November 21, 2016 - November 21, 2016 – There has been much speculation over what Donald Trump’s unexpected election will mean for the loan market, in particular from a regulatory perspective. What follows is an attempt to describe the new reality and develop some educated guesses about how it could impact the regulation of loans and CLOs.
Level-setting the new world: Unlike the past eight years, financial reform legislation that reaches the president’s desk is likely to be signed. President Trump is likely to appoint more conservative and less activist heads of the financial regulators and nominate Supreme Court justices who are less deferential to regulatory rulemaking. On the Congressional side, notwithstanding that the Republicans continue to hold both the Senate (52-48) and the House (with a 45 seat majority), the requirement of a 60 vote majority in the Senate to pass most laws could pose a formidable obstacle to getting broad financial regulatory reform passed. The key question: Will Trump and Chuck Schumer (the incoming Senate Minority Leader), both dealmakers, be able to fend off the opposition of the likes of Senator Warren who is already vocally threatening her own party members if they support such reform?
Three observations: First, while the landscape for financial reform is more favorable, it is important to note that what swept Donald Trump in to office was a populist wave; it remains to be seen whether the president and Congress are willing to go to bat for “Wall Street”. Second, 25 Democrat Senators are up for re-election in 2018, 13 of whom are from states that Trump won or nearly won. Their actions may be driven largely by their impact on their chances for re-election; what that means for financial reform is unknown. Third, although the SEC and the banking agencies are (eventually) likely to be led by people who may be more sympathetic to the markets, many of the recent regulations might be difficult to change in the short term, particularly given that those agencies are mostly staffed by long-term bureaucrats rather than political appointees.
What does this mean for loan regulation? The loan market is mostly impacted by four regulatory mandates. The Volcker Rule prohibits banks from owning securities of CLOs that own bonds; the Risk Retention Rules require CLO managers to hold 5% of the fair value of CLOs they initiate; the Mutual Fund Liquidity Rule requires loan fund managers to classify assets into liquidity buckets (highly liquid, moderately liquid, less liquid and illiquid) and develop board-approved plans to meet redemptions; and the Leveraged Lending Guidance, while not a formal rule, imposes reporting requirements and guidelines governing the kind of leveraged loans a bank can originate.
Notably, Congressman Jeb Hensarling, Chairman of the House Financial Services Committee, had proposed earlier this year the Choice Act, the effect of which would be to largely repeal the Dodd-Frank Act including the Volcker Rule and risk retention for all assets other than mortgages. Most observers believe that the Choice Act as originally proposed has no chance of becoming law but Hensarling recently indicated that he was willing to suggest a modified “Choice Act 2.0” in order to get it passed. Still, it is far too early to speculate on the chances for its full or partial success.
Risk Retention: The inter-agency risk retention rules go into effect on December 24th. They will impose significant costs on managers that are able to comply and may prevent others from even being able to issue CLOs at all. Earlier this year, the House Financial Services Committee passed a bill, HR 4166, that would reduce the amount of retention for qualifying CLOs (“QCLO”s) from 5% of the fair value to 5% of the equity. Prior to the election, the LSTA had been advocating the passage of the QCLO bill during the lame duck session in conjunction with an omnibus appropriations bill (a very low-probability outcome). On Thursday, Republicans announced that instead of an appropriations bill they would only be passing a continuing resolution to fund the government through March. If that happens, the QCLO bill may well be reintroduced next year in what many believe will be a friendlier environment (but see the caveats above).
The Volcker Rule: The CLO market has largely adapted to the multi-agency Volcker Rule. Virtually all U.S. CLOS are loan-only and therefore Volcker compliant and most legacy CLOs have either run off or been amended to comply. However, while loan market participants may not be motivated to expend political capital to revise the rule, it is otherwise very restrictive and expensive for many banks so there could be efforts to revise or repeal the rule through legislation (including through the Choice Act) or – perhaps a lower probability – a new (joint) regulatory rulemaking.
The Mutual Fund Liquidity Rule: This rule was very recently finalized by the SEC and does not go into effect for large fund managers for two years. Although the rule requires extensive work and reporting by fund managers (and imposes new duties on fund boards of directors), the final rule was significantly better than the original proposal for mutual fund managers generally, and loan fund managers in particular. It is too early to determine whether there is an appetite (or ability) to further revise this new rule.
The Leveraged Lending Guidance: The LLG, which was issued in March 2013, has had a considerable impact on the ability of banks to originate leveraged loans. Though structured as “guidance”, it is widely believed that the banking agencies have been enforcing LLG as if it were a rule, and limiting banks’ ability to originate good, but “non-pass”, credits. Thus, some banks might see the new environment in Washington as an opportunity to have the agencies pull back from some of their more restrictive positions in LLG. However, LLG was developed within the banking agencies, and would not be subject to a legislative or rule fix. Instead, the banking agencies themselves would have to decide to pull back – and until new heads of the OCC, Fed and FDIC are installed, it is difficult to predict whether such revisions are possible.
The bottom line: The new political landscape seemingly presents opportunities to fix some of the more burdensome laws and regulations that impact the loan market – and thus reduce financing for U.S. companies. However, navigating the constantly changing labyrinth that is Washington DC is challenging and nothing is certain. The LSTA will continue to closely follow the situation and will continue to engage on behalf of the industry.