higher costs in normal
    times in order to significantly reduce the costs of financial crises.''
    \10\
    ---------------------------------------------------------------------------
         \10\ FSOC Release, at 69,480 n. 119.
    ---------------------------------------------------------------------------
        In short, repealing the SEC's rule requiring institutional prime
    and municipal MMFs to float their NAV is a step backward. In reality,
    we should be floating the NAV for all money market funds, not just
    institutional funds. \11\ In addition, regulators should be weighing
    the need for additional safeguards, including capital buffers. \12\
    Rolling back the progress that the SEC has made in protecting MMFs from
    the potentially disastrous runs is unwise.
    ---------------------------------------------------------------------------
         \11\ As Better Markets detailed in this comment letter: Letter
    from Better Markets to the SEC, Money Market Reform (Release No. 33-
    9408) (Sept. 17, 2013). In our letter, we also explain why the SEC's
    MMF reforms, while critically important, were still only half-measures.
    In addition to floating the NAV for all MMFs, the SEC must apply other
    safeguards, including capital buffers, especially where the fixed NAV
    is allowed to persist.
         \12\ Id. at 2.
    ---------------------------------------------------------------------------
    H.R. 4620--Risk Retention Exemption for Commercial Real Estate Loans
        H.R. 4620 would weaken the risk retention safeguards applicable to
    securitizations of commercial real estate loans. If properly regulated,
    the securitization markets can be an important source of affordable
    credit. However, when the securitization process is marked by
    recklessness or fraud in the origination and pooling of the underlying
    financial assets, coupled with a lack of transparency and disclosure,
    then securitized loans can inflict enormous harm on the entire
    financial system.
    Regulatory Gaps in Securitization Contributed to the Crisis
        It was precisely this type of broken securitization market that
    contributed so heavily to the financial crisis. In the years leading up
    to the crisis, the ``originate to distribute'' model became pervasive
    in the residential mortgage market. Loans were originated for the
    express purpose of being sold into securitization pools, allowing
    lenders to reap enormous fees without bearing the credit risk of
    borrower default. This widespread practice ultimately led to the
    accumulation of massive amounts of high-risk mortgage-backed securities
    in the hands of financial institutions and investors of all types. The
    situation epitomized the very concept of systemic risk, and when the
    housing bubble burst, it took a huge toll on markets, investors, and
    the economy.
        A similar pattern unfolded in the commercial real estate market,
    where underwriting standards sank to meet demand for loans that could
    be securitized. In fact, many banks that failed or were bailed out and
    rescued during the financial crisis did so in part because they held
    badly underwritten commercial real estate loans. The crisis devastated
    not only the residential mortgage backed securities market, but also
    the commercial mortgage backed securities market.
        Risk retention requirements are among the most important reforms in
    this area. They are designed to align the interests of securitizers
    more closely with investors, thereby increasing the quality of assets
    in securitization pools and reducing the risk of loss. These
    requirements help protect investors and restore confidence in mortgage-
    backed securities. This in turn helps allocate capital to real estate
    development in a way that will support economic growth without
    threatening a financial crash. Diluting the risk retention requirements
    is the wrong approach.
    The Bill Would Create a Blanket Exemption for Single or Related Loans
        H.R. 4620 would make two particularly worrisome changes in the risk
    retention rule. First, it would create a blanket exemption for the
    securitization of a single commercial real estate loan or groups of
    related loans. The exemption is unwarranted for several reasons. Even
    single loans and groups of related loans can represent large and
    complex transactions that present underwriting challenges. Moreover,
    securitizations of these types of loans can actually present heightened
    risks of default since the loan pools lack diversity and therefore
    concentrate risk. In addition, the securitization of a group of cross-
    collateralized loans poses greater risk, since the default of one loan
    triggers default of the entire pool. Therefore, the risk retention
    requirements still have an important role to play in incentivizing
    careful underwriting for a single loan or a group of related loans as
    these investments are assembled for sale to investors.
        This exemption is also troubling because it is essentially
    unlimited. The bill would impose no boundary on the number, size,
    quality, or complexity of the loans that would fall within the
    exemption. Under the bill, groups could include any number of loans,
    provided that they have relatively tenuous connections through
    ``related borrowers'' and direct or indirect ownership of the
    underlying properties. Finally, the bill would leave no room for the
    agencies to impose any safeguards or objective risk-limiting
    requirements on such securitizations as a condition for the exemption.
    This restriction prevents the agencies from applying their expertise to
    the task of identifying commercial real estate loans that can be safely
    exempted from the risk retention requirement.
    The Bill Would Weaken the Exemption for Qualified CREs
        The bill would also dilute the protections in the risk retention
    rule applicable to qualified commercial real estate loans. These loans
    are exempt from the risk retention requirement provided they have
    certain attributes that make them relatively low risk. The risk
    retention rule currently specifies the features of qualified commercial
    real estate loans that make them eligible for the exemption. However,
    the bill would eliminate some of those features and actually prohibit
    the agencies from taking them into account when defining the universe
    of qualified loans.
        For example, the bill would permit interest-only loans to qualify,
    even though such loans can adversely affect repayment ability at
    maturity due to the absence of any principal reductions. In addition,
    the bill would prohibit minimum loan term requirements (now set at 10
    years), and it would extend the maximum allowable amortization schedule
    to 30 years (now set at 25 years). It would also bar the application of
    separate loan-to-value caps to account for the risk associated with
    appraisals that use lower capitalization rates than other loans. Yet
    each of these loan characteristics is associated with weaker
    underwriting and heightened risk.
        In short, this bill would create a new exemption from the risk
    retention requirements for all single commercial real estate loans and
    groups of related loans. It would also water down the qualified loan
    exemption, broadening it to encompass loans of lower quality. These
    changes are likely to harm investors and increase the chances for the
    accumulation of systemic risk in the securitization market for
    commercial real estate loans.
    H.R. 3868--Deregulation of Business Development Companies
        H.R. 3868 would weaken multiple regulatory safeguards that govern
    the operation of BDCs. We have concerns, shared by the SEC, that the
    bill would expose investors to significantly greater risk, while
    diverting capital away from the companies they are intended to serve.
        Congress established Business Development Companies in 1980 as a
    special type of closed-end investment company. Their principal mandate
    is to invest in small, growing, or financially troubled businesses,
    many of which cannot obtain credit through more mainstream banking
    channels. To help ensure that BDCs fulfill their underlying purpose,
    the Investment Company Act (ICA) requires BDCs to provide managerial
    assistance to its portfolio companies.
        BDCs already present heightened levels of risk, due to the nature
    of their portfolio companies and the regulatory exemptions they enjoy
    under the ICA. For instance, BDCs are permitted to use more leverage
    than a traditional closed end fund, including a 1-to-1 debt-to equity
    ratio, as opposed to the more conservative 1-to-2 ratio applicable to
    other funds. And they can issue multiple classes of debt securities.
    However, even as it relaxed the regulatory requirements applicable to
    BDCs, Congress recognized that it was important ``to avoid compromising
    needed protections for investors in the name of reducing regulatory
    burdens.'' \13\
    ---------------------------------------------------------------------------
         \13\ See H.R. Rep. No. 1341, 96th Cong., 2d Sess. 20-23 (1980).
    ---------------------------------------------------------------------------
        The proposed bill changes the nature of BDCs by allowing them to
    increase their leverage; invest more money in financial companies
    rather than operating companies; and even purchase a registered
    investment adviser.
    The Bill Would Double Permitted Leverage
        The bill would allow BDCs to borrow more and double their already
    preferential leverage level. Because leverage magnifies potential
    losses as well as gains, this change would expose investors to a
    substantially increased risk of loss. Such losses would fall largely on
    retail investors, as they hold most BDC securities.
        The current trends in BDCs cast further doubt on the wisdom of this
    approach. The BDC universe has expanded rapidly over the last 15 years,
    both in terms of the number of BDCs in operation and their total
    assets. From 2003 to 2015, for example, BDC net assets rose ten-fold,
    from $5 billion to over $52 billion. \14\ On the other hand, reports
    have recently emerged that BDCs are becoming overleveraged even under
    existing regulations. \15\ Adding a new layer of leverage risk under
    these circumstances would seem to be especially unwise.
    ---------------------------------------------------------------------------
         \14\ SEC Chair Mary Jo White, Letter to Representatives Hensarling
    and Waters, Nov. 2, 2015.
         \15\ Fitch: ``BDC's Are Getting Overleveraged'', Barron's (Apr.
    25, 2016).
    ---------------------------------------------------------------------------
    BDCs Would Be Able To Divert Capital From Operating Companies to
            Financial Companies
        H.R. 3868 would also allow BDCs to invest greater amounts in
    financial companies, thus diverting capital from the types of operating
    businesses they were intended to assist. Today, BDCs are required to
    invest 70 percent of their funds in small- or medium-size operating
    companies, referred to as ``qualifying assets'' or ``eligible portfolio
    companies,'' which have often been rejected by ordinary funding
    institutions. Congress did allow BDCs to diversify their holdings by
    investing 30 percent of their funds in other securities, including
    financial firms. The 70 percent-30 percent asset holding structure of
    BDCs was selected after careful consideration and it was ``chosen by
    the [Senate Banking Committee] as a matter of compromise between the
    [SEC] and the business development industry.'' \16\ The 70 percent
    requirement was clearly intended to direct BDC investments toward the
    small businesses that actually produce goods and services.
    ---------------------------------------------------------------------------
         \16\ S. Rept. No. 96-958, 96th Cong., 2d Sess. 23.
    ---------------------------------------------------------------------------
        This bill would expand the definition of ``qualifying assets'' to
    include other types of securities, including those issued by banks,
    brokers, insurance companies, and consumer finance companies, subject
    to a limit of 20 percent of total assets. With this new provision in
    place, BDCs could actually invest up to 50 percent of their assets in
    noneligible portfolio companies, including financial firms. Allowing
    such an increase in funding for financial firms would decrease the
    amount of funding directed to true operating companies by almost 30
    percent. This approach conflicts with the basic rationale for the
    creation of BDCs: channeling capital to businesses in the real economy.
    BDCs Would Be Able To Own a Registered Investment Adviser
        Additionally, the bill would allow BDCs to own registered
    investment advisor firms. This too would divert capital away from the
    operating companies that BDCs were intended to serve. And it would
    enable a BDC, through control of its adviser, to circumvent various
    limits on BDC activities. For example, if the BDC's adviser were to
    manage a number of private funds, and invest BDC money in those funds,
    then it could exceed the BDC leverage limits as well as limits on a
    BDC's investment in financial companies. In addition, the adviser's
    clients would be exposed to conflicts of interest arising from the
    adviser's recommendation to invest in the parent BDC or its portfolio
    of companies.
        In sum, these provisions in H.R. 3868 violate Congress's original
    admonition to avoid comprising necessary investor protections in the
    name of reducing regulatory burden.
    Conclusion
        Thank you again for the opportunity to appear at this hearing
    today. I look forward to your questions.
                                     ______

                        PREPARED STATEMENT OF DREW FUNG
    Managing Director and Head of Debt Investment Group, Clarion Partners,
            on behalf of the Commercial Real Estate Finance Council
                                  May 19, 2016
        Thank you Chairman Crapo and Ranking Member Warner for the
    opportunity to testify today. My name is Drew Fung. I am a Managing
    Director and Head of the Debt Investment Group at Clarion Partners. I
    am testifying today on behalf of the Commercial Real Estate Finance
    Council, or (CREFC), where I am a Member of the Executive Committee.
        CREFC is the collective voice of the roughly $3 trillion commercial
    real estate finance market. CREFC's 300 member firms include balance
    sheet, Agency and Commercial Mortgage-Backed Securities (CMBS) lenders
    as well as loan and bond investors and servicing firms. Our industry
    plays a critical role in financing properties of all types in all 50
    States including apartments, nursing homes, grocery, and retail, just
    to name a few.
        My testimony will focus on the CMBS industry. In today's economy,
    CMBS is an essential financing vehicle for the U.S. economy. However, a
    plethora of new rules and regulations could dramatically affect CMBS
    liquidity, and thereby undermine the viability of this critical source
    of funding.
    Introduction
        The legislators and regulators had a daunting mission in restoring
    the health of the financial services sector following the financial
    crisis and the Great Recession. Eight years later, we have the benefit
    of empirical data and anecdotal experience about the very real costs of
    a macroeconomic crisis and also, the costs of regulation. Underpinning
    this data, it is now also a generally held view that deceleration in
    growth is likely to be a longer term feature of the national and global
    economies.
        It is within the context of this growth picture that we must
    revisit our regulatory regime, and specifically its deleveraging
    objectives. It is critical to note that the Group of Twenty (G20) first
    added financial regulation to its agenda in 2009, broadening and
    enhancing the role that the international regulatory bodies played in
    determining home country requirements. At that time, goals for reducing
    leverage in the system were based on trends and observations ending
    with the deepest points of the mark-to-market losses. At the same time,
    there was little attention paid to the economic effects of regulation.
    It still remains a challenge to determine the collective effects and
    costs of the cumulative regulations aimed at the structured finance
    marketplace, partly because the rules are still being written, partly
    because some final rules have yet to take effect, and partly because
    they are so complex. Even so, many countries are seriously
    reconsidering the burden of the future regulatory agenda, given
    entrenched headwinds to growth. Some are not only contemplating, but
    also actively pursuing, relief for securitized products in order to
    support growth. \1\
    ---------------------------------------------------------------------------
         \1\ The below article discusses some of the measures being
    considered by the European Union: http://www.wsj.com/articles/eu-
    proposes-new-capital-rules-to-boost-securitization-1443610493.
    ---------------------------------------------------------------------------
        More recently, the CMBS market has seen excessive and sustained
    dislocation, also referred to as ``illiquidity''. To a certain degree,
    geopolitical events are to blame for some of the distress that many
    markets experienced in February and March, yet these events do not
    account for all the distress. While other fixed income asset classes
    started to trade more normally in recent months, CMBS continued to
    exhibit numerous signs of relative distress. What accounts for this
    lagging effect on CMBS?
        Market participants are unanimous in their belief that regulation
    is driving much of the present strategic decisions, and the effects of
    that regulation are causing the market to grow thinner and more
    fragile. Despite the fact most participants agree that credit trends in
    the commercial property market remain healthy, issuers and investors
    alike have shed staff, cut their budgets and reduced allocations. Some
    even closed their doors.
        Weeks after researchers and other market watchers released their
    2016 issuance forecasts (as high as $125 billion), many if not most,
    reissued forecasts at roughly half of their original numbers.
    Commercial Mortgage Alert published an estimate of $50-60 billion in
    their most recent issue (05/13/16). In other words, with little to no
    stress, and despite the fact that many other fixed income asset classes
    regained their stride after the February pounding of oil prices and
    other macroeconomic challenges, the CMBS market continued to see record
    levels of volatility. \2\
    ---------------------------------------------------------------------------
         \2\ As measured by the standard deviation of swap spreads, which
    are the benchmark off of which CMBS are priced. Higher standard
    deviations indicate lack of liquidity. Current readings in CMBS suggest
    that the market is undergoing significant stress.
    ---------------------------------------------------------------------------
        While the regulators periodically revisit the deleveraging question
    in speeches and analyses, the U.S. regulators, in particular, seem
    unwilling to meaningfully investigate the role that regulation is
    playing in the fracturing of markets, fund flows, and the global
    slowdown. This frustration was felt by CREFC members while submitting
    comments during the agency rulemaking processes. There are countless
    instances in which our trade association and others provided well
    researched and documented analyses of the CMBS and other structured
    products markets. Yet, the regulators answer with rule requirements
    that are less tailored than they need to be for each asset-class, let
    alone CMBS, in order to maintain the organic efficiencies of the market
    in favor of simplifying the regulatory regime globally. Now that the
    CMBS market is exhibiting severe distress, and there is evidence of a
    negative feedback loop between poor liquidity conditions, lending rates
    and capital raising, the effects of regulation must be addressed, and
    done so quickly.
        A strong contingent of CREFC's members believe that regulatory
    burden is responsible for reducing liquidity in and weakening the
    resilience of our market, despite the impact of geopolitical forces.
    Many believe that liquidity is the CMBS linchpin and that the
    regulations are causing permanent damage to it. Yet, even buy-and-hold
    investors, such as the pension fund universe (that is reportedly 6.99
    percent invested in real estate) \3\ need market liquidity in order to
    be able to meet their own regulatory and fiduciary requirements.
    ---------------------------------------------------------------------------
         \3\ According to a recent survey, U.S. institutional tax-exempt
    exposure to real estate debt and equity grew to $835 billion. One of
    the largest Asset Managers, TIAA-CREF, has $82 billion, or 9.4 percent,
    in exposure of a total of $866 billion in AUM as of 3/31/2015. http://
    www.pionline.com/article/20141027/PRINT/310279999/real-estate-managers-
    back-over-1-trillion-again
    ---------------------------------------------------------------------------
        CREFC and its members believe that thoughtful regulation can be a
    net positive and that some of the new regulatory requirements have
    improved the marketplace and the alignment of interest between issuers
    and investors. While the broad intent of the regulations is well
    founded, the overwhelming burden of rules that lack tailoring to the
    characteristics of different asset classes provides little marginal
    prudential improvement, if at all. At the same time, these rules
    generate significant costs to the end users (i.e., borrowers and
    consumers) and to savers whose investments are devalued as a result.
    Consequently, there is a growing chorus of urgent concerns from all
    ends of the industry that regulation is institutionalizing
    inefficiencies and may even severely disable liquidity for the CMBS
    market permanently.
        Moreover, lenders and investors agree that a dislocation in CMBS
    will travel quickly throughout the commercial real estate (CRE) debt
    and equity markets, impacting valuations and fundamentals. Certain
    aspects of the marketplace are so fragile today--even before half of
    the planned regulations come into place--that CMBS is experiencing
    severe pricing volatility, a marked contraction in issuance and
    reduction in capacity. We are working on borrowed time to investigate
    the solution and to initiate remediation, especially given the current
    schedule of new rules in the pipeline.
    CMBS the Asset Class and Historical Performance
        The securitization of commercial mortgages began out of the
    necessity to clean up the balance sheets of taxpayer-backed depository
    institutions in the late eighties and early nineties. A combination of
    excess development in the wake of strong commercial property demand, a
    subsequent economic downturn, tax reform, and loose credit from
    depository institutions led to a drastic overbuilding of office
    properties. By 1989, 534 depository institutions had become insolvent
    due to imprudent loans. Congress created the Resolution Trust
    Corporation (RTC) in 1989 to dispose of the failed institutions'
    assets. In turn, the RTC pooled the mortgages and sold them off as
    diversified bonds, creating the first CMBS transactions. Since then,
    the market has become much more transparent and investor centric. \4\
    ---------------------------------------------------------------------------
         \4\ Alan C. Garner, ``Is Commercial Real Estate Reliving the 1980s
    and Early 1990s?'' https://www.kansascityfed.org/publicat/econrev/pdf/
    3q08garner.pdf (2008).
    ---------------------------------------------------------------------------
        Credit retracted nationally across industries in the nineties. Not
    only had the universe of lenders shrunk dramatically, but the few banks
    that could lend on property were reluctant to do so, prompting
    innovative financiers to bypass the banking system for the capital
    markets. They pooled commercial loans and sold bonds tied to those
    loans to sophisticated institutional investors from pension funds and
    insurance companies. By 1998, issuance topped $50 billion per year, and
    by 2007, issuance topped $200 billion per year. \5\
    ---------------------------------------------------------------------------
         \5\ Sam Chandan, ``The Past, Present, and Future of CMBS'', http:/
    /realestate.wharton.upenn.edu/research/papers/full/730.pdf (2012).
    ---------------------------------------------------------------------------
        One of the attractive features of CMBS was that institutional
    investors (entities with monthly, quarterly or actuarially driven cash
    flow obligations) could achieve greater diversification across
    geography and asset class than by purchasing or originating whole loans
    themselves. Instead of owning a $50 million loan on a single property,
    the investor could purchase $50 million worth of bonds equally
    diversified on a pro rata basis across 40-100 loans in 10-30 individual
    markets. And importantly, the investor could decide how much risk they
    wanted to take based on a bond's seniority in the capital structure and
    the duration of the security. The most secure bonds received cash flow
    payments first, while the riskiest bonds last. In the event of a
    distressed sale, bond holders are paid before the borrower who
    contributed the equity. Typically, these securities offer more yield,
    transparency, and diversification than similarly rated corporate bonds.
        At the asset level, an investor, generally a business entity (a
    partnership or corporation), seeks to purchase a commercial property
    and obtain debt financing for that transaction. Each commercial
    property can be thought of as a self-contained business with an income
    statement and balance sheet. The rents charged to use a property--
    including monthly apartment, office, or retail rents--serve as the
    ``sales'' or revenue for the business.
        Similarly, a property has expenses in the form of third-party
    property management fees (landscaping, maintenance, etc.), property
    taxes, insurance, leasing expenses (as in the case of an apartment
    leasing manager, or a retail leasing agent, who go and find renters for
    the property), and noncapitalized annual repairs to the property. These
    expenses subtracted from total revenues represent the property's profit
    and loss, or ``P&L''. It is through this number that all applicable
    underwriting calculations, such as debt service coverage ratio (DSCR),
    whether from the investor or lender, are calculated.
        The property owner's ability to pay off debt is not measured (since
    all CMBS loans are nonrecourse), but rather, the property's, or
    business's ability to service monthly payments is measured. A mid- to
    long-term holder of commercial property, regardless of property type,
    buys a building based on how much cash flow, or yield, the asset will
    generate each year, and considers hundreds of data points (ongoing
    surveillance of CMBS is reported on a monthly basis via the CREFC
    Investor Reporting Package (the ``IRP''), a monthly report with over
    750 data fields and supplemental reports providing insight into asset,
    loan, and bond level performance, as well as the final disposition of
    specially serviced CMBS loans, \6\ in addition to a business plan that
    includes market information ranging from demographics, supply and
    demand factors for the asset type, and relative positioning to
    comparable products.
    ---------------------------------------------------------------------------
         \6\ For information on the IRP, please visit: http://
    www.crefc.org/irp or see Appendix A. This information anticipated by
    almost 20 years asset-level information now required by the SEC for
    other asset classes.
    ---------------------------------------------------------------------------
        Post-financial-crisis (also known as ``CMBS 2.0''), there are two
    distinct CMBS markets: the conduit market and the single-asset single-
    borrower (SASB) market. The conduit market pools commercial mortgages
    ranging in size from $2 million to over $100 million (but generally not
    more than $100 to $300 million). These loans are collateralized by
    stabilized, cash-flowing properties with three years of operating
    history and professional ownership. As thousands of small banks either
    closed their doors or were purchased by larger firms in the wake of the
    2008 credit crisis, conduits remain a substantial source of debt for
    secondary and tertiary market real estate operators. Conduit financing
    provides capital for grocery store shopping centers, strip malls,
    family owned hotels, shopping malls, and apartment buildings.
        The other type of CMBS lending is SASB loans. These loans typically
    are larger than $250 million and are made on a single, large property
    or portfolio of properties owned by one borrower such as large, well-
    capitalized, public and private real estate companies. Last year, SASB
    made up over one-third of the total CMBS market, up from roughly 10
    percent historically.
        Institutional investors enthusiastically invest in SASB bonds. The
    demand for this market came about as banks and insurance companies were
    unable or unwilling to offer their balance sheets to finance trophy
    buildings or portfolios of properties. The credit characteristics of
    these loans are highly desirable--often many times oversubscribed by
    investors. Due to the durable nature of CRE's cash flow, and
    subsequently the CMBS bonds, the asset class as a whole has performed
    extremely well. The all-time cumulative loss rate for SASB transactions
    is 0.25 percent, and 2.79 percent for conduit transactions. \7\
    ---------------------------------------------------------------------------
         \7\ As of 08/31/2013, per CREFC's comment letter to regulators.
    ---------------------------------------------------------------------------
        SASB transactions performed better in the depths of the crisis than
    most fixed income markets perform under efficient market conditions.
    Due to the structure and transparency of SASB deals, investors were
    (and still are) able to make informed decisions. With performance
    characteristics such as these, it is fairly improbable that regulation
    could benefit the market. Indeed, when members of the regulatory
    community have been asked this question, often the answer is that it is
    difficult for the agencies to grant exceptions. CREFC discussed these
    issues at length with the Agencies responsible for crafting the risk
    retention, and our list of submissions to the regulators can be found
    in Appendix B. \8\
    ---------------------------------------------------------------------------
         \8\ See CREFC's Letter to various regulators on Risk Retention:
    http://docs.crefc.org/uploadedFiles/CMSA_Site_Home/
    Government_Relations/Financial_Reform/Risk_Retention/
    Risk%20Retention%20Proposed%20Rule%20Comment%20Letter.pdf.
    ---------------------------------------------------------------------------
    Why CMBS: Borrower Access to Credit
        CMBS provides the most democratic and cost effective method of
    financing for small real estate assets. While SASB financing makes it
    possible to spread the risk of a large dollar loan on a single
    property, conduit financing is an essential component of the main-
    street CRE market. If traditional credit providers--banks and life
    companies--service the borrowers who need mid-sized loans, then CMBS
    serves the ends of the barbell, with SASB transactions that are too big
    for a single institution to handle on one end, and loans on small,
    privately owned real estate companies and syndicates that make up 90
    percent of CRE ownership on the other.
        In 2015, CMBS provided 21 percent of all of all CRE loans. This is
    the sector's largest financing source, followed only by agency debt (18
    percent) and regional banks (16 percent). Annual originations by banks
    and life companies ebb and flow, but have generally been steady and
    limited to specific niches. While CMBS's 50 percent market share in
    2007 was arguably too high, as witnessed prior to the crisis,
    securitization has proven to pick up a large portion of the slack that
    portfolio lenders and the Agencies typically eschew.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        One of the most popular sentiments expressed by all types of CREFC
    members (buy- and sell-side) is that the broader CRE market needs CMBS
    in order to function efficiently and to fill the gap in financing needs
    posed by underserved borrowers in smaller cities and suburban areas.
    For instance, Idaho currently has over $1.1 billion worth outstanding
    loans distributed across cities including Boise, Twin Falls, and
    Meridian. Similarly, Virginia and Massachusetts currently have over $26
    billion and $17 billion, respectively, in outstanding CMBS financing
    (please see Appendix G for a breakdown of each State's outstanding CMBS
    loans).
        The CMBS market represents a core source of capital that cannot
    easily be replaced. When new issuance is halved in a single year,
    especially one in which there are significant refinance needs, it is
    realistic to expect a broader market disruption. During liquidity
    interviews, CREFC members had significant concerns over the impact a
    declining new issuance market would have on bond values, and more
    importantly, property values. Members noted that all things being
    equal, removing 20 percent of available debt capital from the
    marketplace would surely depress property values. Members also noted
    that they did not see a ready alternative to CMBS financing--that is,
    long-term, fixed rate mortgages. Instead, bank participation will be
    declining as the regulatory regime is ramped up across all banks, big
    and small, and as the regulators enforce limits on CRE exposures.
        Maintaining availability of CMBS financing is even more critical
    following regulatory warnings regarding CRE concentrations at banks.
    Many bank lenders in our membership report intentions to maintain,
    instead of grow, loan levels, which means that any reduction in the
    CMBS market should represent a reduction in capital availability across
    the sector. While some 1Q 2016 data series indicated that loan levels
    are still growing, the spurt in the first quarter represents loans that
    were negotiated before the end of the year and the prudential agencies
    published a warning to the CRE lenders. \9\ Indeed, the April 2016
    Senior Loan Officer's Opinion Survey reflected a tightening of
    underwriting standards across the industry for the first time in this
    cycle, FRB: Senior Loan Officer Opinion Survey on Bank Lending
    Practices and this is considered to be a leading indicator of future
    trends. Industry watchers report that the CRE loan pipeline has
    contracted in 2Q 2016, which should be reflected in the second half of
    the year.
    ---------------------------------------------------------------------------
         \9\ https://www.federalreserve.gov/bankinforeg/srletters/
    sr1517.htm
    ---------------------------------------------------------------------------
    Evolution of the CMBS Market Before and After the Crisis
        The CMBS market is generally viewed in two historical segments--
    CMBS 1.0, which existed before the crisis, and CMBS 2.0, which
    commenced after the crisis. The reason that the two phases are
    delineated is that the CMBS market has greatly evolved in several
    critical ways since the crisis: (1) pro forma (aspirational)
    underwriting is infrequently mentioned and in fact, underwriting
    criteria have been tightening; \10\ (2) CMBS deals include much greater
    levels of subordination, or cushion, to absorb potential losses (see
    exhibit below); (3) collateralized debt obligations (CDOs) backed by
    CMBS are no longer issued; and, (4) even greater transparency and
    information is provided to investors.
    ---------------------------------------------------------------------------
         \10\ http://www.federalreserve.gov/boarddocs/snloansurvey/201605/

     [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        Recent economic conditions were primed to result in a return of
    aggressive lending and funding. Environments marked by low rates and
    improving credit trends, as we saw in recent years, are prime
    ecosystems for higher leverage, because the economics work. However,
    risky leverage did not return to the CMBS market. In fact, the opposite
    happened. The levels of loan and deal level leverage remained much
    lower than in CMBS issued prior to the crisis (CMBS 1.0). Importantly,
    the double leverage that came with CDO funding seems to be wrung out of
    the system.
        Early regulatory and industry intervention at the beginning of the
    crisis were indeed the integral in weeding out the most ambitious
    lending and financing forms from the CMBS industry. The combination of
    accounting changes and additional requirements of the rating agencies,
    as well as other rules helped to stabilize the CMBS market starting in
    2010. While the Term Asset Backed Loan Facility (TALF) did support
    several CMBS transactions, the TALF's activities in the commercial
    market were limited. In other words, the market participants agreed on
    a new architecture which instilled the requisite confidence from both
    buy and sell sides. This caused the market to rebound with little
    assistance from the TALF facility established to liquefy the market
    during the crisis.
        Indeed, CREFC members played a vital role in this stabilization, as
    our community contributed a critical new feature of the CMBS 2.0
    (postcrisis CMBS) marketplace--additional transparency measures in the
    form of the IRP, described in detail above, and in Annex A, which is
    the deal package. (See Appendix A for more details on CREFC IRP). These
    two transparency measures are proof that through the leadership of
    CREFC, the CMBS industry has self-regulated over the years as investors
    demanded standardized deal documents and up-to-date performance data.
    \11\ However, regulators gave the industry little credit for these
    self-imposed reforms.
    ---------------------------------------------------------------------------
         \11\ A full list of these self-regulatory measures is available in
    CREFC's letter to the Federal Reserve System, the FDIC, Treasury, the
    SEC, and the OCC: http://docs.crefc.org/uploadedFiles/CMSA_Site_Home/
    Government_Relations/Financial_Reform/Risk_Retention/
    Risk%20Retention%20Proposed%20Rule%20Comment%20Letter.pdf.
    ---------------------------------------------------------------------------
        In 2009, CMBS issuance had collapsed to almost $0 from a height of
    $231 billion in 2007. Issuance rebounded to roughly $100 billion in the
    private label market last year. Until recently, many bonds had excess
    bidders and the CMBS market enjoyed inflows of capital correspondent
    with performance. It seemed that despite low interest rates, market
    participants generally agreed that CMBS was functioning well in the
    main.
        As a result, CMBS 2.0 has continued to evolve. First, more
    stringent accounting and rating agency rules resulted in greatly
    reduced economic incentives for CDO structuring. Now that CMBS are not
    releveraged through CDOs, the dollar value of investable capital is
    lower today than it was when interest rates were higher. Second, the
    rating agencies have all significantly revised their models and
    required much greater amounts of subordination. As a result, the bonds
    at the bottom of the stack that absorb losses have roughly doubled.
    Third, better transparency in the form of Annex A and the IRP, now in
    its 8th version, has reinforced better underwriting standards and more
    extensive due diligence. While the market is constantly evolving, CREFC
    believes that these positive conditions are not temporary, but rather
    more permanent features of the CMBS 2.0 market and the upcoming CMBS
    3.0 market.
    Regulatory Regime and the Question of Effectiveness
        The CREFC community is generally supportive of prudent regulation
    that appropriately weighs the cost of the requirements with the
    corresponding benefit it is expected to achieve. In our comments to the
    various regulators, including the Securities and Exchange Commission
    (SEC), we made this fact known and expressed a desire to work with them
    in identifying solutions that would enhance positive market practices,
    including those put in place by the CMBS market itself. Currently, the
    CMBS market is subject to an extraordinary amount of direct regulation,
    and many of these measures have the impact of treating CMBS more
    harshly than other asset classes (e.g., Fundamental Review of the
    Trading Book and Liquidity Coverage Ratio). Further, there are
    innumerable rules that indirectly impact the market by greatly changing
    the conditions under which the entire financial system operates. These
    rules then drive the conditions in which CMBS functions. Of the subset
    of these new rules that affect CMBS most directly, there are:

        the accounting changes FAS 166 / FAS 167;

        rating agency rules;

        Regulation AB II (a set of disclosure requirements);

        reporting requirements to the TRACE facility;

        Volcker Rule (which sanctions CMBS market making but
            presents a set of very high hurdles for compliance);

        Basel III leverage ratio (which affects how market making
            desks fund themselves with repurchase agreements);

        Liquidity Coverage Ratio (LCR);

        Net Stable Funding Ratio;

        Risk based capital rules; and

        Risk Retention rule (which requires that issuers hold 5
            percent of a securitization).

        Last year, CREFC produced a study \12\ of the regulatory impacts on
    the CRE sector overall and found through interviews and quantitative
    analysis that taken together, regulation has done some good things for
    our sector, but it has also reconfigured the structure of the markets
    in such a way that makes it ultimately less resilient in times of
    stress. These outcomes generally run counter to broader policy goals of
    maintaining sound functioning markets and supporting sustainable
    growth. Broadly speaking, the rules under the Dodd-Frank Act and also
    the various components of Basel III discriminate against longer-term
    assets and those that are not highly standardized, such as residential
    mortgages. At the same time, there is little acknowledgment of the
    unique transparency in the CMBS market or how the market functions
    differently than other asset classes that tend to be traded on more of
    a quantitative, and less on a fundamental, basis.
    ---------------------------------------------------------------------------
         \12\ http://www.crefc.org/CREFC/Publications/
    Regulatory_Impact_Study/CREFC/Resources/
    Regulatory_Impact_Study.aspx?hkey=47af34d5-3cea-43e1-942f-309fd7508928

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    CMBS Liquidity and Market Resiliency
        The universal concern of all industry participants is that the
    constant march of new regulatory requirements will create such a drag
    on margins that a critical mass of participants will exit. Many CREFC
    members have commented on this likely end game for CMBS now that they
    can envision a more complete regulatory timeline.
        Starting with the risk retention rule, which goes into effect on
    December 24, 2016, borrowers, issuers, and investors are keenly
    analyzing implementation at this time. CREFC gathered estimates last
    year and found that the regulation would likely add roughly 10 percent
    to the interest rate the borrower pays. This number was calculated
    assuming stable conditions and before CMBS participants started to
    consider the implementation challenges in earnest. Based on a sampling
    of issuers and investors more recently, CREFC found that on average,
    our members believe that much of the current spread widening is driven
    by regulatory burden, suggesting that the 10 percent of marginal costs
    originally estimated will prove to be lower than the actual costs
    incurred in a volatile trading environment such as the one prevailing
    for some time now. Given that risk retention is the next piece of
    regulation to move into effect for our sector, it can reasonably be
    credited as the greatest driver of costs to the borrower at this time
    and one of our industry's top priorities. The regulatory factor is
    often cited as the driving force beyond continued spread volatility at
    this time, while other fixed income asset classes revert back to more
    stable trading environments.
        CREFC and the majority of its members have often supported
    differentiated treatment for SASB bonds, because the asset class has
    performed better than most other fixed income sectors, and in some
    ways, is simply the best performing sector through the crisis. Yet, the
    six regulators that were obligated to promulgate the risk retention
    rule, chose to include SASB deals in the coverage universe, even though
    there was very little, if anything, more that rules and restrictions
    could accomplish with the sector. \13\ The risk retention rule was
    written with conduit structures in mind, yet will also be applied to
    the SASB universe, despite the fact that the requirements cannot be
    adopted without wholesale restructuring the SASB model and the market
    with it.
    ---------------------------------------------------------------------------
         \13\ With an historical realized loss of 0.25 percent, SASB deals
    have performed remarkably well, which explains the spike in investors'
    demand for these bonds in recent quarters.
    ---------------------------------------------------------------------------
        Additionally, it is important to note that risk based capital rules
    and the LCR are steep for our sector, and, more importantly, they treat
    CMBS relatively poorly compared to other financial instruments.
    Additional rounds of Basel capital requirements will make CMBS even
    less viable. Based on a series of interviews conducted with market
    leaders since the beginning of 2016, the FRTB, which changes capital
    requirements for all inventories kept for market making purposes, has
    been cited as one of the most concerning pieces of regulation, if not
    the most. \14\
    ---------------------------------------------------------------------------
         \14\ Even after the Basel Committee on Banking Supervision reduced
    the risk weighted requirements for structured products in their final
    version of the standards published on January 14, 2016, industry
    participants anticipate that new U.S. rules may require that market
    makers maintain more capital than the market value of certain CMBS
    bonds.
    ---------------------------------------------------------------------------
        Even though the Basel Committee on Banking Supervision (BCBS),
    reduced the magnitude of the charges applied to CMBS in the final
    version of the FRTB published on January 14, of this year, these
    requirements place CRE-backed deals on par with subprime residential
    mortgages. In turn, it will be even more challenging to allocate
    capital to CMBS businesses, and ensures increased fragilities. The LCR,
    which is the first of two new liquidity requirements under Basel III,
    is also an example of a punitive approach toward all nonsovereign asset
    classes, but particularly, securitizations and CMBS. The LCR requires
    that CMBS issuers apply an additional cost to the production of their
    assets, even after they have been sold. The recently proposed Net
    Stable Funding Ratio follows the LCR's construction and is expected to
    additionally disadvantage CMBS relative to other asset classes.
    Other Countries Easing Regulatory Treatment of Securitizations
        In contrast to the tightening of the regulatory regime in the U.S.
    anticipated in the near future, the European Union is using the
    securitization markets to help restart growth. Policy makers across
    many jurisdictions and throughout legislative and banking authorities
    have recognized in many ways that the securitization markets can
    provide safe and alternative funding to the banking system. As such,
    the European Central Bank (ECB) is utilizing the financial technology
    as part of its small- and medium-sized business program.
        Additionally, the ECB and other European regulators have begun to
    consider how to ease the burden on safer securitizations through
    reduction of risk based capital requirements and other mitigating
    measures. Importantly, they have noted that compliance and accounting
    measures have increased the discipline in the markets and believe that
    an offset in the capital and liquidity requirements would be warranted.
        The European authorities are not the only jurisdictions
    contemplating a reduction in the regulatory burden on structured
    products. In light of slowing growth globally, other regulatory
    agencies have considered certain changes too, including China, Japan,
    and Australia.
    Regulation and Market Liquidity
        In short, these regulations are and will continue to have a
    significant impact on CMBS. The precipitous decline in CMBS liquidity
    (e.g., inventories, turnover, trade size), especially the prolonged
    spikes in swap spreads, are particularly troubling. These trends
    suggest that the market is trading inefficiently; in the absence of
    credit concerns, anticipation of the next round of regulation must be
    driving much of the volatility. Moreover, certain trends suggest that
    the pattern may be sustained for some time, if not deepened becoming a
    negative feedback loop as many have warned:

      a.  The number of market making platforms is declining rapidly,
            especially those that provide ``balance sheet'' and that can
            hold inventories. Based on a partial survey of the market in
            April, it appears that at least one in five people have been
            downsized this year, and at least one institution, the number
            is reversed; of five original market-making staff, one remains.
            One member investor speculated that there were 10 true dealers
            with capacity to hold inventories and to make markets across a
            range of new issues last year; that number was halved by year-
            end 2015 and as of this writing, the number is now down to two
            or three true market makers.

      b.  As expected, the investors who relied on liquidity--those who
            care more about total returns than relative value--have exited
            en masse in lock step with the liquidity providers, leaving a
            distinct and troublesome gap at the lower end of the bond
            stack.

      c.  Yet, buy-and-hold investors have reacted decisively to the
            distress in the market too by reducing allocations to the
            sector and many are actively retreating from the conduit
            market. All are concerned about the ability to price their
            investments accurately in a volatile market.

      d.  The proportion that CMBS represents in the Barclays Aggregate
            Index, which is the one of most often used fixed income
            benchmark indices, has declined significantly to 1.2 percent
            from a high of 5.7 percent, meaning that the demand for CMBS
            will continue to decline.

      e.  While there were roughly 40 conduit lenders and sellers last
            year, they too are closing their doors and now number roughly
            28.

      f.  The pipeline of new issues has been moving at a slow pace since
            April. The SASB deal calendar, especially, seems to be drying
            up in the summer with a couple of small deals scheduled in June
            and none in July. \15\ Both sides of the business are seeing
            smaller deal sizes, which also indicates general lack of
            liquidity and is a concern for both buyers and sellers.
    ---------------------------------------------------------------------------
         \15\ Commercial Mortgage Alert, 05/13/16.

      g.  The primary hedging instrument for the industry, the CMBX, has
            begun to trade very differently than the underlying cash bonds,
            which also indicates inefficiencies in the market and portends
            a deepening of the dislocation if pricing of the two products,
            the bond and the hedging instrument, do not become reasonably
    ---------------------------------------------------------------------------
            more correlated in their movements again.

        Demand for liquidity relative to market supply is stark. A survey
    of issuers, traders, investors and other market participants conducted
    by CREFC in early February suggests that, market-making capacity was
    already undercapitalized by one quarter to one half. Since then,
    additional traders have lost their seats, draining further capacity
    from the system.
    Recommendations and Conclusions
        Considering all of the perverse impacts of regulations--both
    individually and in the aggregate--our list of recommendations would be
    long, and mostly within the regulatory purview. As such, we began this
    process first by petitioning the regulatory community for correction
    and clarification. Regulators accepted some of our recommendations but
    also declined a good number. It is for this reason that we now seek
    Congressional intervention.
        From the legislative perspective, we urge the Members of this
    Committee to work together in a bipartisan fashion to introduce the
    companion to the bill sponsored by Representative French Hill of
    Arkansas. H.R. 4620, the ``Preserving Access to CRE Capital Act''
    addresses the challenges posed by the risk retention rule in a
    targeted, fair, and responsible fashion. Though the recommendations in
    the bill do not affect the core requirements codified in the Dodd-Frank
    Act, Section 941, \16\ they are meaningful and would have a positive
    impact on the marketplace. The majority of CREFC issuers, investors and
    servicers support the bill, however, there is a minority contingent of
    investors who support the final regulation without modification.
    ---------------------------------------------------------------------------
         \16\ Issuers/sponsors must retain 5 percent of the credit value of
    the bonds for 5 years, during which time the bonds cannot be hedged
    (except for interest rate and foreign exchange).
    ---------------------------------------------------------------------------
    Introduce and Report Out of Committee a Companion to H.R. 4620
        CREFC strongly supports the recommendations below, which restore
    the proper balance between protective measures and a healthy,
    functioning CMBS market for the borrowers and employers in every
    Congressional district. Specifically, the recommendations would: (1)
    exempt from the risk retention requirements the highly sought and
    extraordinarily transparent SASB transactions; (2) set reasonable
    parameters for regulating and designating as ``qualified'' certain
    high-quality commercial loans (QCRE Loans) under the risk retention
    rules; and (3) provide flexibility in structuring the retained interest
    to suit investors without modifying the amount nor relaxing the general
    restrictions surrounding the retained interests.
        First, the recommendations would address the issues related to the
    transparent and high-performing SASB transactions by making them exempt
    from the risk retention requirements. As mentioned above, SASB
    transactions are marked by superior performance--the SASB segment
    booked a mere 0.25 basis points in cumulative losses between 1997 and
    2013. This financing option is ideal for borrowers seeking to finance
    apartment complexes, hotels, office buildings, and, of course, gateway
    market ``trophy'' properties. Despite this superior performance,
    current regulations do not include an exemption for SASB transactions,
    which threaten to raise borrowing costs, decrease borrower choice in
    this market, and induce them to seek other modes of financing that may
    be less transparent and low risk (e.g., corporate bond markets).
        Second, the recommendations would put in place commonsense
    parameters for considering which CRE loans would be deemed
    ``qualified'' under the risk retention requirements. Currently, only a
    small percentage of CMBS loans would be considered as QCRE loans, and
    exempt from the risk retention requirements. Although modeled after the
    Qualified Residential Mortgage (QRM) exception, the application of QCRE
    has vastly different consequences. Surprisingly, private label
    residential mortgage-backed securities were given a generous set of
    qualifying requirements under the QRM standard; in fact, it is
    estimated that nearly all of today's RMBS loans would qualify for an
    exemption. Yet, conversely, in the CMBS space, the qualifying
    conditions are so onerous that only 3 percent-8 percent of all CMBS
    conduit loans written since 1997 would qualify for an exemption from
    the core 5 percent risk retention requirement. This has little sense of
    proportion or compelling rationale.
        H.R. 4620 would moderately widen the underwriting requirements for
    QCRE, thus helping maintain credit quality in this space, along with
    stable pricing and availability of financing for a broad swath of
    business owners. Specifically, the bill would allow pools of unrelated/
    unaffiliated, or conduit loans will be allowed to amortize over not
    more than 30 years (from the current 25-year standard); permit low-LTV
    interest-only loans to be treated as ``qualified'' where no authority
    was granted previously; and permit loans less than 10 years in term as
    qualifying for exemption under the QCRE rule. We expect that this would
    raise the QCRE percentage to about 15 percent of all loans, still well
    below all the RMBS loans that will qualify under the QRM exception. In
    other words, the parameters are targeted and responsible. In no way
    would it allow a blanket carve out for the CMBS community, rather it
    would only truly apply to transparent and highly performing loans.
        Third, under the risk retention rules, there are special rules for
    CMBS that allow a third-party investor to purchase the B-piece (known
    under the rule as the eligible horizontal residual interest, or
    ``EHRI''). The risk retention rule allows up to two third-party
    investors to share the 5 percent retention burden, but requires them to
    hold their positions pari passu (i.e., horizontally). The proposed
    legislation supported by CREFC would allow third-party purchasers to
    share the retention obligation pari passu or in a senior-subordinate
    (i.e., vertical) structure. H.R. 4620 does nothing at all to change the
    core retention requirement or any of the other requirements surrounding
    the B-piece investors. The core 5 percent retention requirement and all
    other general requirements (e.g., substantive due diligence, holding
    the interest for 5 years, etc.) would remain intact.
        The legislation allows for a reasonable amount of flexibility in
    how the B-piece is held internally by two purchasers. This flexibility
    will allow the B-piece buyer to match investor capital with the
    additional capital investment (the retained risk amount) that the rules
    require. For CMBS, the required amount of risk retained will be about
    two times that of what is currently invested by B-piece buyers in a
    typical CMBS deal. That is a massive amount of incremental capital B-
    piece buyers have to raise in order to be risk retention compliant. And
    that investment is essentially nontransferable--meaning that the funds
    raised will be ``parked'' in a single deal for at least 5 year.
    Obviously, this comes with an illiquidity premium that investors will
    seek--further increasing costs to borrowers. The senior-sub structure
    will be used to help align investors with this new retained risk
    requirement. It will not affect at all the amount of risk that must be
    retained, the underwriting due diligence required by the rules or the
    holding period requirements of the rules. It simply gives the industry
    flexibility to achieve the risk retention goals of the regulations and
    is supported by 14 real estate trade associations. \17\
    ---------------------------------------------------------------------------
         \17\ See Appendix B for Industry Support Letter to House Financial
    Services Committee
    ---------------------------------------------------------------------------
    Conclusion
        CREFC would like to thank the Members of this Subcommittee for
    providing us the opportunity to submit this statement. CREFC asks that
    the Subcommittee give serious consideration to the negative
    consequences of the latest round of rulemaking--consequences far beyond
    the CMBS markets. More to the point: without a robust and competitive
    CMBS marketplace our members anticipate a liquidity-driven stress event
    that could potentially take years to rebalance as market participants
    leave the arena for other lines of business. This imbalance will have
    far-reaching and profound effects on communities in a very visible way,
    by constricting the funding for commercial properties that we all come
    to rely on daily for our groceries, housing, workplaces, health care,
    education, and goods and services. In short, the roughly $200 billion
    of maturing CMBS debt in the next 2 years will need to be financed
    regardless of the actions Congress takes. In the absence of
    intervention and continuity of a competitive CMBS marketplace, we fear
    that buildings currently funded could fall into foreclosure, resulting
    in blighted, perhaps empty structures and loss of principal for
    America's pension and other investors and retirees.
        We remain optimistic that there is time to correct this looming
    liquidity crunch, and we are eager to work with Members of the
    Committee, and with Congress, to ensure that the discretely tailored
    recommendations become law.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

            RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN CRAPO
                       FROM MICHAEL J. AROUGHETI

    Q.1. Can you explain the impact of the ROE for BDC investors
    and how operating efficiently as a BDC structure can help
    investors earn better returns, especially compared to other
    financial services companies or products?

    A.1. A higher return on equity for a BDC translates into higher
    dividends for investors (due to the pass through nature of the
    earnings) and potentially growth in net asset value for the
    BDC. Research has shown that higher ROEs typically translate
    into improved stock price valuations for BDCs (see chart
    below). By operating more efficiently, a BDC can improve its
    ROE. There are several ways a BDC can improve its ROE through
    efficient operations: (1) given the positive spread between
    asset yields and borrowings, higher leverage results in
    improved ROEs, (2) increasing asset yields or reducing funding
    costs can improve ROE, (3) increased scale in assets can
    improve ROE as greater interest income is spread over some
    fixed operating costs.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        Over the last 2 years, large BDCs have generated higher
    returns on equity than comparable mid-size banks. As the chart
    below indicates, large BDCs have averaged returns on equity of
    over 9 percent compared to return on equity for the KBW mid-cap
    index ranging from 7.6 percent to 8.5 percent.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        BDCs have historically generated higher ROEs using less
    leverage. As the table below indicates, BDCs operate with
    average assets to equity of 1.89x compared to 8.88x for BBB
    Banks. In addition, the BDCs have favorable efficiency ratios
    compared to the banking sector.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    Q.2. During the hearing there was some discussion over whether
    institutional investors are more or less active in the BDC
    space. What is the data over the last 5 years?

    A.2. Institutional investors are still a very meaningful owner
    in the BDC sector and there has not been a mass exit of
    actively managed institutional accounts. In March 2014 the
    passive investment funds that tracked the Russell 2000 had to
    exit the space due to the removal of BDCs from the Russell
    indices. The removal was related to pressure exerted on the
    Russell by large passive funds and the additional fee
    calculations that were required with BDC ownership. While the
    removal was unfortunate (and ill-advised) it did not impact the
    majority of institutional investors for Ares, but it did have
    an impact on the majority of the BDC industry, triggering a 25
    percent reduction across the industry.
        Figure 1 provides data on institutional ownership in the
    BDC sector ($ ownership and average # of accounts). We would
    note that the number of institutional owners has increased but
    the $ amount in the sector has declined. We attribute the
    decline to two factors: (1) 10-12 percent of the sector
    holdings were in passive funds that exited BDCs in 2014 due to
    the Russell index exclusion and, (2) three of the BDCs in the
    data set (AINV, FSC, PSEC) have experienced significant issues
    post the recession and have price declines of -62 percent, -52
    percent, -40 percent, respectively. Excluding these outsized
    price declines the institutional ownership in the data set
    increased on a dollar basis by +16 percent over the past 5
    years (even with the Russell exclusion). Institutions are not
    avoiding fundamentally strong BDCs.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    Q.3. How does a registered investment advisor (RIA) help a BDC
    fulfill its core mission of providing capital for growing
    small- and middle-market companies and what guard rails might
    help ensure that it is not used for purposes well beyond the
    BDC's core mission?

    A.3. The proposed bill would allow BDCs to own registered
    investment advisers, which as a technical matter is currently
    prohibited under the 1940 Act. Investments in RIAs owned by
    BDCs serve as an extension of the BDCs' mission to raise
    capital from third party investors and then, in turn, deploy
    that capital to small- and medium-sized companies. For example,
    a large institutional investor may desire to make investments
    in small- and medium-sized U.S. private companies, but is
    unable to (or prefers not to) make such investments through the
    equity of a publicly traded entity such as a BDC. Finally, it
    is important to note that BDCs are currently able to, without
    restriction, own unregistered investment advisers.
        The SEC has recently issued exemptive orders on this topic,
    which include very specific conditions to be satisfied in order
    for a BDC to own, make investments in and grow an RIA. We
    believe that these conditions create sufficient existing
    ``guardrails'' to ensure that a BDC-owned RIA remains, as a
    general matter, focused on the BDC's core mission, stated
    investment objective, and Congress's 1980 mandate to create
    BDCs.

    Q.4. BDCs are investment vehicles open to retail or ``mom and
    pop'' investors. What has been the overall return to a retail
    investor in the BDC sector over the last 1, 3, 5, and 10 years,
    and can you compare it to other benchmarks?

    A.4. BDCs only have one class of stock (per regulation) and are
    attractive investment vehicles for both retail and
    institutional investors. The return to the retail investor and
    the institutional investor is exactly the same; there is no
    preferential treatment for either investment group. Figure 2
    below provides the total return in ARCC stock since IPO
    relative to the Wells Fargo BDC Index and the S&P 500.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        The chart below highlights ARCC and BDC sector total
    returns to investors over the last 1, 3, 5, and 10 year
    periods.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                                    ------

            RESPONSES TO WRITTEN QUESTIONS OF SENATOR BROWN
                          FROM STEPHEN W. HALL

    Q.1. During the hearing, there was discussion of the upcoming
    SEC rules requiring a floating net asset value (NAV) for
    institutional prime and municipal money market funds (MMFs). In
    particular, it was suggested that a floating NAV would reduce
    investor demand for municipal MMFs and then reduce demand for
    short-term obligations of municipalities. It was argued that
    these changes could raise municipalities' borrowing costs.
        Based on any publically available information, please
    describe your understanding of the assets under management
    (AUM) of (i) all municipal MMFs, (ii) institutional municipal
    MMFs (which will have a floating NAV under the new rules) and
    (iii) retail municipal MMFs (which will not be subject to a
    floating NAV). Please also discuss the market that retail and
    institutional municipal MMFs serve, in particular the
    identities of the purchasers of the funds and investments of
    the funds.

    A.1. Recent data confirm that the floating NAV will have little
    if any impact on municipal financing--Table 1 below sets forth
    information about the level of investment by institutional
    municipal MMFs in municipal debt. It confirms one of the key
    points that the SEC highlighted when it issued its rule
    implementing the floating NAV. In its 2014 release explaining
    the final rule, the SEC observed that the upcoming transition
    of institutional municipal MMFs to a floating NAV would likely
    have a minimal impact on municipal finance, because
    ``institutional tax-exempt funds hold approximately 2 percent
    of the total municipal debt outstanding and thus at most 2
    percent is at risk of leaving the municipal debt market.'' \1\
    ---------------------------------------------------------------------------
         \1\ SEC: Money Market Fund Reform; Amendments to Form PF (p.255)
    (emphasis added).
    ---------------------------------------------------------------------------
        Recent data confirm this point and it is critical to a
    proper assessment of the impact of institutional municipal MMFs
    on municipalities' borrowing costs. As reflected in Table 1,
    institutional municipal MMFs currently hold even less of the
    total $3.7 trillion municipal debt market today than in 2014,
    now amounting to only 1.22 percent or $45.7 billion dollars.
    This means that the floating NAV will have an even more minimal
    potential impact on the borrowing cost of municipalities .
    ---------------------------------------------------------------------------
         \2\ Data pulled from multiple publicly available sources are
    linked in this response.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        Recent trends in the level of investment in various types
    of MMFs support this conclusion. As reflected in Table 2 below,
    investment in all municipal MMFs has decreased somewhat over
    the last 6 months. However, the data suggest that this is not
    due to the floating NAV rule but is instead part of a broader
    trend. In fact, retail municipal MMFs have experienced a
    greater reduction in dollars invested than institutional
    municipal MMFs have experienced. Compare third and fourth
    columns in Table 2 (showing that nearly $3 billion more has
    been withdrawn from retail municipal MMFs than from
    institutional MMFs). Yet retail municipal MMFs will not be
    subject to the floating NAV, so the floating NAV cannot account
    for the decrease.
        Furthermore, retail prime MMFs have also experienced a
    nearly 16 percent decline in investment dollars over the last 6
    months. See sixth column of Table 2. They too will be exempt
    from the floating NAV, further indicating that any decrease in
    municipal MMF investment is actually part of a larger trend
    affecting nongovernmental MMFs, unrelated to the floating NAV.
    Any number of factors may be contributing to this trend,
    including a shift in demand due to ultra-low risk in government
    MMFs or recent volatility in the yields offered by MMFs.
    ---------------------------------------------------------------------------
        \3\ ICI Research and Statistics: ``Release: Money Market Fund
    Assets June 9, 2016'', and ``Summary: Money Market Fund Assets Data
    (xls)''.

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

        Even if the floating NAV were to have some dampening effect
    on the 1.22 percent invested in institutional municipal MMFs,
    it will not significantly reduce municipalities' access to
    financing. For example, even with the floating NAV in place,
    institutional investors will still have an incentive to seek
    out the beneficial tax exemptions associated with municipal
    MMFs. In addition, some investors may withdraw from
    institutional municipal MMFs but then migrate to retail
    municipal MMFs, causing no net change in funds invested in
    municipal MMFs. For example, as the SEC explained in the final
    rule, some retail investors currently invest in municipal MMFs
    through omnibus institutional accounts. Some estimates
    submitted to the SEC indicate that as much as 50 percent of the
    assets held in ostensibly institutional municipal MMFs are
    actually beneficially owned by institutions on behalf of
    investors. \4\ To the extent the rule prompts them to withdraw
    from institutional funds, they are likely to reinvest in retail
    municipal MMFs, with no negative impact on municipal financing
    via MMFs.
    ---------------------------------------------------------------------------
         \4\ SEC: Money Market Fund Reform; Amendments to Form PF (p.247).
    ---------------------------------------------------------------------------
        Finally, any impact of the floating NAV must be viewed in a
    larger context. The reforms adopted by the SEC in its rule are
    necessary to help mitigate the risk of another devastating
    financial crisis. \5\ In reality, as we explained in our
    testimony and in our comment letter to the SEC, \6\ the SEC
    reforms are only a partial solution, and more needs to be done.
    But at least they begin to address the proven threat to
    financial stability posed by MMFs, as exemplified by the
    dramatic run on the Reserve Primary Fund during the 2008
    financial crisis (see response to Question #2 below). The
    floating NAV is a critical element of those reforms. If it is
    rolled back, the risk of another devastating financial crisis,
    and its intensity, will increase. As we saw in 2008, such a
    crisis would throw all MMF markets into disarray, cause a
    massive and prolonged increase in unemployment, and ultimately
    devastate economic growth--to the detriment of local
    governments along with everyone else. The far wiser course is
    to allow all of the SEC reforms to go into effect,
    notwithstanding any minimal or speculative impact they may have
    on municipal financing obtained through MMFs.
    ---------------------------------------------------------------------------
         \5\ ``Better Markets, The Cost of the Crisis: $20 Trillion and
    Counting'' (2015), available at www.bettermarkets.com/costofthecrisis
    (incorporated herein by reference as if fully set forth).
         \6\ Testimony of Stephen W. Hall, Better Markets, Inc., Before the
    Subcommittee on Securities, Insurance, and Investment of the U.S.
    Senate Committee on Banking, Housing, and Urban Affairs, ``Improving
    Communities' and Businesses' Access to Capital and Economic
    Development'', May 19, 2016, at p.6 and n.11; Comment Letter From
    Better Markets to the SEC, Money Market Reform (Release No. 33-9408)
    (Sept. 17, 2013).

    Q.2. As discussed at the hearing, S. 1802 would allow MMFs of
    all types to use a stable NAV instead of a floating NAV. One
    witness, the Idaho State Treasurer, expressed concern that if
    prime institutional MMFs, which typically hold short-term
    corporate debt, are required to have a floating NAV, those
    funds could become less desirable and no longer satisfy his
    investment criteria. The impact on prime institutional MMFs may
    be difficult to quantify or predict, but those were among the
    investments that suffered significant distress during the
    financial crisis.
        Based on reports or studies, including by the Department of
    the Treasury or the Securities and Exchange Commission, how did
    the financial crisis impact prime institutional MMFs?
    Specifically, please discuss any data that describes the
    ``run'' on prime institutional MMF assets. Also, what kinds of
    companies are the typical investments of prime MMFs?

    A.2. Part 1: The 2008 financial crisis crippled prime
    institutional MMFs, and a future crisis would have the same
    devastating impact--The financial crisis made it painfully
    clear that MMFs present a serious risk of systemically
    significant runs and that those runs can cripple the short-term
    credit markets, potentially tipping the entire financial system
    into chaos. In the most compelling example of MMF run risk, the
    Reserve Primary Fund broke the buck on September 19, 2008, due
    to losses on debt instruments issued by Lehman Brothers
    Holdings, Inc. This nearly unprecedented event happened even
    though Lehman-related assets comprised only 1.2 percent of the
    fund's total assets.
        When the fund sponsors declined to provide support and
    priced its securities at $0.97 per share, a run immediately
    ensued. Within 2 days, investors sought to redeem $40 billion
    from the fund. This required the fund to sell tens of billions
    of dollars in assets immediately so that it could pay for the
    flood of shareholder redemptions. This fire sale in turn
    depressed asset values, further weakening the fund. The run
    quickly spread to the entire prime MMF industry, and during the
    week of September 15, 2008, investors withdrew approximately
    $310 billion (or 15 percent) of prime MMF assets.
        That September, over 90 percent of the redemptions from
    prime MMFS were from institutional not retail funds. This
    caused immediate havoc in the short-term funding markets,
    triggering a vicious cycle of asset fire sales, depressed
    prices, redemption requests, more asset fire sales, and rapidly
    evaporating liquidity. That month alone MMFs reduced their
    holdings of commercial paper by about $170 billion or 25
    percent. \7\ The run abated only after the Treasury, on
    September 19, 2008, established the Temporary Guarantee Program
    for Money Market Funds, and the Federal Reserve established a
    variety of facilities to support the credit markets frozen by
    the MMF crisis. \8\
    ---------------------------------------------------------------------------
         \7\ SEC: President's Working Group Report on Money Market Fund
    Reform, at 11-12 (Release No. IC-29497) (11/3/2010).
         \8\ See ``SEC Division of Risk, Strategy, and Financial
    Innovation, Response to Questions Posed by Commissioners Aguilar,
    Paredes, and Gallagher'', at 12 (Nov. 30, 2012), available at http://
    www.sec.gov/news/studies/2012/money-market-funds-memo-2012.pdf.
    ---------------------------------------------------------------------------
        Notwithstanding this unprecedented and massive intervention
    in what was then a $3.7 trillion market, the September 2008 run
    resulted in large and rapid divestment by MMFs in short-term
    instruments, ``which severely exacerbated stress in already
    strained financial markets.'' \9\ The decline in outstanding
    commercial paper contributed to a sharp rise in borrowing costs
    for commercial paper issuers. \10\ In addition, while the
    losses ultimately sustained by investors in the Reserve Primary
    Fund were modest, those investors suffered substantial
    liquidity damage, losing access to their money for an extended
    period pending the outcome of judicial proceedings. \11\
    ---------------------------------------------------------------------------
         \9\ See generally ``FSOC, Proposed Recommendations Regarding Money
    Market Mutual Fund Reform'', 77 FR at 66,464 (Nov. 19, 2012) (FSOC
    Proposal).
         \10\ ``FSOC Proposal'', at 69,455, 69,458, 69,464; ``Perspectives
    on Money Market Mutual Fund Reforms'', Hearing Before the S. Comm. on
    Banking, Housing, and Urban Affairs, 112th Cong. 6 (June 21, 2012)
    (Testimony of Mary Schapiro, Chairman, SEC) available at http://
    www.banking.senate.gov/public/
    index.cfm?FuseAction=Files.View&FileStore_id=66f4ddb5-4823-4341-bad9-
    8f99cdf5fe9a (Schapiro Testimony).
         \11\ Schapiro Testimony, supra n.8, at 6-7.
    ---------------------------------------------------------------------------
        The buckling of MMFs contributed heavily to the financial
    crisis, and all sectors of the economy paid a heavy price:
    ``Regardless of which metric you look at--long-term
    unemployment, number of foreclosures, small business growth,
    Federal R&D spending--there is irrefutable evidence that the
    financial crisis of 2008 and the subsequent Great Recession
    have set the U.S. and tens of millions of Americans back like
    no other economic calamity since the Great Depression.'' \12\
    MMF reform is essential to prevent a recurrence. As stated by
    the SEC, ``[w]ithout additional reforms to more fully mitigate
    the risk of a run spreading among MMFs, the actions to support
    the MMF industry that the U.S. Government took beginning in
    2008 may create an expectation for similar Government support
    during future financial crises, and the resulting moral hazard
    may make crises in the MMF industry more frequent than the
    historical record would suggest.'' \13\
    ---------------------------------------------------------------------------
         \12\ Better Markets: ``The Cost of the Crisis'', at 95.
         \13\ ``President's Working Group Report on Money Market Fund
    Reform'', at 18 (Release No. IC-29497) (11/3/2010).
    ---------------------------------------------------------------------------
        Part 2: The types of companies that are the typical
    investments of prime MMFs--The aggregated data from the SEC,
    reflected in Table 3 below, reveals that prime MMFs invest
    largely in private debt instruments but historically hold about
    20 percent of assets in Government issuances. The 80 percent is
    invested in two types of nongovernmental obligations:
    certificates of deposits from banks and thrift institutions,
    and short term issuances including commercial paper and
    securities issued by financial institutions, securitizers, and
    nonfinancial institutions.
    ---------------------------------------------------------------------------
        \14\ SEC Division of Investment Management: ``Money Market Fund
    Statistics'', at 13 (06/14/2016).

    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]