Securitization pioneer Mayer Brown worked in the 1980s with Continental Bank Corp., acquired by Bank of America in 1994, to structure some of the industry's first receivables-finance transactions, enabling Midwest manufacturers to finance the production of agricultural equipment sold to creditworthy farmers. Founded in Chicago in the late 1800s, the law firm is a leader in auto-loan and credit-card asset-backed securities (ABS), and its practice today touches virtually every type of securitized asset. They include other consumer loans, mortgage-backed securities, collateralized loan obligations (CLOs), and other esoteric assets such as solar loans, cell towers, shipping containers, aircraft leases, railcars and utility tariff bonds. The firm is also active in overseas securitization markets.
J. Paul Forrester, Julie Gillespie and Ryan Suda, partners in Mayer Brown's securitization practice, spoke recently with Asset Securitization Report about key developments and issues participants in the ABS market are facing.
Asset Securitization Report: We live in unprecedented times. What developments and trends does Mayer Brown see impacting the securitization market?
J. Paul Forrester: We present a "What to Expect" event every year, and 80% of the presentation this year is on regulatory developments. Securitization has been a very active focus for the SEC, banking regulators, and most recently the insurance regulators. We recently hired Michelle Stasny, who spent nearly a decade in the SEC's structured finance office, and she has written comment letters on SEC proposals for industry groups.
Julie Gillespie: One of the big market trends in the last two years has been the growing importance of private funds and insurance companies as a source of financing for all types of financial assets. So we've been very focused on National Association of Insurance Commissioners (NAIC) regulations.
ASR: What are the issues there?
JPF: The NAIC has a fundamental problem in that its risk-based capital (RBC) system was put in place in the early 1990s as an early warning of insolvency. The original RBC factors for debt securities were based on risk measures for corporate bonds. So essentially the NAIC has had to retrofit the system for structured finance, and it's struggling with ABS residual interests with significant tail-risk exposure. They currently get RBC of 30%, calibrated using S&P corporate equity data that's viewed as inappropriate for ABS, despite little supporting data. So the NAIC been working for over a year to recalibrate for ABS and has pushed for an interim RBC charge of 45%, a 50% increase.
Insurance companies don't buy a lot of residuals, but they buy some. If the NAIC adopts the interim proposal, it would apply to 2023 statutory reporting, and affected U.S. insurers would have to get the related investments off their books by year-end, to avoid the capital-charge increase. So there could be significant turmoil in CLO equity and other ABS residuals held by U.S. insurers.
ASR: When will the NAIC likely decide whether to adopt the interim proposal?
Ryan Suda: By June 30, the deadline for changes to RBC to be effective for a particular year. A lot of market participants are not aware of how soon that could go into effect, and it will apply to all ABS.
A second NAIC initiative would eliminate the use of rating-agency ratings to determine RBC charges for rated CLO tranches and would instead determine those RBC charges using a modeling methodology developed by the NAIC for all CLO investments by U.S. insurers. This initiative has raised questions about why the NAIC is doing this and whether it can achieve more accurate modeling than the rating agencies. The proposal to model CLO investments was adopted late last year and the work plan for developing the required model/methodology has a self-imposed and possibly aspirational deadline of Jan. 1, 2024.
JPF: And much worse than that, NAIC stress tests under its models show losses in the AA tranches, which has the marketplace concerned because if the NAIC's current models ultimately prevail, even a AA rating will not be AA for risk-based capital purposes. It's potentially an existential issue for CLOs, given that insurance companies hold $225 billion in CLOs. Much of it is senior debt, but more importantly U.S. insurers are estimated to hold 65% to 70% of the mezzanine tranche—the BBB class. There's no other obvious institutional capital that would replace them if insurance companies walk away from those investments.
An ad hoc group that includes regulators, NAIC staff and industry representatives is working on the required model, including required assumptions and--what will almost certainly be more controversial--scenarios and stress tests.
ASR: The deadline to transition away from Libor arrives at the end of June. Will the markets be ready?
JPF: Activity to pursue the transition has clearly accelerated, but it was left pretty late to be fully orderly. Legacy loans without adequate fallback language are OK because the Libor Act will transition them. However, it transitions those loans to SOFR plus the credit spreads adjustments (CSAs) recommended by the Alternative Reference Rates Committee (ARRC), and these are significantly higher than current spot spreads. Borrowers may not be happy with that result, but the contracts can be transitioned.
However, there's a significant bubble we see that still has to be fixed—including leveraged loans with fallback language, such as to prime or base rate. They're outside the Libor Act provisions and as a result have to be amended or refinanced. It's a clear trend that most amendments now include the ARRC's CSAs (11 bps for one-month term SOFR and 26 bps for three-month term SOFR). But there's been some apparent resistance because borrowers wanted to transition at current spot rates, at something closer to 10 bps or 15 bps for three-month Libor, and CLO equity investors are concerned because their assets are being refinanced at a tighter spread than the related CLO liabilities.
RS: When there's that mismatch created by asymmetric spread adjustments between loan assets and CLO liabilities, equity takes a substantial hit. So equity investors are asking their CLO managers to object to loan amendments that use a spread adjustment other than the ARRC-recommended value.
ASR: another issue that could dramatically impact CLOs is a lawsuit seeking to treat loans syndicated to nonbanks as securities, and an appeals court has asked the SEC to weigh in on by June 27.
JPF: That's potentially a big deal. Until the appeal is decided we won't know for sure, but the first-instance judgment was pretty robust. As a legal matter, the issue probably turns on the related facts drawn out in the district court proceeding. Everybody is going to handicap it differently, but in my view if the appellate court follows prior cases that have raised this issue, then it should reach the same conclusion—that syndicated leveraged loans are not "securities" under the Securities Act of 1933 or the Securities Exchange Act of 1934. However, there is some concern about what the SEC will say.
What makes the market nervous is that some of the policies and other pressures to improve the market actually make leveraged loans look a lot more like securities, such as requiring transparency, quicker settlements and potentially listing on exchanges and even clearing. So it's only going to make the historical distinction between loans and securities harder to draw. However, in this case, it was a large, syndicated loan and there were 150 lenders who participated; notwithstanding that, the trial court said the loan is not a security.
