With CLO issuance on the rise, it’s easy to forget that there are a number of regulatory threats to this important source of liquidity for corporate loans.
Proposed rules on risk retention for securitized products have gotten the most attention, and could do the most damage by making it uneconomical for most money managers to issue new collateralized loan obligations. But they are not the only threat posed by the implementation of the Dodd-Frank Act.
Proposed reporting requirements for securitizations and rules designed to prevent conflicts of interest for securitizers could also negatively impact CLOs, as could a revamp of the U.S. withholding tax system.
Bram Smith, executive director of the Loan Syndication and Trading Association (LSTA), said the regulation does not target CLOs, or at least not CLOs that purchase their collateral on the open market, and that are not designed to move assets off lenders’ balance sheets.
Nevertheless, these structured investment vehicles have gotten caught up by various rules, in part because legislators and regulators didn’t know much about the corporate loan market. CLOs “are collateral damage,” he said.
The LSTA, which has been doing the lion’s share of lobbying to ensure that rules are better aligned with the realities of the CLO and loan markets, devoted a session of its annual conference this month to regulatory reform.
So what’s the worst case scenario? “Because the regulatory rules overlap, it’s possible that CLOs could not be issued and that existing ones would have to be called, and European banks would have to sell all of their CLO notes at the same time, creating a glut,” Meredith Coffey, the trade group’s senior vice president of research, told attendees at the conference in New York.
“It looks like that won’t happen,” she continued, “but it could have happened under the proposed rules.”
Why should loan market participants care? CLOs are “still the biggest part of the institutional loan market, at around 50% of the loan index,” Coffey said. “If something impacts CLOs, then it also impacts the loan market.”
In a telephone interview, Coffey said risk retention rules implementing Dodd-Frank and the Foreign Account Tax Compliance Act (FACTA) are the two biggest threats to the CLO market; risk retention “because it would shut CLO issuance down and FATCA because it’s an extraordinary problem for existing CLOs.”
Dodd-Frank will require securitizers to retain a 5% economic interest in the assets being securitized. That means an investment firm managing a $400 million CLO would have to retain $20 million of the CLO notes.
“Not many managers can do that even once, and certainly not several times,” Coffey said. While there have been some recent deals in which the manager has kept some or all of the equity, these have primarily been private equity firms, which “have a natural place to put it,” she said. “That’s not true of most money managers.”
Smith, speaking in the same telephone interview, noted that the proposed regulations would require CLO managers to hold on to this slice for the life of the transaction, without hedging it. “That’s a very unnatural action for a money manager,” he said.
While there are some big institutions that may be able to do this for a few CLOs, “they won’t be able to do it for many.” And even at these institutions, CLOs “will have to compete internally for scarce capital against other investment opportunities. If the returns on CLO equity are not attractive, the managers will invest elsewhere. Smaller managers will be nearly shut out entirely."
Coffey said the LSTA has proposed language that would “ring fence” CLOs from risk retention requirements. It would do this by defining CLOs as vehicles that must be invested in corporate credit, of which 90% is senior secured loans, among other things. Also, since regulators are concerned about re-securitization, the proposed language would define CLOs as vehicles that do not invest in derivatives or asset-backed securities such as other CLO notes. “A CLO is really providing real loans to real companies,” she said.
In order to address regulators’ concerns about ensuring the alignment of interest between CLOs and their investors, the LSTA has also proposed language requiring that 60% of manager compensation be subordinated to interest payments on the CLO’s secured notes.
The Foreign Account Tax Compliance Act, a major revamp of the U.S. withholding tax system that was enacted in 2010 as part of the Hiring Incentives to Restore Employment Act, will require certain U.S. taxpayers holding financial assets outside the U.S. to report those assets to the Internal Revenue Service. It will also require foreign financial institutions to report directly to the IRS certain information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest, according to information on the IRS’ website.
Coffey said this reporting requirement is a problem because CLOs often don’t know who its end investors are” While the CLO makes interest and principal payments via to investors through a series of intermediaries, including the trustee and the Depository Trust & Clearing Corp., the last payment might go to bank account. “Moreover if the tax information is not provided, the penalty is incredibly Draconian: a 30% withholding tax.”
While there is some language grandfathering vehicles already in existence when the proposed rule takes effect, existing CLOs could easily trigger the reporting requirement by acquiring a new asset. “Something as simple as amendment [to a loan in a CLO’s portfolio] that changes the spread materially could trigger the FATCA restrictions and withholding,” Coffey said.
“Our recommendation is two-fold,” Coffey said. “Existing CLOs should be fully exempted, and CLOs issued after FATCA is in place, should have an upstream certification process. [Each party] would certify that the next person in the chain [of payments] is in compliance.”
Coffey said some newer CLOs are addressing this proposed requirement in a more head-on fashion: the deal documentation lets investors know that the CLO will probably be subject to FATCA and provide that, if an investor is “recalcitrant,” and refuses to provide tax information, it can be “removed.” In other words, the security can be sold.
“The markets may be already putting a mechanism in place to get future CLOs to be workable in FATCA, but we still have problem with existing CLOs,” she said.
Coffey said proposed rules imposing new reporting requirements on all asset backed securities are “less of a problem” for CLOs than the risk retention rules or FATCA; the issue is that “the proposed reporting fields simply don’t align with the CLO market.” The LSTA has made recommendations for fields that would better align.
Proposals for implementing the Volcker Rule would prohibit banking entities from engaging in any activity that present a material conflict of interest with clients, customers. Coffey said this poses two potential issues for CLOs. One is that regulators “don’t want anyone who is structuring an ABS, for example, to have a short position” in the securities.
“I think this really applies to structuring synthetic ABS,” which hold credit default swaps, rather than securities or loans. “We will only speak to open market, cash-flow CLOs and it looks like they might not be affected on the structuring side,”she said.
However, Coffey said the language of the proposed rules is” very broad, and it could sweep up collateral managers as well as the underwriters. That would mean that a very large money management firm that manages a CLO and also manages equities, bonds and synthetic assets couldn’t have a short position in the CLO — or, perhaps, other similar instruments — in any of the other investment vehicles it manages.”
“The LSTA is still working through how to approach this, but there are plenty of rules in place for collateral managers, such as disclosure rules, information barriers that already appropriately address these issues,” she said.
