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CLO Volume Hits Record As PE, Wall Street Look To Stay Ahead Of New Rule

March was a record month for CLO issuance with $15.2 billion in deals coming to market, bringing the YTD total to $29 billion and making Q1 2015 the best first quarter in history for CLO new issue volume. 

As Deutsche Bank notes, supply (in terms of the loans backing the deals) isn’t necessarily aligned with demand which should keep spreads tight because when yield-starved investors can get 150bps over LIBOR for an AAA-rated tranche (let’s just forget the fact that there’s no telling what “AAA” even means anymore), they’ll take it, especially when loaning money to recently bailed out European countries will now guarantee you a loss (thanks, NIRP) and when your deposits may be taxed to subsidize new home buyers’ mortgages. 

Another factor is limited supply of new collateral... Without issuance picking up we are likely to see loan spreads tightening given the strong demand from CLOs and that in turn would require CLO spreads to tighten.

So that explains the demand side of the equation and touches on underlying supply (i.e. leveraged loan issuance), but what accounts for the fact that Q1 2015 was the best first quarter on record in terms of bringing deals to market? Here’s Bloomberg to venture a guess:

Only 10 out of the top 30 money managers may be able to comply with new regulations requiring them to hold a 5 percent stake in funds they manage, which take effect in December 2016, according to consulting firm Oliver Wyman.


Managers “want to get deals done early before risk retention kicks in,” Rishad Ahluwalia, the London-based head of global CLO research at JPMorgan, said in a telephone interview.


The risk-retention rule, released in October, is part of of the 2010 Dodd-Frank Act enacted in response to the credit crisis that was fueled in part by the securitized debt that bundle mortgages. CLOs bundle speculative-grade corporate loans that have been used to finance some of the biggest buyouts in history.

The thing about choosing the reference pool for a CDO is that if you have to retain some of the credit risk then you might be inclined to be a bit more selective in choosing what goes into the underlying portfolio, and that’s no fun because once you start asking about underwriting standards lenders get nervous and the universe of collateral starts to dry up and then the whole securitization machine grinds to a halt which isn’t good for anyone who gets to collect fees along the way as loans are sliced up and sold to “sophisticated” investors who may or may not be buying into the next Abacus. Well, it only took one implosion of the entire global financial infrastructure for the government to catch on to the fact that securitization can encourage poor underwriting standards and last October — a short six years after this very same originate-to-sell model collapsed the entire system — America’s regulators attempted to address moral hazard by requiring CLO issuers to retain 5% of the credit risk to the deals they bring to market.

As a reminder, here’s what Bloomberg had to say at the time: 

U.S. regulators will make investment firms or banks that create securities backed by high-risk corporate loans retain a portion of their new deals.


The final rule released today includes a requirement that managers of collateralized loan obligations ranging from Apollo Global Management LLC and Symphony Asset Management LLC hold on to at least 5 percent of the debt they package or sell.


Alternatively, banks underwriting CLOs could hang on to a piece.


The rule has drawn protests from bankers and managers of the funds and would make it more expensive to put together CLOs, which have been issued at a record pace this year. Regulators are trying to curb excessive risk taking in response to the credit crisis that was fueled in part by securitized debt, particularly in the mortgage market.

So in short, record issuance seems to indicate that issuers want to get these deals to market before they’re forced to hold onto 5% of the possibly-toxic credit risk they’re selling to investors, something which isn’t exactly confidence inspiring when one is looking to assess the degree to which we’re all safer in the post-crisis financial world. Where the whole thing gets really amusing though is in the government’s 500-page final rule on the issue wherein banks and other “commenters” (i.e. all ABS issuers) attempt to explain why the rule isn’t fair and the government attempts to explain why the commenters are being completely ridiculous.

Here’s the government stating the obvious: 

Moreover, contrary to commenters’ suggestions, as discussed below, developments in the CLO and leveraged loan market suggest that CLOs present many of the same incentive alignment and systemic risk concerns that the risk retention requirements of section 15G were intended to address. CLO issuance has been increasing in recent years. Paralleling this increase has been rapid growth in the issuance of leveraged loans, which are the primary assets purchased by most CLOs. Heightened activity in the leveraged loan market has been driven by search for yield and a corresponding increase in risk appetite by investors…


The agencies note that there is evidence that this increased activity in the leveraged loan market has coincided with widespread loosening of underwriting standards. In fact, a recent review of a sample of leveraged loans by the Federal banking agencies found that forty-two percent of leveraged loans examined were criticized by examiners. The agencies believe that increases in the origination and pooling of poorly underwritten leveraged loans could expose the financial system to risks….


As discussed in more detail below, these developments in the leveraged loan and CLO market represent similar dynamics to issues in the originate-to distribute model that were a major factor in the recent financial crisis. For these reasons, and others discussed below, the agencies believe it is appropriate to apply risk retention rules to open market CLOs as well as balance sheet CLOs. 

While that seems to make all kinds of sense (which is rare as it relates to analysis by official regulatory bodies, especially those whose mandate it is to oversee the financial markets), the PE firms and Wall Street banks of the world were quick to explain that actually, the risk retention rule should not apply because CLO issuers are not “securitizers” and (get this) CLOs are not really asset backed securities. Perhaps anticipating that even the government wasn’t gullible or lobbied enough to accept such a ridiculous excuse, the “commenters” attempted to play the old “one move and the underqualified borrower gets it” routine.

As discussed in the reproposal, many commenters on the original proposal raised concerns regarding the impact of the proposal on open market CLOs. Some commenters asserted that most asset management firms currently serving as open market CLO managers do not have the balance sheet capacity to fund 5 percent horizontal or vertical slices of the CLO. They asserted that imposing standard risk retention requirements on these managers could cause independent CLO managers to exit the market or be acquired by larger firms. According to these commenters, the resulting erosion in market competition could increase the cost of credit for large companies that are of lower credit quality or that do not have a third-party evaluation of the likelihood of timely payment of interest and repayment of principal and that are represented in CLO portfolios above the level that otherwise would be consistent with the credit quality of these companies.


The agencies received many comments asserting that the proposed options for open market CLOs would be unworkable under existing CLO practices and would lead to a significant reduction in CLO offerings and a corresponding reduction in credit to commercial borrowers. These commenters asserted that the likelihood of a significant number of lead arrangers retaining 5 percent risk retention (in any of the forms permitted by the rule) would be remote and only the largest CLO managers would be able to finance the proposed risk retention requirement through the standard risk retention option. While larger managers might have sufficient financing, several commented that the risk retention requirements would make the management of CLOs less profitable and might cause many managers to decrease their activity in the market. One commenter highlighted a recently issued paper by the Bank of England and the European Central Bank to suggest that risk retention rules in Europe that apply to CLO managers have contributed to a reduction in European CLO issuance. Several commenters asserted that if the risk retention requirement causes a reduction in participation by open market CLOs in the leveraged loan market, some of the resulting reduced credit availability would be replaced by non-CLO credit providers, but cost of capital and instability in the market would increase. 

So essentially, it’s all about keeping credit flowing to deserving borrowers and not at all about a desire to keep exposure to 5% of a collateral pool littered with loans to “companies that are of lower credit quality or that do not have a third-party evaluation of the likelihood of timely payment of interest and repayment of principal” off of the books. 

The real punchline though is the government explaining that despite commenters’ objections, issuers are indeed securitizers because they securitized the underlying loans and CLOs are indeed asset backed securities because, well, they are securities backed by assets.

Certain commenters also asserted that open market CLO managers are not “securitizers” under section 15G of the Exchange Act and, therefore, the agencies do not have the statutory authority to subject them to risk retention requirements...

As explained in the reproposal, the agencies believe that CLO managers are clearly included within the statutory definition of “securitizer” set forth in section 15G of the Exchange Act. Subpart (a)(3)(B) of section 15G begins the definition of a “securitizer” by describing a securitizer as a “person who organizes and initiates an asset backed securities transaction.” 


CLOs clearly meet the definition of “asset-backed security” set forth in section 3 of the Exchange Act, which defines “asset-backed security” as “a fixed income or other security collateralized by any type of self liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on the cash flow from the asset.”  As discussed above, a CLO is a fixed income or other security that is typically collateralized by portions of tranches of senior, secured commercial loans or similar obligations. The holder of a CLO is dependent upon the cash flow from the assets collateralizing the CLO in order to receive payments. Accordingly, a CLO is an asset-backed securities transaction for purposes of the risk retention rules.

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So at the end of the day, no one wants to eat their own cooking — not even 5% of it.