Up until the coronavirus outbreak froze new-issue activity in collateralized loan obligations, an increasing share of U.S. managers had been adding voluntary risk-retention features to their deals.
In the last two quarters of 2019, according to Fitch Ratings, more U.S. managers of collateralized loan obligations (CLOs) had been structuring some of their transactions to comply with risk-retention rules.
A little more than 16 percent of CLOs, issued in Q3 2019 and rated by Fitch Ratings, were designed to abide by risk-retention requirements, according to data from the agency. In the following quarter, that number increased substantially, to 28.5 percent, according to Derek Miller, head of U.S. structured credit at Fitch.
The push is reportedly in response to growing numbers of managers seeking to make their deals compliant for European Union risk-retention requirements, as well as demands from Japanese investors seeking to avoid conflicts with that nation’s own retention requirements that were enacted in 2019.
While U.S. CLOs are effectively exempt from the Japanese risk-retention regulations, many investors are focused on due-diligence of underlying loan assets because the institutions bear the burden of showing the CLOs they own have no “improper” assets, according to guidance from Pittsburgh-based law firm K&L Gates.
So risk-retention features would certainly improve an investors’ case that its CLO holdings meet regulatory muster – which otherwise would result in more required capital, since Japanese banks would be forced to triple the risk weighting of “inappropriately formed” securitized assets.
“The market would certainly suffer if Japanese investors were to leave the market,” said Gregg Jubin, managing partner of the Washington, D.C. office of law firm Cadwalader Wickersham & Taft. “As a byproduct of that, CLOs would evolve if they had to.”
Managers here are no longer required to adhere to U.S. risk-retention requirements created a decade ago under Dodd-Frank. A federal court ruling in 2018 overruled regulators’ controversial move that had forced lightly capitalized CLO managers to share “skin in the game” (a minimum of 5% of a deal’s notional value) in their newly issued portfolios. The ruling was from a lawsuit filed by industry trade group, the Loan Syndications and Trading Association.
Most deals dropped the risk-retention features on subsequent issues after the ruling, although some seeking dual-market investors in the U.S. and Europe continued to comply with EU standards that remain in effect.
In late 2018, concerns were raised that forthcoming Japanese risk-retention regulations would keep Japanese banks from investing in U.S. CLOs lacking risk retention. By most industry views, Japanese banks are believed to make up a substantial share of the investor base for U.S. speculative-grade corporate loans, buying between 50% and 75% of all AAA-rated CLO securities issued each year.
Since they are nondisclosed private transactions, CLO investment levels vary between observers in the marketplace. Japanese investors hold about 15 percent of outstanding U.S. CLOs, according to the Bank of Japan’s “Financial System Report,” published in October 2019. Research from investment bank KBW estimated in March that Japanese banks have a larger 22% exposure to U.S. CLOs.
Stiff roadblocks to Japanese investors were effectively cleared in March 2019 when the Japanese Financial Services Agency carved out U.S. CLO assets from the regulations, so long as banks could show their investment holdings were “not inappropriately formed” in regards to risk management. How those loan assets could meet that standard was not clearly defined however, with an LSTA official noting a “fair amount of uncertainty” about how Japanese banks would establish their assets’ compliance with the rules.
“These are buy and hold investors,” Joseph W. Beach, a partner at Cadwalader, “so they bring more competition into the buyer’s market.”
“In this environment we are going to continue to see that risk retention will continue in Europe and where the Japanese FSA will continue to have a carve-out exempting risk retention for US CLOs,” said Laila Kollmorgen, a managing director and portfolio manager at PineBridge Investments, an asset manager headquartered in New York City.
Outstanding U.S. CLOs amount to about $553 billion, according to Moody’s Investors Service. That accounts for the substantial majority of the outstanding CLOs worldwide, which the Bank of England estimated to be about $750 billion including European-based deals.
