The LSTA Wednesday evening submitted its comment letter on the revised risk-retention requirements outlined under Dodd-Frank to joint federal regulators (including the Federal Reserve, the Office of the Comptroller of the Currency, the FDIC, and the SEC).
In the letter, the LSTA – at the request of the federal agencies for additional ideas – lays out two proposals that it hopes could mitigate the issues raised by risk retention in its current form. It also repeats its view that in its current form, risk retention would seriously harm the market.
The first proposal expands the concept of a qualified commercial loan (QCL), which is currently used to preclude residential mortgages from risk retention. The idea here would be to redefine the QCL concept using a set of predefined criteria to create a class of leveraged loans that if used as CLO collateral would exempt the loans from the retention requirement.
The LSTA suggests there are a number of key attributes to the leveraged loan market that would support the concept of creating a subset of loans or QCLs that are exempt from retention, not least the rigorous three-tiered underwriting process underpinning CLO construction. Other supportive factors include the fact that CLO managers are active managers engaged in buying and selling loans to maintain a track record, and that as registered advisors, CLO managers operate with a fiduciary responsibility to their investors.
Finally, the LSTA cites the overall strength of the CLO market, which has demonstrated a continued strong performance over the years, and which boasts a default rate that is lower than that of the loan market.
This robust set of conditions should underpin the ability to create a set of higher-quality loans that would be exempt from retention, says the LSTA.
The second proposal concerns third-party sponsors, whereby a third party holds at least 5% of the equity and is involved in structuring the CLO transaction as well as holding the consent right for the loan collateral selection.
A similar idea was considered by a number of European managers earlier this year, with Cairn Capital tapping into a third-party sponsor – in this case the San Bernardino County Employees’ Retirement Association – to retain the equity.
However, while the EBA eliminated this option for European CLO managers via the release of the Capital Requirements Regulation (CRR) in May (this consultation ruled out the use of a third-party sponsor), the U.S. agencies have indicated that they may be willing to consider this proposal.
These latest proposals follow a previous proposal put forward by the LSTA in its April letter, whereby the CLO manager would hold 5% of equity plus unfunded Class M notes that replicate and replace the fee stream.
Accessing all options
Clearly these proposals are not without their issues – a QCL subset of loans within the overall asset class, for instance, could impose a liquidity premium on these assets. As well, managers choosing to include non-QCL assets as collateral would still have to hold some retention to cover exempt assets in the portfolio.
Meanwhile, with regard to the second proposal, there is no real understanding of how deep the market for third-party equity investors might be, while the restriction on hedging the retention piece for the life of the deal may also prove problematic, leading the LSTA to explore the concept of including a sunset provision, limiting the prohibition on hedging/selling the piece for two years when it should be clear whether the structure works.
That said, if CLOs are to be swept up in the retention regulation, then creating as many partial solutions available to CLO managers to mitigate the impact is essential, says the LSTA.
Aside from putting forward these new proposals, the LSTA uses today’s letter to examine the alternative “lead arranger” option, put forward by the federal agencies in their reproposal issued at the end of August. In a nutshell, a lead arranger would agree to hold 5% of a CLO-eligible tranche for the life of the deal without hedging, provided it used these loans as collateral.
The initial market reaction to the August revisions suggested the proposal was unfeasible, but the LSTA has spent the intervening months holding in-depth discussions with lead arrangers to fully assess not only whether they would be able to meet the requirements, but also whether there is any iteration that might work as a solution.
The overriding response was “no.” Arranging banks said they would not hold on their books enough of these institutional loans to satisfy the requirement, even less so without the ability to hedge. Further, the arrangers agreed that any other iteration – perhaps holding a revolver rather than an institutional piece, or sharing the risk among the arranger group of a specific deal – would also not work.
Essentially that renders this “lead arranger” proposal unfeasible, while the initial “manager” option (whereby the CLO manager retains a 5% stake in the CLO vehicle either via a horizontal or vertical slice) is also considered widely damaging to the future health of the U.S. CLO market and the leveraged loan market.
U.S. CLO issuance this year has reached $64 billion, the third-highest annual figure on record, according to LCD. After falling following the credit crisis, CLO managers now represent just over 50% of the institutional investor base for primary leveraged loans (1Q-3Q13).
There is no doubt both within the LSTA and across the broader market that the impact of the retention proposal will be significant, given that the CLO market is a crucial provider of liquidity to the broader syndicated loan market. Broadly speaking, analysts, arrangers, and CLO managers agree that risks include greater volatility in the loan market, manager consolidation, and a meaningful decrease in issuance after the rules take effect as the number of managers able to issue CLOs decreases.
According to the surveys conducted this past summer by the LSTA, the majority of managers do not have the internal funding to enable them to purchase and retain 5% of the fair value of any new CLO notes.
Indeed, while the LSTA has determined the potential for the market to shrink at least 75% under the regulation – a point recognized by the federal agencies – the agencies have not fulfilled their obligation to perform a thorough cost-benefit analysis to establish if the risks outweigh the costs. The LSTA reiterates this point in today’s letter, suggesting that there is no possibility for them to prove this assumption.
Finally, the LSTA uses the letter to reiterate several other points made previously, including the agencies’ lack of statutory authority to ask CLO managers to retain the risk. In the August reproposal the federal agencies address this legal argument, and in today’s letter the LSTA addresses that response, arguing again that securitization retention rules are intended to cover entities such as banks, which originate to distribute, rather than CLO managers, which select rather than originate assets for their securitizations.
The LSTA also highlights the fact that the options put forward by the agencies to enable a sponsor to fulfill the statute’s requirement that a sponsor hold 5% of the credit risk are not equal. Specifically, a 5% retention via the horizontal slice equates to more than 5% of credit risk. While conceding this point in the reproposal, noting that 5% of the vertical does amount to less than 5% of the horizontal in terms of credit risk, the agencies fail to actually address the issue, the LSTA says.
Moving forward, with the comment period now closed, the federal agencies will have to assess and react to what is expected to be a multitude of comments across numerous ABS asset classes. The regulation becomes effective two years after the publication of the final rule, so likely no earlier than early 2016. – Sarah Husband