June 14, 2017 - Recently, two important financial regulatory reform efforts were launched, each of which was large in scope and could have important ramifications for the loan market and beyond. As reported by the Wall Street Journal, on June 7th, the House of Representatives passed the CHOICE Act, a sweeping bill that would repeal much of the 2010 Dodd-Frank Act. Then, as reported by Bloomberg, on Monday, Treasury Secretary Mnuchin released a 150 page report, “A Financial System That Creates Economic Opportunities” (the “Report”), the first in a series in response to President Trump’s March 3rdExecutive Order outlining “Core Principles” for financial regulation. The Report was also sweeping but its goals much more modest than those of the CHOICE Act. We will examine how each of the CHOICE Act and the Report could impact the loan market and discuss the possible avenues to reform of loan market regulation. Next week we will do a deeper dive into the treasury report.
The CHOICE Act would repeal risk retention for most asset classes thereby releasing CLO managers from their current obligation to hold 5% of the fair value of any deal they initiate. It would also repeal the Volcker Rule in its entirety. While Volcker was originally designed to prohibit banks from owning equity interests in private equity and hedge funds (“covered funds”), it has been interpreted by the regulators as extending to the ownership of interests in debt securities of CLOs. Thus, repeal of Volcker would end that restriction. In contrast, while not seeking repeal of Volcker, Treasury argues that the “covered funds” definition in Volcker is too broad, “including types of entities beyond private equity and hedge funds” and suggests that rather than defining covered funds by reference to whether they would be investment companies under the ‘40 Act but for certain exemptions, the agencies “adopt a simple definition that focuses on the characteristics of hedge funds and private equity funds”. It is likely that CLOs would be carved out of a narrowly tailored definition and banks would once again be able to purchase CLO debt securities. Notably, unlike the CHOICE Act, this first installment of the Report does not address risk retention at all (its focus is mainly on the banking system) but many observers believe that the next report, which will cover the capital markets, will address that issue. The Report does address the Leveraged Lending Guidance (“LLG”), which is not covered by the CHOICE Act. The Report expressed concern with ambiguity of the definitions in the LLG as well as a lack of clarity around penalties for noncompliance. This ambiguity meant that banks had to wait unto ex post facto regulatory review to get clarity on whether a loan would pass or fail supervisory review. Moreover, the absence of clear compliance rules appears to have resulted in fewer leveraged loans being made by banks – but not necessarily fewer loans in the system. Instead, leveraged lending migrated to less regulated non-banks, “a dynamic which makes it far less clear that the guidance actually diminished risk to financial stability…” The report recommends that (i) the LLG should be re-issued for public comment and refined with the objective of reducing ambiguity and achieving consistency in supervision, examination and enforcement, and (ii) banks should be encouraged to incorporate clear but robust metrics when underwriting leveraged loans instead of relying on the 6X leveraged ration discussed in the LLG.
What happens now? While the CHOICE Act passed along party lines and the White House signaled its support, most Washington observers view the prospects for passage by the Senate of the CHOICE Act as dim. Instead, the Senate appears to be taking a much less ambitious and more targeted approach. As we recently noted, Senators Mike Crapo and Sherrod Brown, the Chairman and Ranking Member, respectively, of the Senate Banking Committee, requested proposals that would foster economic growth and are likely to use some of the 130 responses they received as a starting ground for more moderate and targeted financial regulatory reform. Similarly, the first installment of the Report charts a more modest path. The Report helps chart a course that that the administration will be pushing in negotiations with the Senate and the House. Ultimately, to the extent there is any financial regulatory reform during this session of Congress, it will result from some combination of CHOICE Act provisions, targeted reforms identified by the Senate, and ideas generated by the Administration in response to its Executive Order. We will continue to follow these events closely. For detailed summaries of the Report. Please see these memos from Cleary and MoFo.