[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
__________
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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\
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\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
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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\
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\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.
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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.
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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\
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\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
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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\
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\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
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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.
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\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\
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\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.
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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.
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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.
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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.
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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.
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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.
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The chart below highlights ARCC and BDC sector total
returns to investors over the last 1, 3, 5, and 10 year
periods.
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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\
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\1\ SEC: Money Market Fund Reform; Amendments to Form PF (p.255)
(emphasis added).
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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 .
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\2\ Data pulled from multiple publicly available sources are
linked in this response.
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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.
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\3\ ICI Research and Statistics: ``Release: Money Market Fund
Assets June 9, 2016'', and ``Summary: Money Market Fund Assets Data
(xls)''.
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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.
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\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.
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\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\
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\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.
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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.
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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.
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\14\ SEC Division of Investment Management: ``Money Market Fund
Statistics'', at 13 (06/14/2016).
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