A bipartisan bill that would exempt certain collateralized leveraged obligations from risk-retention requirements has been reintroduced in the House of Representatives, following last year’s failed legislative attempt at carving out “qualified” CLOs.
The legislation, sponsored by Rep. Andy Barr, R-Ky., and Rep. David Scott, D-Ga., would create a “qualified” category of CLOs. It is modeled on an exemption that allows sponsors of residential mortgage bonds to avoid holding on to 5% of the economic risk of deals if the loans used as collateral demonstrate a lower risk of default. For mortgages, the standards are the same as those for loans meeting the act’s Ability to Repay rule.
The new CLO bill, introduced Sept. 14, largely tracks measures proposed in legislation by Barr and Scott in December 2015 and later introduced and passed by a House subcommittee. That bill never made it the floor for a vote, however.
Managers of qualified CLOs would not be entirely off the hook; they would still have to retain the equity, or first-loss position in a deal, typically less than 5% of the economic risk. Managers would also need to certify strong underwriting standards, minimum capital structures and a proper alignment of interests between sponsors and investors.
The syndicated loan industry has been lobbying for relief from risk retention rules since six federal agencies led by the Federal Reserve Board of Governors included this asset class among those covered by the Dodd-Frank Act regulation. The rules took effect for CLOs in December 2016.
As predicted, many smaller CLO managers have either left the market or established ties with larger, better-capitalized firms in order to comply with the rules, which are burdensome for asset management firms with little balance sheet of their own. To issue a $500 million CLO, for example, a manager would have to hold on to $25 million of the securities.
Many firms brought in outside capital to hold the risk via permanently financed vehicles (often through bank debt),.
The Loan Syndications & Trading Association, an industry trade group, has lobbied regulators, the Obama and Trump administrations and Congress – and has filed a federal lawsuit – in hopes of reducing the burden on CLO managers.
Many in the industry warn the rules could slow lending to below investment grade comapines, since CLOs are some of the biggest buyers of junk-rated loans. So far, however, that has not been the case, So far this year, issuance of CLOs is some $200 billion, while issuance of speculative grade corporate loans has topped $900 billion. (Both figures include both new-issue loans and refinancings.)
In a newsletter published Friday, the LSTA said that many CLO managers will likely run low on capital for new deals beginning in mid-2018. Most of the capital raised to date has been used to refinance deals that were previously grandfathered, triggering the need to comply, the group noted. “Thus, this capital isn’t being used for new credit formation for companies, but rather to make existing CLOs work in ... today’s spread environment.”
While “the CLO market is currently doing well,” Barr said in a statement, “I am concerned that in the event of another economic crisis, due to the currently misaligned regulation on CLOs, this valuable and safe form of financing will dry up at the worst possible time.”