After a strong recent performance, the CLO new issuance market now faces potential challenges posed by risk retention rules under the Dodd-Frank Act.
According to a report published by Moody's Investors Service, risk retention may be effective in the more troubled asset classes but in the case of the CLO market, it may actually create more problems than it solves.
Dodd-Frank could create some misalignments of interest between CLO managers and investors. In order to satisfy the new risk retention mandates, managers may decide to hold more CLO equity than normal. This would provide a new economic incentive for them to pursue self-interested, high equity returns at the cost of noteholders.
Despite the ample selection of the new risk retention options offered, several cannot be applied to successfully to most CLOs as they pose direct challenges to the new CLO issuance market. These issues threaten the continuation of recent strong performances observed in the marketplace, and are counterintuitive to the rapid recovery that occurred over the prior years.
The enactment of Dodd-Frank could also lead to a severe concentration of power among firms within the industry, which could have ambiguous long-term effects. Due to the increased burden of risk for the manager, as seen in the 5 per cent rule proposed under the Act, fewer small, independent firms will survive in the issuance marketplace.
Moody’s analysts said in the report that the high-level of investor-held discipline, already present in CLOs, expressed in the form of structural fees serves the same purpose as the risk retention legislation under Dodd-Frank. The collateral manager fee structure provides managers with an economic incentive for strong CLO performance and the avoidance of risk, according to the report. Similarly, the common practice of managers distributing interest to CLO noteholders first before collecting a fee themselves achieves the same objective as the risk retention legislation.
The effectiveness of this structural fee can be seen in the performance of the CLO market throughout the financial crisis -- 90% of CLO notes outstanding and initially rated by Moody's as “Aaa” are currently rated “Aa” and higher. While CLO tranches did experience downgrades, when compared with the extent suffered by other types of securitizations, this asset class performed moderately well.
According to the Moody’s Report, the risk retention legislation under Dodd-Frank could begin to impact the CLO market even before it takes effect in mid-2013 due to market participants’ anticipation.