U.S. CLOs risk losing Japanese investor base under proposed rule

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Risk retention in U.S. CLOs just won’t die.

Less than a year after a U.S. appeals court overturned federal risk-retention rules for collateralized loan obligations, “skin in the game” is once again front and center for loan portfolio managers – this time through a proposed Japanese regulation impacting the CLO sector’s largest investor base.

The Japanese Financial Services Agency published a proposed rule on Dec. 28 that would discourage investments by Japanese institutional investors in securitizations that lack risk-retention structures. The Japanese retention requirement would apply punitive regulatory capital risk charges on Japan’s regulated banks for their ABS holdings that aren’t compliant with risk-retention standards.

The proposed rules would only impacts future asset purchases; existing CLOs holdings are grandfathered. Still, the proposal is raising alarms in the U.S., where CLO market, where Japanese banks purchase between 50% and 75% of all newly issued AAA rated CLO securities, according to global law firm Milbank, Tweed, Hadley & McCloy.

The Loan Syndications & Trading Association has “been engaged” with Japanese FSA officials for "several months" about carving out an exemption for CLOs, the trade group's vice president Meredith Coffey said in an email.

In a client alert published Monday out of its London office, Milbank warned that the new proposal, if it goes into effect, could reapply de facto risk-retention standards on managers with no choice but to rekindle risk-retention features on CLOs in order to access the cornerstone investor base for senior CLO securities.

The requirement, if finalized by Japanese regulators, means U.S. CLO industry could “see a return to retention-compliant U.S. CLO structures, to the extent that such transactions are to be marketed in Japan, together with its consequent costs and complexities.”

In a structured finance research note published Wednesday, Wells Fargo thinks the rule, if implemented, could both damp new CLO issuance in the near term and lead to more favorable pricing for existing deals that comply with risk retention.

Wells noted that if the rule were to apply to U.S. CLOs, "we would expect much less U.S. CLO issuance in the near term" until managers could comply.

Wells also expects "tightening for deals that would comply – including Euro and MM CLOs (which should have an easier path to compliance), and widening for non-compliant deals," the report stated. Lead analyst Dave Preston, head of CLO and commercial ABS research, reports only 18% of U.S. CLOs issued in 2018 were in compliance with similar European risk-retention requirements.

The Milbank alert, written in conjunction with Tokyo law firm Anderson, Mori & Tomotsune, also stated that the risk-retention proposal “bears a number of similarities to existing risk retention legislation in the U.S. and Europe, and may result in some Japanese investors being disincentivised from purchasing [securitization] positions where an appropriate entity has not committed to hold a 5% retention piece in the transaction,” the alert stated.

The Japanese retention requirement proposal adopts the minimum 5% compliance standard for originator-held stakes that was previously applied to U.S. CLOs, and still stands for CLOs issued in Europe.

The rules would put the onus on Japanese institutional investors through an “indirect” compliance requirement showing their securitization holdings meeting the minimum retention standards. Failing that, an imposed extra capital charge for a noncompliant securitization asset would be applied, and would be triple what it otherwise would cost in the risk-weighting of the Japanese bank’s ABS holdings, according to Milbank.

A record $128.1 million of open-market, broadly syndicated U.S. CLOs were issued in 2018, the vast majority of them subsequent to a D.C. Court of Appeals ruling in February (later finalized that spring) that set aside regulations that had required managers retain a minimum 5% value of newly issued deal either on their own books, or assigned to a majority-owned capitalized vehicle.

“[F]ollowing the D.C. Circuit Court ruling that the U.S. risk retention legislation does not apply to ‘open market CLOs, compliance with the US risk retention rules now applies only to a small subset of US CLOs,” according to the client alert.

The LSTA is preparing a formal response to the proposal (public comments are due on the proposal Jan. 28, according to Milbank), and is expected to seek a carve-out from the rule to preserve the current CLO market ecosystem between U.S. issuers and Japanese banks, according to LSTA general counsel Elliot Ganz.

The LSTA is banking on getting the exemption through a provision in the proposed rule “that suggests that an investor would not have to hold excess capital, even if there is no risk retention, so long as the assets underlying the securitization were not 'originated inappropriately,' " Ganz said in an interview.

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