Like a pesky cold, the loan market just can’t shake the “skin in the game” provision — a risk retention rule in the Dodd-Frank bill that would require “a securitizer” to retain 5% of the assets of a securitized vehicle.
Following a Federal Reserve study in October, which acknowledged that all structured vehicles are not created equal and shouldn’t be treated as such, market participants expected CLOs to be exempted from the 5% rule. So when the FDIC announced its proposed regulations the last week of March, lumping CLOs in with securitizations, market participants found themselves taken aback.
Continuing its fight against a blanket “skin in the game” regulation, the Loan Syndications and Trading Association (LSTA) is preparing a comment letter and planning to meet with lawmakers in an effort to help create a more nuanced rule that would be appropriate for CLOs. The LSTA has already met with more than 20 lawmakers, as well as the Securities and Exchange Commission, the Federal Deposit Insurance Corp., the Federal Reserve and the Office of the Comptroller of the Currency.
“LSTA members are quite concerned that the risk retention rules, which were structured with “originate-to-distribute” ABS in mind, simply don’t fit the CLO architecture,” said Meredith Coffey, executive vice president of the LSTA. “As a result, as currently written, the risk retention rules could hamstring the revival of the CLO market. This is particularly unfortunate as CLOs performed exactly as structured in the downturn.”
Others agree the rules could ail the CLO market. “The [proposed rules] may limit CLO new issuance,” said David Preston, an analyst at Wells Fargo. The rules could also “reduce the universe of CLO managers by limiting new CLO issuance to managers affiliated with larger, deep-pocketed institutions, which could, in turn, limit competition among CLO managers.” According to Preston, in the absence of new CLOs, investors will turn to secondary CLOs or refinance/restructure existing CLOs.
The proposed rules were issued by the FDIC last week in the 374-page Joint Notice of Proposed Rulemaking. FDIC Chair Sheila Bair said in a statement, “Fundamentally, this rule is about reforming the ‘originate-to-distribute’ model for securitization and realigning the interests in structured finance.”
The rule would specifically require the securitizer to retain 5% of the aggregate credit risk of the assets. The proposed rules designate the securitizer as the CLO manager because the CLO manager selects the commercial loans that are purchased.
There are several ways a CLO manager can retain risk under the regulation. One way is to take a 5% pro rata vertical slice through each issued class. Another way is to take a 5% horizontal slice, in which the CLO manager retains first-loss position in an amount equal to at least 5% of the par value of the CLO. The CLO manager could also combine these options, taking an L-shaped portion of the CLO that consists of both a vertical slice and a horizontal slice (for detailed examples, please see cart below). The CLO manager could also opt to set up a cash reserve fund that is equal to 5% of the CLO valued at par. The last option is to, as the rule states, take a “representative sample,” in which the CLO manager retains a randomly picked pool of assets equal to 5.265% of the unpaid principal balance of the fund.
A Boston-based investor who is against the 5% rule said, “There is a lot of pushback going on. The goal [of the rules] is to have some ‘skin in the game.’ But there are arguments out there that managers have tiered management fee structures, so there is an alignment of financial interest already in the structure. In addition, there are reputational alignments of interest, i.e. loan managers are incentivized to make these deals work or lose their franchise.”
The proposed regulation was a shock for some market participants, mainly because they were banking on a Federal Reserve study that was conducted in October 2010, which examined the impact of the risk retention rules on nine types of securitizations and the existing fee and incentive structures for each.
The Fed’s study, according to Preston, did an “excellent job of reviewing the various investor protections currently in the different types of securitizations.”
When the study was over, it found that a one-size-fits-all risk retention rule for the different types of securitizations was not appropriate. The Fed’s recommendations, though, have apparently been ignored.
“The reaction thus far is WTF?” said a New York-based investor.
The proposed rules are problematic for the CLO market because market participants say many CLO managers don’t have the liquidity to purchase 5% of a CLO valued at par.
According to a recent LSTA poll, 87% of participants said they could not retain a 5% vertical slice. “If the vertical pro rata strip approach doesn’t work, then the L-shaped option won’t work either,” Coffey wrote in a recent LSTA letter to its members. Of the CLO managers the LSTA polled, only five said they could raise a new CLO if they had to retain a horizontal slice.
“We believe this rule could effectively exclude independent asset management companies from the primary CLO market,” said Preston. “These firms generally issue CLOs to gain asset management fee income, and these firms typically do not have sufficient capital to purchase 5% of a new CLO.”
The CLO market has its next checkup with lawmakers on June 10, which is the end of the comment period for the proposed rules. After that, regulators will finalize the rules. Market sources familiar with the regulation process are unsure how long finalization will take, but they speculate it will happen sometime in early autumn. The rules would go into effect two years later.