There's a Downside to Deregulation for CLOs
There’s considerable optimism in the CLO industry about regulatory relief under the Trump Administration, at some point. Yet much of the discussion at an industry conference in New York Wednesday was devoted to the potential complications that could result from rolling back rules enacted by the previous administration under Dodd-Frank.
Or, as Patrick Pinschmidt, a former Treasury Department official and executive director of the Financial Stability Oversight Council, put it, “deregulation can sometimes be as lengthy and cumbersome as regulation.”
Pinschmidt, the keynote speaker, said that any easing of regulation would likely come at the agency level from political appointees, given the difficulty in getting Congress to act. But he warned that “gutting" Dodd-Frank would resurrect past problems of "limited transparency" and "siloed" regulatory oversight. Pinschmidt also cautioned that, “while we should do what can to encourage a level playing field internationally,” a dramatic easing of risk retention requirements and leveraged lending guidance could jeopardize harmonization of regulation in the United States and abroad.
That was certainly on the minds of CLO managers who have completed deals designed to be dually compliant with risk retention rules here and in the European Union.
Amir Vardi, a managing director at Credit Suisse Asset Management, said that his firm completed a dually compliant CLO last year, and was looking at doing more. But he worries that if U.S. risk retention rules are relaxed, “never mind if Europe [risk retention requirement] gets worse,” CSAM might be stuck holding “skin in the game” of its deals longer than it would like.
Mark Sanofsky, a managing director at CIFC, has similar concerns, but thinks that “Europe is just too valuable to pass up,” particularly given the uncertainty about potential deregulation in the U.S. “I wouldn’t make deal Euro compliant for a single $3 million investment, but we’re seeing more than that,” he said.
The cost-benefit analysis of doing dually compliant deals is complicated by the fact that EU regulators are contemplating changes to their risk retention rules as well. But rather than easing up, they are looking at more onerous requirements. Currently same level, 5%, but the obligation does not rest with the sponsor, or manager of the deal. Rather, certain investors are prohibited from investing in deals that do not comply. Proposed changes would shift the obligation to the sponsor. Sagi Tamir, a partner at law firm Mayer Brown, noted that, while enforcement is left to the discretion of EU member states, “the penalties are pretty harsh.” There are fines and temporary bans on CLO managers.
The amount of skin managers must keep in their deals could also rise, to as high as 20%, though the actual level may depend on type of holding. Regulators may also review the appropriate level every few years. Tamir said
Possible easing of Volcker Rule restrictions, which make it unattractive for CLOs to invest in high yield bonds, would appear to pose fewer complications. The rule prohibits banks from proprietary trading and, as a corollary, having an ownership interest in what are defined as “covered funds.” CLOs fall into this category if they hold bonds or other types of securities, as opposed to loans.
“I have nagging suspicion that banks have better success pushing back Volcker than risk retention,” said Edmond Seferi, a partner at Morgan, Lewis & Bockius. “That’s the regulation their lobbying is most focused on.”
Credit Suisse Asset Management isn’t waiting for the Volcker Rule to be relaxed. Vardi said the firm has already taken two existing deals out of compliance when it refinanced them. The manager is contemplating doing a new deal that is non-compliant, if there is enough interest among non-bank investors such as insurance companies.
“The market finds a way,” he said.