April 18, 2017 - Could there be legislative help on the risk retention front? Perhaps. But as market participants have learned, it is easy to have one’s hopes raised – and even easier to see them dashed. Below we discuss the opening offered by the Senate Banking Committee, and the LSTA’s response.
On March 20th, Senate Banking Chairman Mike Crapo (R-ID) and Ranking Member Sherrod Brown (D-OH) issued a public request for legislative proposals to foster economic growth. Responses, which had to be substantive, explain the impact on the economy and consumers, and include legislative language, were due on April 14th.
Responding to the request, the LSTA submitted a comment letter that explained the role of CLOs in providing nearly $450 billion of financing to companies that employ more than 7 million people in the U.S., according to www.loansmeanbusiness.com/positive-impact. The letter discussed the Dodd-Frank Act, and how the final rule applied risk retention to the managers of Open Market CLOs, even though i) these are not the originate-to-distribute securitizations Dodd-Frank targeted and ii) CLO managers don’t own the assets being securitized (unlike originate to distribute securitizations) and therefore actually have to buy notes in order to “retain” them. Furthermore, we observed that in the horizontal retention option, the final rule required far more than the 5% credit risk retention that the Dodd-Frank Act mandated.
So what to do? We (re)recommended the concept of a “Qualified CLO”, whereby the manager of a CLO that meets protective tests in six areas – i) asset quality protections, ii) diversification requirements, iii) structural protections, iv) alignment of interests of managers and investors, v) regulatory oversight and vi) transparency and disclosure – be permitted to retain risk by purchasing and holding 5% of the CLO equity as well as having at least half its fees subordinated to noteholder payments. Together, the equity retention and the subordinated payments total well more than the 5% credit risk envisioned by the Dodd-Frank Act. (And, that’s in addition to the suite of protections!) In addition to the proposal, the letter also included possible regulatory text as well as research demonstrating how the proposed approach meets the Dodd-Frank Act’s target retention level.