Collateralized loan obligation managers and arrangers have long argued that they should not be subject to the requirements to retain “skin in the game” of these deals. CLOs, which are backed by below investment grade corporate loans, didn’t contribute to the financial crisis, the argument goes, and they shouldn’t have to pay the price for it.
Regulators have granted CLOs an exception, but it’s unlikely to reduce the burden on managers, likely forcing many of them to raise capital, sell themselves to a larger manager, or call deals early.
Dodd-Frank calls for securitizers to retain at least 5% of credit risk in any securitized assets. This is intended to discourage the kind of lax underwriting of residential mortgages and other kinds of debt that many believe did contribute to the financial crisis. The original rules, released in April 2011, proposed general methods for meeting this requirement, including holding 5% of each tranche issued, 5% of the first-loss tranche, and a cash-reserve account.
This produced a storm of commentary that CLO managers, which buy loans used as collateral, rather than underwrite them, shouldn’t be considered securitizers. Commentators also argue that many CLO managers do not have the financial ability to satisfy this requirement, and that shutting them out of the market would increase the cost of financing for noninvestment grade companies.
Regulators attempted to provide greater flexibility in new rules proposed in August, at least for CLOs that acquire their collateral from third parties in the open market. It does not apply to CLOs that obtain the majority of their assets from entities that control or influence its portfolio selection (known as balance sheet CLOs).
This exception allows the bank that is the lead arranger of a loan to retain the risk instead of the CLO manager. However, a deal using this exception would have to contain only eligible loans and therefore would have a much more limited universe.
A deal using this exception would also be prohibited from owning bonds or other assets, further limiting the selection. Many recently issued CLOs allow for as much as 10% of their portfolios to be allocated to bonds.
But the primary reason the exception is considered unworkable is that it places an unrealistic burden on banks that originate loans and syndicate them to investors.
“Expecting the lead arranger to agree to covenants maintaining a 5% stake in the specific tranche that is unhedged, plus an initial hold of 20% of the credit facility, is not practical,” Barclays stated in a report published on Sept. 6.
“While in a time of significant stress, it is feasible that a bank would be open to such an arrangement for a few specific transactions, we do not expect enough deals to fit these criteria for a functioning CLO market to exist based on these exemptions.”
When a loan is syndicated, it is usually provided by a group of lenders and is structured, arranged, and administered by one or many commercial or investment banks known as arrangers. The lead manager on the syndicated loan is usually in charge of preparing and executing the transaction and helps in choosing the syndicate’s member institutions.
Although it was once common for lead arrangers to retain stakes in these loans, that was partly because broader market demand was limited, and high-yield assets did not incur regulatory penalties.
But as Fitch Ratings pointed out in a Sept. 17 report, in recent years the healthy demand for loan from non-bank investors including mutual funds and CLOs has transformed the role played by banks in this market.
“As new loan activity has remained strong in 2013, banks have increasingly shifted their focus away from holding loan positions to serve primarily as facilitators and distributors in the market,” it stated.
New capital regulations have also shifted banks’ focus principally toward participation as facilitators in the leveraged loan market, according to Fitch.
In other words, this exception is pretty much a no-go.
“While we are generally in favor of optionality and believe the more the merrier when it comes to potential retention providers, we fear that few, if any, lead arrangers will accept the invitation being extended by the agencies,” said John Timperio, a partner, and Ahmad Elkhouly, an associate, at law firm Dechert in a Sept. 3 client alert.
Further, the law firm said that complying with this new proposal would considerably change the economics and capital charges on lead arrangers. And since there are other buyers of loans, such as retail mutual funds, banks have no real incentive to comply. “We do not believe lead arrangers would feel compelled to change the way they operate in order to participate in originating CLO-eligible loan tranches,” it stated.
For CLOs, the retention requirement would be effective two years after the date the final rules are published in the Federal Register. With the comment period for the latest proposal closing on Oct. 30, that would mean November 2015 at the earliest.
If the risk retention rule is implemented as currently written, Dechert believes it would probably adversely impact the cost and availability of below investment grade corporate credit. Additionally, considering that only the biggest and best capitalized managers can fund the required risk retention, Dechert expects a new consolidation wave and other partnership arrangements to happen among managers. This would inevitably result in a reduced number of managers as well as less competition.
Wells Fargo also expects the ranks of CLO managers to shrink under the rules as currently written. In a Sept. 20 report, David Preston, the firm’s director of CLOs, CDOs and commercial asset-backed securities research, noted that purchasing 5% of a CLO would take up a large portion of the annual revenue of many of smaller management firms. “Therefore, once risk retention takes effect, it is likely that these smaller managers, blocked from the primary market, will sell the CLO management contracts or the platforms once the existing deals begin to amortize,” he wrote. “This would limit investor choice and consolidate more risk in the CLO market, as large CLO managers would grow even larger.”
Furthermore, there is no guarantee that larger managers able to purchase 5% of the CLO, will find that to be the best use of capital. “The equity portion retained by the manager would have a lower return profile due to the delay in cash flows,” Preston wrote. “At this point, we think the vertical slice may be the more viable option, given the decreased equity returns caused by the cash flow restrictions. The decreased return of the manager’s equity slice will likely make the risk/reward profile of that investment less compelling.”
So even if a select group of managers is still able to issue CLOs, Wells Fargo would still expect a meaningful decrease in issuance after the rules take effect.
But while the long-term outlook for CLO issuance is cloudy, near-term demand is strong. In fact, with rates headed higher, investors are clamoring for assets such as loans and CLOs that have floating rates. Barclays expects issuance to exceed $65 billion for 2013 as a whole, and other estimates range as high as $70 billion. That would represent a roughly 30% increase over 2012, although much of this will effectively refinance older CLOs that are nearing the end of their investment lives.
If anything, Barclays said, the proposed rules could pull issuance forward, as CLO managers are motivated to get as many deals as possible done before risk retention takes effect. The catch: these deals are likely to have shorter periods in which they cannot be called, so as to allow managers to avoid the proposed rules.
Barclays noted that CLO non-call periods have hovered round two years since 2010, but said they could decline to allow new vehicles to be refinanced before risk retention takes effect.
“While longer reinvestment periods are always desirable for CLO managers, we would not be surprised to also see an increase in reinvestment periods as the deadline for risk retention approaches,” the analysts wrote.