An industry group representing the $800 billion leveraged loan market and $350 billion market for collateralized loan obligations is asking a D.C. Court of Appeals to suspend the final risk retention rule approved by regulators last month.
The Loan Syndications and Trading Association filed a petition on Nov. 10 against the Federal Reserve Board and Securities and Exchange Commission, calling the rule "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law."
"We have sought a reasonable solution for years," said Bram Smith, the executive director of the LTSA, in an e-mailed statement to American Banker. "None of our material proposals were implemented into the rule."
The 163-word challenge is being mounted as a last resort to lessen the impact of multiple new regulations affecting the market this year.
The petition also appears to have been made quietly. That could be due to the impact the suit would have if it was successful. The trade group is asking the court to void the entire rule, including an exemption for "qualified residential mortgages" that is widely considered favorable to the industry.
The risk retention rule requires issuers across several structured finance market segments to hold a first-loss piece of the transaction. The rule is intended as skin in the game for the securities firms underwrite, sell and manage. CLO fund managers or bank underwriters must now hold 5% in a given transaction.
Regulators also shocked the loan market in December last year when they finalized the Volcker Rule. That rule has received heavy pushback from the industry, which claims bank holders are looking at significant write-downs as they are forced to divest CLOs into a softer market.
The chances that the appeals court will ultimately overturn the risk retention rule appear slim, but a court victory may not be the ultimate goal. Observers suggested the lawsuit was intended to prod regulators and lawmakers to act on their own.
Paul Forrester, a partner at Mayer Brown, noted that regulators changed the Volcker Rule after a lawsuit was filed by the American Bankers Association last year. (The lawsuit was later dropped.)
"A cynical view is that they have gotten regulators' attention under the threat of litigation, just as the community banks sued right after Volcker [Rule] and treatment over Trups CDOs," Forrester said. "So there is recent evidence that the threat of litigation can be effective."
Jaret Seiberg, an analyst with Guggenheim Securities, wrote to clients that the lawsuit may "increase the chance that Republicans include exempting CLOs from risk retention as part of a deregulatory bill."
David Preston, a Wells Fargo Securities analyst, is forecasting consolidation in the CLO market as smaller managers find the market too complex.
"The composition of the loan market may change, leading to more volatility," he said in a recent client note. "Risk retention may become effective at an inopportune time: just as the credit cycle turns, short-term rates rise, and new bank regulations become effective or require increased compliance."
Business development companies may emerge as the winners, he said. Those funds may be able to work around compliance and become more opportunistic CLO buyers.
Last week, senior executives from investment firms including GE Capital Markets, Apollo Investment Management, New Mountain Capital and Triangle Capital Corporation met at the Plaza Hotel below New York's Central Park. One topic of discussion led by Wells Fargo Securities was where BDCs should search for the best risk-adjusted returns. CLOs are one of those places, they said.
Issuers have sold $9.5 billion in CLOs this month and $114 billion in CLOs year-to-date, according to data from Standard & Poor's. This year's issuance surpassed the volume record of $96 billion set in 2006.
Investors in the leveraged loan market, meanwhile, withdrew $374 million from leveraged loans last week, making it the 19th week of consecutive outflows, according to Lipper.