U.S. CLOs get a pass from Japanese risk retention, but at a price

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CLOs managers can avoid Japan's new "skin in the game" rules, though they will have to jump through some hoops.

It remains to be seen how much of a burden this will be.

A final risk retention rule published by the Japanese Financial Services Agency on March 15 has a carve-out for U.S. collateralized loan obligations; it applies solely to CLOs backed by broadly syndicated loans acquired in the open market. In this respect, it is similar to the exemption that such CLOs now enjoy in the U.S.

However, unlike in the U.S., where banks are simply prohibited from holding ownership interests in CLOs that do not comply with risk retention, Japanese banks are required to hold more capital against noncompliant CLOs. This was a cause for great concern when the rule was originally proposed in December, since Japanese banks are big buyers of the AAA-rated tranches of U.S. CLOs.

In order to avoid triggering higher risk weighting for securities issued by CLOs whose managers do not hold on to 5% of the economic risk in their deals, Japanese banks must ensure that these deals are "not inappropriately formed." According to law firm Dechert, those due diligence exercises include confirmation of “reasonable standards” for the acquisition and replacement of loans by managers, and risk analysis that potentially involve stress tests conducted by the investor that the pool of assets remain sound under JFSA standards.

The final rules apply to deals issued after March 31. Deals issued before that date are grandfathered.

Elliot Ganz, general counsel and chief of staff for the Loan Syndications and Trading Association, said the final rule does not spell out clear pathways to judge loans as appropriately underwritten. "There is a fair amount of uncertainty about what that means and what they need to do to establish that,” he said.

Also unknown is how much more compliance preparation activity this will mean for U.S. managers of open-market CLOs. “I think it will be more of a burden,” added Ganz. “If you ask me for [information on] five loans, that’s one thing. If you ask me for 25 loans, that’s five times more work.”

Still, the final rule is “largely positive” for CLO managers, according to Wells Fargo. In a report published Friday, the bank noted that, without the carve-out, U.S. CLOs would have had to change their strategy once again. Just over a year ago, a U.S. federal appeals court ruled that risk retention did not apply to open-market CLOs. However, structured finance analyst David Preston also cautioned in the report that “Japanese financial institutions will increase their due diligence in CLO transactions, leading to more disclosures/paperwork for U.S. managers.”

Wells estimates that Japanese banks own 20% to 25% of the outstanding AAA tranches of U.S. CLOs. Law firm Milbank, Tweed, Hadley & McCloy puts the figure even higher, at 50% to 70%.

in a report issued Monday, law firm Dechert wrote that it also sees more due diligence by Japanese investors "not only with respect to the loans in the CLO at the time the Japanese investors acquire their CLO notes, but also with respect to the credit underwriting and servicing practices of the collateral manager and the stress testing and structuring of the CLO.”

The final rule also clarified that Japanese banks will be subject to higher capital requirements for U.S. CLOs backed by loans to small and medium-sized companies that don't comply with risk retention, according to Ganz. That's because managers of these deals generally use them to securitize loans that they originated themselves and hold on their balance sheets. This is less of a concern, however, since managers of so-called middle-market CLOs generally retain a large economic interest in their deals.

The LSTA has been in talks with Japanese regulators since before the Dec. 28 proposal was first issued, lobbying for the exemption and clarifications to the statute.

In January, the trade group filed a comment letter with the JFSA taking the position that broadly syndicated loan CLOs should be exempt because they are not securitizations as defined by the JFSA.

The LSTA asserted that since CLO managers do not underwrite the loans they acquire in the open market, their portfolios do not constitute a collection of originations – or “original assets” – by the sponsor. Without “original assets,” there is no securitization, which, in turn, means no securitization exposure for CLO investors.

LSTA officials also argued for CLOs’ exemption based on the regulation’s carve-out for securitizations with assets that were appropriately underwritten – which under the JFSA’s proposal would mean “original assets ... deemed not to have been inadequately formed.”

The assets are safe for CLO investors because they are first-lien and secured loans with limited call protections, pay “relatively large spreads” and have an active and liquid secondary market, the LSTA stated in its letter.

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