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CLOs may already have an out from Japanese risk retention rules

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Risk-retention rules that Japan's Financial Services Agency has proposed for securitizations may not apply to U.S. collateralized loan obligations after all.

The Loan Syndications & Trading Association thinks CLOs that acquire loans used as collateral in the "open market," rather than originating the loans themselves, may benefit from a loophole in the proposed rules.

Simply put, these CLOs don't meet the criteria for a securitization as it is currently defined by Japanese regulators.

In a comment letter filed with the JFSA on Monday, the U.S. trade group noted that open-market CLOs are not backed by “original assets” transferred into the conduit by a lender.

In its letter, the LSTA stated the JFSA proposal describes a securitization transaction as a “stratification” of credit risk related to the "original assets” transferred to a “securitization conduit.” Under those terms, CLOs aren’t covered because there are no “original assets” in their portfolio that meet the JFSA’s definition, because independent CLO managers do not underwrite the loans.

Without “original assets,” there’s no securitization – and therefore no “securitization exposure” for investors in CLO notes, the letter added.

“While the LSTA is not an expert in Japanese law or regulations, it appears that the FSA’s regulations, much like the U.S. statutory requirement, could be construed as not applying to Open Market CLOs and their managers,” the letter stated.

The reading of the proposal would not provide the same exemption from middle-market, or balance-sheet, CLOs since those are traditionally offered by lenders to smaller corporates. Most issuers of middle-market CLOs also retain large portions of deals, anyway, providing compliance for the proposed regulation.

The JFSA's new rule that would discourage investments by Japanese institutions in securitizations that lack risk-retention structures. The regulation would force regulated banks to triple their risk-weighted capital reserves against ABS holdings that aren’t compliant with standards that include a sponsor’s minimum 5% stake in the notional value of a deal (similar to existing European risk-retention rules).

The JFSA proposal raised alarms within the BSL U.S. CLO industry this month, as Japanese banks purchase between 50% and 75% of all newly issued AAA rated CLO securities, according to global law firm Milbank, Tweed, Hadley & McCloy.

If the rule is enacted, U.S. CLO managers could not market notes to their primary investor base for senior notes, unless they enact costly risk-retention strategies that most have dropped since a federal appeals court last year overturned rules applying short-lived U.S. risk-retention standards on domestic deals.

LSTA officials, who have been in talks with Japanese regulators for months beore the December proposal, also intend to argue for CLOs’ exemption based on the proposed regulation’s carve-out for securitizations with assets that were “appropriately” underwritten.

The LSTA’s 15-page letter includes background descriptions on the CLO industry’s soundness and deep investor protections, including the existing alignment of manager interests with CLO investors through numerous investor-protection deal covenants that, if breached, divert cash flow away from the equity holders (including managers) to pay senior noteholder principal.

The LSTA also emphasizes the importance of CLOs to the leveraged loan market. CLOs are a primary source of funding for corporate speculative-grade loans, holding $560 billion of $1.1 trillion in outstanding loans in the market at the end of 2018. CLOs are also a check on market volatility in loan pricing and availability, since CLOs are long-term investment vehicles that do not operate “mark-to-market” on short-term investor redemptions like mutual and exchange-traded loan funds.

These assets are safe for CLOs since they are generally first-lien, secured loans (used for operational, merger/acquisition or refinancing proceeds) with limited call protections, that pay “relatively large spreads” and have an active, and liquid, secondary market, the LSTA pointed out in its letter.

Last year’s active CLO trading volume exceeded $720 billion, with most loans held in BSL CLOs receiving an average of four active daily dealer bids, according to Wells Fargo.

Risk-retention regulations would either limit CLO formation or increase costs on managers that would have “adverse effects on the availability and pricing of capital in the leveraged loan markets.”

The requirement, if finalized by Japanese regulators, means U.S. CLO industry could “see a return to retention-compliant U.S. CLO structures, to the extent that such transactions are to be marketed in Japan, together with its consequent costs and complexities,” according to a January client alert published by Milbank.

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