It could be the end of the line for balance-sheet collateralized loan obligations, as banks are finding alternative structures, such as synthetics, more attractive.
Also a factor is the high percentage of problematic deals structured in the past few years. Nearly half the balance-sheet CLOs issued by banks have had early amortizations, said Richard Gugliada a managing director at Standard & Poor's Ratings Service.
"The whole balance-sheet CLO business has been substantially curtailed because of the troubles many of the deals have had," Gugliada said.
On the flip side, the synthetic market has grown dramatically in the bank sector over the last year and will continue to grow, Gugliada predicts, particularly now that the regulators are allowing banks to receive capital relief for the synthetics markets.
"Using synthetic structures, you can less expensively transfer credit risk through derivatives than through a large multi-million dollar-funded transaction," explained an investment banker working in the sector.
Though there's been more defaults on large corporate loans over the last two years - which has caused the early amortization events - no investors have suffered losses associated with the early payouts, the banker said. The balance-sheet CLOs have certain triggers, which force the transactions to pay out after a certain number of defaults have occurred.
In a synthetic CLO, the issuing bank will enter into an agreement - or swap contract - with a credit-enhancing agent. The bank pays the entity to assume the credit risk of an identified portfolio of assets. Once the transaction exceeds first loss, the credit-enhancing agent pays the bank directly. By transferring the risk, the bank receives off balance sheet treatment for regulatory purposes.
"But this is not a cash-funded deal," said Scott Gordon, a managing director at Ambac. "There's no cash exchange, except that the credit enhancer gets paid a premium, and in turn then pays losses. But the bank is not transferring the assets off the balance sheet for accounting purposes. There is no special purpose vehicle to own the assets. The bank owns the assets."
However, pending the new regulatory or ratings based approach to risk-capital weighting, synthetic transactions may be less cost effective.
That proposal, in short, creates a scale where a bank pays only 20% of the capital charge on its triple-A loans, compared to a 200% capital charge on a double-B loan.
"Moving to that structure, one might say that securitization or risk transfer doesn't make as much sense, because now certain loans on the books have a lower capital charge, so there is not as much incentive to transfer them off the balance sheet," the investment banker said.
However, most bank's core commercial and industrial loan portfolios are in the triple-B and double-B areas, so the capital charge will be equal or greater to the current, and the bank may still consider securitization.
"What a bank can do - and this will be interesting to see what happens - if they transfer the loans into the CLO they can take back the rated pieces of that CLO, like a double-B or a triple-B, and hold less capital against it in this new regime," the banker said.
Basically, a bank could take a portfolio of triple-B loans, structure a CLO and then sell off the triple-A pieces cheaply, retaining only the double-B and triple-B tranches. Under the new regulations, the bank would not be required to hold dollar-for-dollar against these securities, thereby finding capital relief.
This perspective suggests there could actually be a renewed incentive for the cash flow CLO.
However, the banker explained, "That's not saying it overwhelms all of the cost efficiencies of the synthetics."
Furthermore, there are other tagged-on requirements that remove incentive from the cash flow CLO: namely, increased capital charge for any transaction that has an early amortization event.
"It's very much a balancing act," the banker said. "You've got benefits on one side of the ratings-based approach, and you've got additional surcharge for early amortization. But if structured properly, the transactions can be as or more efficient."
