May 9, 2017 - The Donald Trump Presidency hit its ballyhooed 100-day mark on April 29th. To commemorate the occasion, the LSTA hosted a CLE Webcast on May 4th to discuss what has – and hasn’t – changed. Below we discuss key insights from the segment, which included i) means by which regulation can change, ii) what specifically might be happening to Leveraged Lending Guidance, and iii) how the “avenues” for regulatory change can be navigated to help fix risk retention.
To set the stage, we noted that while much attention has focused on President Trump’s pronouncements via twitter, the reality is that Washington remains Washington. To get appointments through, bills passed and regulatory rules fixed, the process remains the same – and remains slow.
With the Washington process remaining the same, this means there are four avenues to fix counterproductive regulations: Administrative/Executive Orders, Regulatory Action, Legislative Action and Legal Challenges.
First, the Administration has the ability to announce its policy and philosophies through Executive Orders (EOs). A key example is the February 3rd Executive Order on Core Principles for Regulating the US Financial System, which laid out the administration’s principles and required the Treasury Secretary to prepare a report that identified laws, regulation and guidance that inhibit those regulatory principles.
While EOs often don’t actually change rules, they help inform the second approach: fixes by the regulators themselves. With guidance from the Executive Branch, the regulatory agencies themselves might rethink rules, either by entering a new rulemaking process, issuing guidance or simply reducing the level of enforcement. While we may not see immediate change from the regulatory agencies, President Trump will appoint new heads of all the financial regulators in the next two years. Thus, there is significant scope for change in the medium term.
The next avenue runs through Congress. In a more normal environment, legislative solutions would mean passing bipartisan “fixes” to regulations that don’t work. In today’s polarized environment, legislative fixes are leaning on the Congressional Review Act (“CRA”) which allows Congress to revoke rules that were issued and sent to Congress in the past 60 legislative days. While the CRA was only used once prior to the current session, it has been used upwards of 13 times this year. (Be aware, though, that the CRA’s timeframe is running out.)
Finally, regulations can be – and, post-Dodd-Frank, frequently have been – challenged in court.
We are seeing all avenues in play today. The most dramatic event was Senator Pat Toomey (R-PA) asking the Government Accountability Office (GAO) to decide whether the Leveraged Lending Guidance is a Rule under the CRA. If the GAO determines it is a Rule, then the House and Senate have 60 days to revoke the “Guidance”. Remarkably, if Congress revokes and the President signs it, the regulatory agencies cannot issue a similar rule without direction from lawmakers.
So, could this mean that regulation of leveraged lending ends? Most likely not. Regulators have broad powers under their Safety & Soundness mandate. However, it does raise the question of whether some of the more egregious aspects of the Guidance – such as moving goalposts or solid investment grade companies being categorized as leveraged companies – might be moderated.
Risk retention is the other immediate focus. While CLO formation has recovered after a slow January, that doesn’t mean the CLO managers have returned the same way. When we speak with market participants, it seems that managers broadly cluster into three categories. First are the CLO managers that are either naturally capital rich or have restructured themselves to have good access to risk retention capital. These managers may affirmatively like risk retention because it is a competitive advantage. Managers in the next group have found ways to make risk retention work, either by working with a capital rich partner or using vertical financing or both. While this group functions in a risk retention world, it is often by paying away a component of their fees. The third group has not yet found a sustainable risk retention solution.
While Group 1 may affirmatively like risk retention, Groups 2 and 3 most likely do not. In turn, the LSTA continues to seek sensible risk retention fixes, using the avenues described above. First, with the EO offering an opening, the LSTA submitted a letter to Treasury Secretary Mnuchin suggesting easy fixes for the application of risk retention on CLOs. In particular – reflecting a Regulatory approach – the LSTA letter noted that the SEC has the ability to modify or waive the risk retention rules for the CLOs that it alone regulates. The next avenue runs through the Legislative Branch. Representative Hensarling (R-TX) recently passed the CHOICE Act – his Dodd-Frank fix bill – through the House Financial Services Committee. While this bill is likely to pass out of the House on a party-line vote, it is not expected to survive unscathed in the Senate. In contrast, in the Senate, Banking Committee Chairman Crapo (R-ID) and Ranking Member Brown (D-OH) asked for proposals for commonsense regulatory reform that both Republicans and Democrats can support. While we are not sure that fixing CLO risk retention is a cause they will immediately take up, we used this opening to offer the QCLO as a legislative solution. Finally, the LSTA continues with its litigation effort on risk retention. As members know, in October 2014, the LSTA sued the Fed and the SEC on the (mis)application of risk retention to CLOs. The litigation process has been grinding on for nearly three years, first at the Court of Appeals, then at the District Court and now back at the Court of Appeals. We are now entering the end stages. On April 19th, the LSTA submitted its opening brief in its appeal on risk retention. The briefing process will run through the summer, oral arguments are likely to occur in the fall and a final ruling will likely emerge in early 2018.
We leave with a word of warning – but also of hope. For those members that called us on November 9th, asking whether regulation would be swept away immediately, we continue to counsel patience. We do not expect to see massive changes in 2017. However, with regulatory overreach apparent, the House, Senate and White House all in Republican hands and the President’s ability to appoint all new regulators, in the medium term, we may well see a “right-sizing” of regulation.