Like a shark swimming near a crowded beach, the Dodd-Frank financial reform bill is causing a lot of anxiety for bank loan market participants, especially those who have anything to do with CLOs.
But fear not, like Chief Brody and the drunken fisherman in “Jaws,” there are forces at work trying to stop the bill from causing chaos in the bank loan market.
The main issue bank loan market participants have with the bill, which could be signed into law this month, is the risk retention provision, which would require “securitizers” and “originators” to hold a slice of an asset and hence some of the risk. This could deter banks from diving into new CLOs, make deals more expensive for borrowers, and slow down the formation of new CLOs, hindering the recovery in the CLO market and ultimately the loan market.
“The regulations could redefine securitizations and CLOs — and possibly leveraged loans — as well,” the Loan Syndications and Trading Association (LSTA) wrote in a letter to its clients. “To be fair, the financial regulatory reform bill never explicitly targets the syndicated loan or CLO market. However, the language in the bill is sweeping, and CLOs may well be swept up.”
The legislation is, in fact, a response to the meltdown in the housing market, a problem that was exacerbated by the widespread syndication of risky subprime mortgages to CDOs and other investment vehicles. The intention of the regulation is to reduce risk by requiring lenders to hang on to a portion of the debt they underwrite, rather than pass all the risk on to other banks and investors. The risk retention provision has been dubbed by regulators and market participants as “skin in the game.” But syndicated loans should not be associated with residential mortgage-backed securities, the LSTA said.
“CLOs have nothing to do with residential mortgage-backed securities,” said Bram Smith, executive director of the LSTA. “They are actively managed, have the interests of managers aligned with the note holders, pricing information, and a track record of strong performance, among other aspects.”
The LSTA is working to change the misperception that CLOs carry the same risks as CDOs and to have the final regulation reflect loan market participants’ concerns. The organization has written white papers explaining how the requirements would damage the loan market. It also plans to engage regulators to help press its case.
And the LSTA is not alone. Several CLO managers and bankers who spoke with Bank Loan Report said they are also considering taking such actions to stop the risk retention provision in the legislation from affecting bank loans. Though it should be noted that banks have a lot of other more pressing issues, such as credit card fee restrictions, to deal with as well.
Groups like the LSTA are first trying to have several aspects of the bill clarified, especially what a “securitizer” and “originator” actually is and how much risk these parties have to hold.
“The bill apparently does not spell out which party must retain the risk, i.e., the CLO itself, the underwriting bank or the CLO manager,” David Preston and Zachary Bolster, two analysts at Wells Fargo, wrote in a recent report. “In addition, there is no explicit definition of risk retention.”
According to the language in the bill, a “securitizer” is an issuer of an asset-backed security or a person who organizes and initiates an asset-backed transaction by selling or transferring assets, either directly or indirectly. In the bank loan market, that theoretically could be anyone selling the loans to a CLO.
Meanwhile, according to the bill, an “originator” is a person who, through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security and sells it directly or indirectly to a “securitizer.” In the loan market, however, that could be any bank that holds a loan that eventually ends up in a CLO.
“So bank A could be a co-agent on the loan and make the loan. Then, for risk management purposes, Bank A sells part of the loan to bank B, who then sells the loan to bank C, who sells it to a CLO. Bank A may be on the hook for a 5% risk retention, even though it’s far removed,” said Meredith Coffey, executive vice president of research and analysis at the LSTA. “This will create a lot of confusion and lack of clarity. It’s not clear who has to hold the risk, and that could hinder the recovery of CLO market.”
The legislation’s definition of an ABS is a type of fixed income or other security collateralized by any type of self-liquidating financial asset that receives a payment from that asset — CDOs, including CLOs, would be grouped together with other ABS.
“These definitions might be clearer in the context of a static securitization of assets initiated by an originator. However, they are far from clear for a cash-flow CLO that is actively managed by a third-party manager who buys loans in the secondary market,” the LSTA wrote in its letter. Also, since a CLO holds the loans — and possibly all the credit risk already, “it’s not clear what risk retention would mean in the context of a vehicle that already holds all the risk.”
You’ll Have Some Time...
On June 30, the House passed the financial regulatory reform bill. Due to the death of Sen. Robert Byrd (D-W.Va.), the Senate’s vote probably won’t take place until mid-July. Presuming the bill is passed by Congress and signed by the President, regulators will begin studying and implementing the bill later this year.
Within 90 days of the bill’s passing, the regulators — The Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Securities and Exchange Commission — will have to submit a report to Congress on the risk retention provision’s impact on each asset class affected by the provision.
Within 180 days, the Treasury Secretary must submit a report on the macroeconomic effects caused by the risk retention provision. And within 270 days, the regulatory bodies will jointly prescribe regulations that would dictate how much risk “securitizers” have to hold. Two years after that, those regulations would go into effect.