CLO managers have been lobbying hard to shape rules requiring them to keep skin in the game.’ Now they are getting support from an unlikely source European central bankers.
Dodd-Frank calls for issuers of all asset-backed securities to retain not less than 5% of the credit risk in these deals. The idea is to better align the incentives of issuers and investors, so as to improve the quality of the underlying assets and avoid the kind of meltdown that occurred in mortgage backed securities during the 2007-2008 financial crisis.
Loan market participants feel the rules are unnecessary for collateralized loan obligations, which typically acquire their collateral senior secured, below investment grade commercial loans - in the open market, rather than originate the loans themselves. And they argue that retaining 5% of a deal is unduly burdensome for sponsors, many of whom are investment management firms with small balance sheets.
So lenders and CLO managers have asked regulators to define a category of high quality CLO that would be subject to different risk retention requirements. To qualify, managers would have to meet restrictions on asset quality, portfolio diversification, CLO structure, alignment of interests between managers and investors, regulation of the CLO manager itself, and transparency and disclosure.
The Bank of England and the European Central Bank have endorsed a similar approach to encouraging Europe’s moribund asset-backed market. In late May, the central banks released a draft paper and sought comment on “qualifying securitisations” that would be “simpler, more structurally robust and transparent, enabling investors to model and understand with confidence the risks incurred.” This in turn would create an increase in liquidity.
The criteria for a qualifying securitization include asset characteristics, key structural aspects of the securitization, transparency requirements, and key roles for external parties.
The similarities were not lost on the Loan Syndications and Trading Association, a U.S. industry trade group, which submitted a letter to U.S. regulators on June 25 drawing attention to several points made in a BOE/ECB discussion paper. “Our letter draws attention to a number of parallels between qualifying securitizations,’ which are robust, simple, and transparent, and the proposed Qualified CLO structure,” LSTA Executive Director R. Bram Smith said in a press release issued the same day.
The LSTA's letter notes that the principles behind qualifying securitizations described in the BOE/ECB paper are similar and are designed to produce the same public policy benefits as those in the U.S. financial industry’s qualified CLO proposal, submitted by the LSTA, the Structured Finance Industry Group, and the Securities and Financial Markets Association.
The LSTA’s letter was submitted to the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, Securities and Exchange Commission, and Department of Housing and Urban Development.
The latest salvo comes amid reports that the Treasury Department expects to finalize risk retention requirements shortly. The rules were originally proposed in 2010 and were re-proposed last year.
While risk retention rules could discourage the creation of deals, CLO managers are making hay while the sun shines. New issuance reached a record $35.6 billion in the second quarter, surpassing the prior second-quarter record set in 2007, according to Thomson Reuters LPC. With $58 billion in CLO issuance through the end of June, a majority of managers, arrangers and investors say the market is “easily” on track to surpass $100 billion in issuance.
Many new CLOs being constructed to comply with the Volcker Rule, which puts deals backed by bonds off limits to banks. According to Thomson Reuters, this is attracting a broader investor base. In a report issued July 1, it stated that have spreads on triple-A rated tranches of CLOs have been “favorable,” persistently in the high 140 bps context in most of the quarter.
“Banks have returned, to some degree, while arrangers expect that growth from non-traditional investors including money managers will continue given the availability of shorter duration notes via refinanced deals,” the report stated.