Earlier this year, a panel of judges at the Federal Circuit Court decided unanimously to lift a rule imposing “risk retention” on managers of commercial loan securitizations, because it did not comport with the statutory language of the Dodd-Frank Act.
As a former portfolio manager and the executive director of the trade association that brought that lawsuit on behalf of managers of “collateralized loan obligations,” or CLOs, I am, of course, grateful for this result. Yet, I also remain frustrated by the time, effort and resources spent by our members in complying with this ill-fitting rule and by us in pursuing the three-and-a-half-year judicial odyssey that ultimately led to the right result. Now this CLO saga is finally coming to a close, but it’s worth noting that it brought to light lessons that Congress and regulators should take to heart.
Our legal battle should underscore for policymakers three important principles. First, deliberation is much more important than speed. Second, the trend of delegating to the agencies virtually all of the responsibility for implementing financial rules has gone too far. Third, requiring implementation through multiagency rulemaking is fraught with peril.
Dodd-Frank required parties that originate loans and then sell them to securitization vehicles to retain at least 5% of the credit risk associated with those securitizations. This provision was designed to address concerns that banks were originating bad loans, such as subprime mortgages, without regard to their credit quality. By requiring loan originators to keep “skin in the game,” Congress believed they would be more careful in underwriting future loans. Implementation of the law was delegated to the banking agencies and the Securities and Exchange Commission, and they imposed risk retention rules on virtually all securitizations, including CLOs. (Ironically, however, most residential mortgage securitizations, which were largely responsible for the 2008 financial crisis, did not have to comply.)
But that posed a problem. In contrast to subprime loan originators, CLO managers are hired by investors to actively manage a portfolio of loans to U.S. companies. As such, requiring CLO managers to comply with risk retention would be similar to demanding that a mutual fund manager buy $5 of Google stock for every $100 of Google stock it buys for its clients. It just doesn’t make sense.
My organization, the Loan Syndications and Trading Association, first sought a solution that would work for all the regulatory agencies and the market. Discussions failed, in part because even though the SEC is the primary regulator for almost all CLO managers, we also had to negotiate with three banking agencies, each of whom had its own views. Forging a consensus under those circumstances proved impossible. Consequently, we were forced to sue.
We argued that the agencies exceeded their statutory authority because CLO managers receive money from investors like insurance companies, pension funds and banks and use those investments to purchase in the open market portfolios of commercial loans to American companies. CLO managers, in contrast to banks, do not originate any loans. And unlike the scary types of securitizations highlighted in "The Big Short," CLOs are very straightforward — no subprime real estate, nothing synthetic, no betting against anyone. Indeed, CLOs provide over $500 billion to growing American companies and have a 20-year track record of success. Even the federal regulatory agencies admitted in their court filings that CLOs performed extraordinarily well through the recent financial crisis.
Still, the agencies moved forward with the risk retention rules, dramatically changing the business model for CLO management in ways that actually added risk to the system. No longer could a CLO manager attract investors solely on the basis of its track record for picking loans and managing credit — instead, its ability to raise third-party capital became paramount. Many managers were forced to comply with risk retention by borrowing money, adding leverage and potential volatility to an otherwise stable, long-term product. Moreover, the risk retention rules particularly disadvantaged smaller companies who did not have the kind of access to third-party capital that was available to far larger managers.
Many companies were unable to raise that capital and were forced to sell themselves. After struggling for years, others ultimately found ways to comply but not without significant cost in money and time. We are grateful that the appeals court understood that, as we always believed, risk retention was not meant to apply to CLO managers.
What are the lessons for Congress and the regulators? Let me suggest a few. In a rush to address the financial crisis, the Dodd-Frank Act was put together too quickly, without the kind of deliberation that is necessary for such a sweeping financial regulatory bill. Moreover, most of the implementation of the law was delegated to the banking regulators and the SEC rather than being laid out in the statute itself. Worse, much of the rulemaking, including risk retention, involved multiple agencies, all of which had their own separate, distinct and often conflicting mandates. The process was long and unwieldy and led to some questionable results. In the future, Congress would be better off taking the time to deliberate fully, delegating less to the agencies and, when it does delegate, identifying a single, lead agency to implement specific rules.
While we ultimately won our legal challenge, the costs imposed on the CLO market and the harm that risk retention did to individual managers cannot be reversed. We hope that future generations will not have to undergo so many efforts to right a rushed and ill-fitting rule. But now that this saga is finally over, our members can get back to what they do best: providing capital to growing American companies.