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







                                                        S. Hrg. 114-388


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

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

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

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

                    ONE HUNDRED FOURTEENTH CONGRESS

                             SECOND SESSION

                                   ON

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

                               __________

                              MAY 19, 2016

                               __________

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


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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
---------------------------------------------------------------------------
    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.
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Local Government Investment Pools
    As Idaho State Treasurer, I am both a manager of, and investor in, 
money market funds, as well as being a borrower from them.
    First, here is how the SEC floating NAV requirement impacted me as 
the manager, in Idaho, of an investment pool that is equivalent to a 
prime money market fund.
    I am responsible for the management of our LGIP, which we offer to 
Idaho municipalities and other local government subdivisions for their 
cash management. It has a daily balance in excess of $3.2 billion. 
LGIPs use amortized cost valuation to operate similarly to money market 
funds and offer their participants a stable, $1 unit price.
    Although LGIPs are exempt from registration under the Investment 
Company Act, and therefore not directly subject to Rule 2a-7, they are 
still subject to Government Accounting Standards Board (GASB) 
accounting principles. GASB sets accounting and financial reporting 
standards for external investment pools and pool participants. Until 
recently, GASB principles required LGIPs to follow 2a-7 like 
procedures. Thus, when the SEC said that ``non-natural persons'', such 
as Idaho local governments, can no longer benefit from amortized cost, 
our Idaho LGIP was faced with the prospect of not being able to comply 
with the GASB accounting principle.
    This past December, GASB acted to restore amortized cost to LGIPs 
by issuing accounting statement No. 79. \6\ It requires LGIPs to meet 
many of the requirements of Rule 2a-7, such as portfolio duration and 
maturity, quality of portfolio assets, diversification of investments, 
and portfolio liquidity, but ``de-links'' from Rule 2a-7 to permit 
LGIPs to continue to use amortized cost valuation and penny rounding, 
and thereby transact with participants at a stable NAV per unit or 
share.
---------------------------------------------------------------------------
     \6\ http://www.gasb.org/cs/
ContentServer?c==Pronouncement_C&pagename=GASBo/
o2FPronouncement_C%2FGASB SummaryPage&cid=1176167863852
---------------------------------------------------------------------------
    Your enactment of S. 1802 restores the stable, $1 per share of the 
money market fund by enabling any money market fund to elect to 
continue to use the amortized cost method of valuing its portfolio.
How S. 1802 Supports Liquidity Management
    Although, thanks to GASB, our LGIP is not subject to the pending 
floating NAV requirement of the SEC's Rule 2a-7, we are still impacted 
by that requirement. Like in other States, apart from LGIPs, we also 
invest public cash in financial instruments that meet the investment 
policies of our State code, as well our investment objective priorities 
of safety, liquidity and yield. Eligible instruments include 
Treasuries, U.S. Government agency securities, and stable value 
Government and prime money market funds.
    Safety of principal is the foremost objective of our investment 
program. That is why, in addition to Idaho's LGIP, State agencies and 
local municipalities also use money market funds where appropriate for 
specialized cash management applications. For example, at any point in 
time, Idaho agencies and public entities will have between $300 and 
$500 million invested in prime money market funds.
    If stable value prime money market funds are no longer a permitted 
investment option, Treasurers will have limited choices for using 
pooled investment vehicles to invest in financial instruments that meet 
the needs of their investment programs. Further, with over $400 billion 
in prime money market fund assets converting to Government funds, rates 
on U.S. Treasuries are being driven even lower.
    Even in the absence of the SEC's floating NAV requirement, 
liquidity management is an enormous challenge for State and local 
government entities. This makes enactment of S. 1802 doubly important. 
It will allow our liquidity management programs to continue to hold 
money markets funds in their portfolios that invest in assets other 
than U.S. Government securities. In addition to capital preservation, 
it will allow us to earn market rates of return throughout budgetary 
and economic cycles, which benefits our citizens.
Conclusion
    S. 1802 will do much to preserve Idaho's access to capital and 
economic development for our communities and businesses. It will 
preserve stable value money market funds as a safe, liquid, market-rate 
investment for our State's cash management needs, and as a source of 
capital for public infrastructure investment and businesses growth. At 
the same time, this legislation protects the positive changes adopted 
by the SEC in 2010 and 2014 that have mitigated risk in, and 
strengthened the resilience of, money market funds without disturbing 
the authority of the SEC to regulate money market funds in its 
discretion. In S. 1802, Congress properly exercises its discretion to 
draw the policy line between regulating money market funds and killing 
them by imposing a floating NAV requirement.
    I appreciate your leadership on this issue, Mr. Chairman, and 
encourage the full Senate to support S. 1802 and protect the liquidity 
and investment options of State and local governments and all other 
investors.


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



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


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


                 PREPARED STATEMENT OF STEPHEN W. HALL
     Legal Director and Securities Specialist, Better Markets, Inc.
                              May 19, 2016
Introduction
    Chairman Crapo, Ranking Member Warner, and Members of the 
Subcommittee, thank you for the opportunity to testify today on behalf 
of Better Markets. Better Markets is a nonprofit, nonpartisan 
organization that promotes the public interest in the domestic and 
global capital and commodity markets. Its goal is to help establish a 
stronger, safer financial system that is less prone to crisis and the 
need for taxpayer bailouts. Better Markets seeks to achieve these goals 
through regulatory comment, public advocacy, independent research, and 
litigation. Through these channels, we serve as a counterweight to the 
financial industry to help ensure that policy makers and regulators 
prioritize the interests of hardworking Americans over special 
interests.
    Better Markets supports the goal of promoting and protecting 
capital formation for the benefit of the real economy but has serious 
concerns about all three of the bills that are the subject of this 
hearing. They would remove or weaken regulations aimed at protecting 
investors and maintaining financial market stability in the areas of 
money markets funds, real estate securitizations, and business 
development companies.
    In my testimony, I'll describe the perspective that Better Markets 
brings to these issues; offer a general assessment of the deregulatory 
approach reflected in these measures; and highlight specific provisions 
in each of these bills that we believe would be harmful.
The Better Markets Perspective
    Better Markets firmly believes that vibrant, fair, and stable 
capital markets are crucial to generating economic growth and 
prosperity for all Americans. We also believe that achieving these 
goals requires a strong regulatory framework. That framework must be 
capable of protecting investors to sustain their confidence in our 
markets and preserve their willingness to participate in capital 
formation. And above all, our regulations must limit systemic risk in 
our markets to avoid a recurrence of the type of devastating financial 
crisis that nearly destroyed our economy in 2008.
    That crisis was the worst financial disaster since the Great Crash 
of 1929, and it produced the worst economy our Nation has seen since 
the Great Depression of the 1930s. It nearly destroyed our financial 
system, obliterating millions of jobs, triggering a tidal wave of home 
foreclosures, and wiping out the savings of countless American 
households. Small businesses were particularly hard hit. In 2008, for 
the first time in history, more businesses failed than were started. 
The costs have been staggering: tens of trillions of dollars in lost 
GDP and inestimable human suffering. \1\
---------------------------------------------------------------------------
     \1\ Better Markets, ``The Cost of the Crisis: $20 Trillion and 
Counting'', (July 2015), available at http://www.bettermarkets.com/
sites/default/files/Better%20Markets%20-%20Cost%20of
%20the%20Crisis.pdf.
---------------------------------------------------------------------------
    And the crisis is still being felt today. Underemployment remains 
at almost 10 percent, 6.7 million homes are still underwater; median 
wages remain stagnant; and middle class Americans still struggle with 
$3.5 trillion in nonmortgage consumer debt.
    The lesson is clear: Without effective rules, our financial system 
is susceptible to financial crisis, and financial crisis poses the 
single greatest threat to capital formation and economic growth, 
especially among small businesses. Strong regulation is thus essential 
for protecting and promoting capital markets that support the real 
economy and ensure long term economic prosperity.
General Concerns
    The deregulatory approach in these bills raises a number of 
concerns. First, we question whether these measures will really help 
businesses and municipalities access the capital they need to expand 
and contribute to economic growth. Throughout its history, members of 
the financial services industry have opposed regulation based on 
confident predictions that regulatory safeguards applied to their 
activities will limit access to capital and stifle economic growth. In 
fact, however, these claims tend to be speculative, anecdotal, and 
ultimately unfounded. In this case, we haven't seen credible evidence 
that these bills will materially benefit our financial system or the 
larger economy.
    Second, if enacted, these bills will come with a heavy price. They 
will expose investors to an increased risk of loss. Inflicting harm on 
investors doesn't fuel the real economy, and it ultimately undermines 
the investor confidence that is so essential to a well-functioning 
capital market.
    Of greatest concern, these bills would also lead us in the 
dangerous direction of increased systemic risk and a greater likelihood 
of financial crisis. For example, we know for a fact that money market 
funds and the securitization of real estate loans contributed heavily 
to the 2008 financial crisis. The floating net asset value (NAV) and 
the risk retention, or ``skin in the game,'' requirements that will 
soon take effect are key regulatory reforms designed to reduce the risk 
that our financial system--and these markets in particular--will once 
again be thrown into chaos. The bills at the center of this hearing 
would repeal or weaken those reforms before they have been given a 
chance to work. As result, these bills would increase the prospects for 
another devastating financial crisis that would destroy our economic 
growth.
    Perhaps the Financial Stability Oversight Counsel (FSOC) said it 
best when it issued its proposed recommendations on money market 
reform. At the top of their list was the floating NAV. The FSOC 
observed that by reducing the risk of runs on money market funds, their 
recommendations would decrease both the likelihood and severity of 
future financial crises. \2\ It explained that because financial crises 
have such a profoundly damaging impact on economic activity and 
economic growth, ``reforms that even modestly reduce the probability or 
severity of a financial crisis would have considerable benefits in 
terms of greater expected economic activity and, therefore, higher 
expected economic growth.'' \3\
---------------------------------------------------------------------------
     \2\ Proposed Recommendations Regarding Money Market Fund Reform, 
77 FR 69,455 (Nov. 19, 2012), at 69,481 (FSOC Release).
     \3\ Id. at 69,482 (emphasis added).
---------------------------------------------------------------------------
    The bills we're discussing today are at odds with this approach. 
They would weaken regulatory safeguards, thereby increasing the 
probability of another financial crisis, while putting investors 
needlessly at risk. We believe they would be counterproductive.
S. 1802--Deregulation of Money Market Funds
    S. 1802 would allow all money market funds (MMFs) to maintain a 
fixed net asset value. This provision would effectively repeal the 
SEC's 2014 rule requiring institutional prime and institutional 
municipal money market funds to adopt a floating NAV. But to ensure 
that money market funds remain stable, we actually need to apply more 
regulation in this area, not less. The bill is a step in the wrong 
direction.
MMFs Are Vulnerable to Destabilizing Runs
    MMFs are susceptible to runs and when they do occur, the financial 
system can experience major disruptions that cripple the short-term 
credit markets. MMFs do not come with any form of reliable capital 
buffer or Government insurance that can mitigate the effect of a run. 
In addition, the MMF market is large, amounting to $2.7 trillion, and 
relatively concentrated. MMFs are highly interconnected with other 
financial institutions, and they are widely used by individuals, 
institutions, and businesses as cash management vehicles or as sources 
of credit. By virtue of these characteristics, MMFs present an ongoing 
risk of runs that can spread widely and rapidly throughout the 
financial system.
    The financial crisis of 2008 made this threat painfully clear. In 
the most compelling example of run risk, the Reserve Primary Fund broke 
the buck on September 16, 2008, due to losses on debt instruments 
issued by Lehman Brothers Holdings, Inc. Although that debt was only 
1.2 percent of the fund's total assets, a run ensued when the fund 
sponsors declined to provide support. Within 2 days, investors sought 
to redeem $40 billion from the fund. This required the fund to dump 
tens of billions of dollars in assets immediately so that it could pay 
for the flood of shareholder redemptions. This fire sale in turn 
depressed asset values, further weakening the fund.
    The run quickly spread to the entire prime MMF industry, and during 
the week of September 15, 2008, investors withdrew approximately $310 
billion (or 15 percent) of prime MMF assets. This industry-wide run 
caused immediate havoc in the short-term funding markets, triggering a 
vicious cycle of asset fire sales, falling asset prices, and mounting 
redemption requests. The run abated only after the Treasury, on 
September 19, 2008, established the Temporary Guarantee Program to 
guarantee money market funds, and the Federal Reserve established a 
variety of facilities to support the credit markets frozen by the MMF 
crisis. \4\ The entire $3.7 trillion money market fund industry was 
backstopped, putting taxpayers on the hook for any losses.
---------------------------------------------------------------------------
     \4\ See SEC Division of Risk, Strategy, and Financial Innovation, 
``Response to Questions Posed by Commissioners Aguilar, Paredes, and 
Gallagher'', at 12 (Nov. 30, 2012), available at http://www.sec.gov/
news/studies/2012/money-market-funds-memo-2012.pdf.
---------------------------------------------------------------------------
    The collapse of the Reserve Primary Fund was not the first time--or 
the last--when MMFs faced significant stresses and potential collapse. 
During the crisis, other money market funds experienced significant 
stress levels requiring their sponsors to provide support. Going 
further back in time, one study found 144 cases from 1989 to 2003 in 
which MMFs would have broken the buck had it not been for sponsor 
support. \5\ Another survey revealed 78 instances between 2007 and 2011 
in which sponsors provided support to their MMFs in the form of either 
cash contributions or purchases of securities from the fund at inflated 
prices. \6\ Relying on sponsors to maintain a stable NAV is an 
unreliable approach, as we learned from the financial crisis.
---------------------------------------------------------------------------
     \5\ Moody's Investors Service, Special Comment, ``Sponsor Support 
Key to Money Market Funds'' (Aug. 9, 2010), available at http://
www.alston.com/files/docs/Moody's_Report.pdf; see also Release at 
69,462 n. 28.
     \6\ See Steffanie A. Brady, et al., Federal Reserve Bank of 
Boston, Risk and Policy Analysis Unit, ``The Stability of Prime Money 
Market Mutual Funds: Sponsor Support From 2007 to 2011'', Working Paper 
RPA 12-3, at 4 (Aug. 13, 2012), available at http://www.bos.frb.org/
bankinfo/qau/wp/2012/qau1203.pdf; see also SEC Press Release, supra 
note 10, at 4 (citing over 300 instances since the 1980s of sponsor 
support necessitated by the diminished value of holdings or 
extraordinary redemptions).
---------------------------------------------------------------------------
    As the SEC and the FSOC have concluded, requiring MMFs to maintain 
a floating NAV is one the most important reforms we can adopt to reduce 
this run risk. Under this approach, instead of being fixed artificially 
at $1.00, the price of shares fluctuate and reflect the actual market 
value of the assets in the fund portfolio.
The Floating NAV Mitigates Run Risk
    Floating the NAV offers several benefits. First and foremost, it 
reduces the incentive of any investor to expedite withdrawals from a 
stressed MMF in hopes of redeeming at the $1.00 price as opposed to 
something lower. \7\ Investors who withdraw first no longer benefit 
from a ``first mover advantage,'' since they receive the actual market-
based value of their shares. Eliminating this first mover advantage 
substantially reduces run risk.
---------------------------------------------------------------------------
     \7\ Money Market Fund Reform; Amendments to Form PF; Proposed 
Rule, 78 FR 36,834 (June 19, 2013), at 36,850.
---------------------------------------------------------------------------
    Second, the floating NAV also promotes greater fairness among 
investors. \8\ As a result of the artificially stable NAV, an investor 
that succeeds in redeeming early in a downward spiral may receive more 
than they are due by liquidating at $1.00 per share even though the 
underlying assets are actually worth less. Without a sponsor 
contribution or other rescue, that differential in share value is paid 
by the shareholders remaining in the fund. Early redeemers receive a 
windfall and later redeemers pay the cost. The floating NAV eliminates 
this disparity and unfairness.
---------------------------------------------------------------------------
     \8\ Id.
---------------------------------------------------------------------------
    Finally, floating the NAV also enhances transparency. A fluctuating 
NAV helps correct the basic misconception among many investors that 
their MMF investment cannot lose value. Instead, investors see plainly 
that they bear the risk of loss as to MMFs, just as they do with other 
investment vehicles. Acclimating MMF investors to share price 
fluctuations would further mitigate their tendency to run in panic at 
the prospect that their MMF will ``break the buck.'' \9\
---------------------------------------------------------------------------
     \9\ Id. at 36,851.
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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\
---------------------------------------------------------------------------
     \2\ As measured by the standard deviation of swap spreads, which 
are the benchmark off of which CMBS are priced. Higher standard 
deviations indicate lack of liquidity. Current readings in CMBS suggest 
that the market is undergoing significant stress.
---------------------------------------------------------------------------
    While the regulators periodically revisit the deleveraging question 
in speeches and analyses, the U.S. regulators, in particular, seem 
unwilling to meaningfully investigate the role that regulation is 
playing in the fracturing of markets, fund flows, and the global 
slowdown. This frustration was felt by CREFC members while submitting 
comments during the agency rulemaking processes. There are countless 
instances in which our trade association and others provided well 
researched and documented analyses of the CMBS and other structured 
products markets. Yet, the regulators answer with rule requirements 
that are less tailored than they need to be for each asset-class, let 
alone CMBS, in order to maintain the organic efficiencies of the market 
in favor of simplifying the regulatory regime globally. Now that the 
CMBS market is exhibiting severe distress, and there is evidence of a 
negative feedback loop between poor liquidity conditions, lending rates 
and capital raising, the effects of regulation must be addressed, and 
done so quickly.
    A strong contingent of CREFC's members believe that regulatory 
burden is responsible for reducing liquidity in and weakening the 
resilience of our market, despite the impact of geopolitical forces. 
Many believe that liquidity is the CMBS linchpin and that the 
regulations are causing permanent damage to it. Yet, even buy-and-hold 
investors, such as the pension fund universe (that is reportedly 6.99 
percent invested in real estate) \3\ need market liquidity in order to 
be able to meet their own regulatory and fiduciary requirements.
---------------------------------------------------------------------------
     \3\ According to a recent survey, U.S. institutional tax-exempt 
exposure to real estate debt and equity grew to $835 billion. One of 
the largest Asset Managers, TIAA-CREF, has $82 billion, or 9.4 percent, 
in exposure of a total of $866 billion in AUM as of 3/31/2015. http://
www.pionline.com/article/20141027/PRINT/310279999/real-estate-managers-
back-over-1-trillion-again
---------------------------------------------------------------------------
    CREFC and its members believe that thoughtful regulation can be a 
net positive and that some of the new regulatory requirements have 
improved the marketplace and the alignment of interest between issuers 
and investors. While the broad intent of the regulations is well 
founded, the overwhelming burden of rules that lack tailoring to the 
characteristics of different asset classes provides little marginal 
prudential improvement, if at all. At the same time, these rules 
generate significant costs to the end users (i.e., borrowers and 
consumers) and to savers whose investments are devalued as a result. 
Consequently, there is a growing chorus of urgent concerns from all 
ends of the industry that regulation is institutionalizing 
inefficiencies and may even severely disable liquidity for the CMBS 
market permanently.
    Moreover, lenders and investors agree that a dislocation in CMBS 
will travel quickly throughout the commercial real estate (CRE) debt 
and equity markets, impacting valuations and fundamentals. Certain 
aspects of the marketplace are so fragile today--even before half of 
the planned regulations come into place--that CMBS is experiencing 
severe pricing volatility, a marked contraction in issuance and 
reduction in capacity. We are working on borrowed time to investigate 
the solution and to initiate remediation, especially given the current 
schedule of new rules in the pipeline.
CMBS the Asset Class and Historical Performance
    The securitization of commercial mortgages began out of the 
necessity to clean up the balance sheets of taxpayer-backed depository 
institutions in the late eighties and early nineties. A combination of 
excess development in the wake of strong commercial property demand, a 
subsequent economic downturn, tax reform, and loose credit from 
depository institutions led to a drastic overbuilding of office 
properties. By 1989, 534 depository institutions had become insolvent 
due to imprudent loans. Congress created the Resolution Trust 
Corporation (RTC) in 1989 to dispose of the failed institutions' 
assets. In turn, the RTC pooled the mortgages and sold them off as 
diversified bonds, creating the first CMBS transactions. Since then, 
the market has become much more transparent and investor centric. \4\
---------------------------------------------------------------------------
     \4\ Alan C. Garner, ``Is Commercial Real Estate Reliving the 1980s 
and Early 1990s?'' https://www.kansascityfed.org/publicat/econrev/pdf/
3q08garner.pdf (2008).
---------------------------------------------------------------------------
    Credit retracted nationally across industries in the nineties. Not 
only had the universe of lenders shrunk dramatically, but the few banks 
that could lend on property were reluctant to do so, prompting 
innovative financiers to bypass the banking system for the capital 
markets. They pooled commercial loans and sold bonds tied to those 
loans to sophisticated institutional investors from pension funds and 
insurance companies. By 1998, issuance topped $50 billion per year, and 
by 2007, issuance topped $200 billion per year. \5\
---------------------------------------------------------------------------
     \5\ Sam Chandan, ``The Past, Present, and Future of CMBS'', http:/
/realestate.wharton.upenn.edu/research/papers/full/730.pdf (2012).
---------------------------------------------------------------------------
    One of the attractive features of CMBS was that institutional 
investors (entities with monthly, quarterly or actuarially driven cash 
flow obligations) could achieve greater diversification across 
geography and asset class than by purchasing or originating whole loans 
themselves. Instead of owning a $50 million loan on a single property, 
the investor could purchase $50 million worth of bonds equally 
diversified on a pro rata basis across 40-100 loans in 10-30 individual 
markets. And importantly, the investor could decide how much risk they 
wanted to take based on a bond's seniority in the capital structure and 
the duration of the security. The most secure bonds received cash flow 
payments first, while the riskiest bonds last. In the event of a 
distressed sale, bond holders are paid before the borrower who 
contributed the equity. Typically, these securities offer more yield, 
transparency, and diversification than similarly rated corporate bonds.
    At the asset level, an investor, generally a business entity (a 
partnership or corporation), seeks to purchase a commercial property 
and obtain debt financing for that transaction. Each commercial 
property can be thought of as a self-contained business with an income 
statement and balance sheet. The rents charged to use a property--
including monthly apartment, office, or retail rents--serve as the 
``sales'' or revenue for the business.
    Similarly, a property has expenses in the form of third-party 
property management fees (landscaping, maintenance, etc.), property 
taxes, insurance, leasing expenses (as in the case of an apartment 
leasing manager, or a retail leasing agent, who go and find renters for 
the property), and noncapitalized annual repairs to the property. These 
expenses subtracted from total revenues represent the property's profit 
and loss, or ``P&L''. It is through this number that all applicable 
underwriting calculations, such as debt service coverage ratio (DSCR), 
whether from the investor or lender, are calculated.
    The property owner's ability to pay off debt is not measured (since 
all CMBS loans are nonrecourse), but rather, the property's, or 
business's ability to service monthly payments is measured. A mid- to 
long-term holder of commercial property, regardless of property type, 
buys a building based on how much cash flow, or yield, the asset will 
generate each year, and considers hundreds of data points (ongoing 
surveillance of CMBS is reported on a monthly basis via the CREFC 
Investor Reporting Package (the ``IRP''), a monthly report with over 
750 data fields and supplemental reports providing insight into asset, 
loan, and bond level performance, as well as the final disposition of 
specially serviced CMBS loans, \6\ in addition to a business plan that 
includes market information ranging from demographics, supply and 
demand factors for the asset type, and relative positioning to 
comparable products.
---------------------------------------------------------------------------
     \6\ For information on the IRP, please visit: http://
www.crefc.org/irp or see Appendix A. This information anticipated by 
almost 20 years asset-level information now required by the SEC for 
other asset classes.
---------------------------------------------------------------------------
    Post-financial-crisis (also known as ``CMBS 2.0''), there are two 
distinct CMBS markets: the conduit market and the single-asset single-
borrower (SASB) market. The conduit market pools commercial mortgages 
ranging in size from $2 million to over $100 million (but generally not 
more than $100 to $300 million). These loans are collateralized by 
stabilized, cash-flowing properties with three years of operating 
history and professional ownership. As thousands of small banks either 
closed their doors or were purchased by larger firms in the wake of the 
2008 credit crisis, conduits remain a substantial source of debt for 
secondary and tertiary market real estate operators. Conduit financing 
provides capital for grocery store shopping centers, strip malls, 
family owned hotels, shopping malls, and apartment buildings.
    The other type of CMBS lending is SASB loans. These loans typically 
are larger than $250 million and are made on a single, large property 
or portfolio of properties owned by one borrower such as large, well-
capitalized, public and private real estate companies. Last year, SASB 
made up over one-third of the total CMBS market, up from roughly 10 
percent historically.
    Institutional investors enthusiastically invest in SASB bonds. The 
demand for this market came about as banks and insurance companies were 
unable or unwilling to offer their balance sheets to finance trophy 
buildings or portfolios of properties. The credit characteristics of 
these loans are highly desirable--often many times oversubscribed by 
investors. Due to the durable nature of CRE's cash flow, and 
subsequently the CMBS bonds, the asset class as a whole has performed 
extremely well. The all-time cumulative loss rate for SASB transactions 
is 0.25 percent, and 2.79 percent for conduit transactions. \7\
---------------------------------------------------------------------------
     \7\ As of 08/31/2013, per CREFC's comment letter to regulators.
---------------------------------------------------------------------------
    SASB transactions performed better in the depths of the crisis than 
most fixed income markets perform under efficient market conditions. 
Due to the structure and transparency of SASB deals, investors were 
(and still are) able to make informed decisions. With performance 
characteristics such as these, it is fairly improbable that regulation 
could benefit the market. Indeed, when members of the regulatory 
community have been asked this question, often the answer is that it is 
difficult for the agencies to grant exceptions. CREFC discussed these 
issues at length with the Agencies responsible for crafting the risk 
retention, and our list of submissions to the regulators can be found 
in Appendix B. \8\
---------------------------------------------------------------------------
     \8\ See CREFC's Letter to various regulators on Risk Retention: 
http://docs.crefc.org/uploadedFiles/CMSA_Site_Home/
Government_Relations/Financial_Reform/Risk_Retention/
Risk%20Retention%20Proposed%20Rule%20Comment%20Letter.pdf.
---------------------------------------------------------------------------
Why CMBS: Borrower Access to Credit
    CMBS provides the most democratic and cost effective method of 
financing for small real estate assets. While SASB financing makes it 
possible to spread the risk of a large dollar loan on a single 
property, conduit financing is an essential component of the main-
street CRE market. If traditional credit providers--banks and life 
companies--service the borrowers who need mid-sized loans, then CMBS 
serves the ends of the barbell, with SASB transactions that are too big 
for a single institution to handle on one end, and loans on small, 
privately owned real estate companies and syndicates that make up 90 
percent of CRE ownership on the other.
    In 2015, CMBS provided 21 percent of all of all CRE loans. This is 
the sector's largest financing source, followed only by agency debt (18 
percent) and regional banks (16 percent). Annual originations by banks 
and life companies ebb and flow, but have generally been steady and 
limited to specific niches. While CMBS's 50 percent market share in 
2007 was arguably too high, as witnessed prior to the crisis, 
securitization has proven to pick up a large portion of the slack that 
portfolio lenders and the Agencies typically eschew.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


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




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

    the accounting changes FAS 166 / FAS 167;

    rating agency rules;

    Regulation AB II (a set of disclosure requirements);

    reporting requirements to the TRACE facility;

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

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

    Liquidity Coverage Ratio (LCR);

    Net Stable Funding Ratio;

    Risk based capital rules; and

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

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

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

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

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

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

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

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

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

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

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

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

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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\
---------------------------------------------------------------------------
     \1\ SEC: Money Market Fund Reform; Amendments to Form PF (p.255) 
(emphasis added).
---------------------------------------------------------------------------
    Recent data confirm this point and it is critical to a 
proper assessment of the impact of institutional municipal MMFs 
on municipalities' borrowing costs. As reflected in Table 1, 
institutional municipal MMFs currently hold even less of the 
total $3.7 trillion municipal debt market today than in 2014, 
now amounting to only 1.22 percent or $45.7 billion dollars. 
This means that the floating NAV will have an even more minimal 
potential impact on the borrowing cost of municipalities .
---------------------------------------------------------------------------
     \2\ Data pulled from multiple publicly available sources are 
linked in this response.

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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. 
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
     \4\ SEC: Money Market Fund Reform; Amendments to Form PF (p.247).
---------------------------------------------------------------------------
    Finally, any impact of the floating NAV must be viewed in a 
larger context. The reforms adopted by the SEC in its rule are 
necessary to help mitigate the risk of another devastating 
financial crisis. \5\ In reality, as we explained in our 
testimony and in our comment letter to the SEC, \6\ the SEC 
reforms are only a partial solution, and more needs to be done. 
But at least they begin to address the proven threat to 
financial stability posed by MMFs, as exemplified by the 
dramatic run on the Reserve Primary Fund during the 2008 
financial crisis (see response to Question #2 below). The 
floating NAV is a critical element of those reforms. If it is 
rolled back, the risk of another devastating financial crisis, 
and its intensity, will increase. As we saw in 2008, such a 
crisis would throw all MMF markets into disarray, cause a 
massive and prolonged increase in unemployment, and ultimately 
devastate economic growth--to the detriment of local 
governments along with everyone else. The far wiser course is 
to allow all of the SEC reforms to go into effect, 
notwithstanding any minimal or speculative impact they may have 
on municipal financing obtained through MMFs.
---------------------------------------------------------------------------
     \5\ ``Better Markets, The Cost of the Crisis: $20 Trillion and 
Counting'' (2015), available at www.bettermarkets.com/costofthecrisis 
(incorporated herein by reference as if fully set forth).
     \6\ Testimony of Stephen W. Hall, Better Markets, Inc., Before the 
Subcommittee on Securities, Insurance, and Investment of the U.S. 
Senate Committee on Banking, Housing, and Urban Affairs, ``Improving 
Communities' and Businesses' Access to Capital and Economic 
Development'', May 19, 2016, at p.6 and n.11; Comment Letter From 
Better Markets to the SEC, Money Market Reform (Release No. 33-9408) 
(Sept. 17, 2013).

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

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