October 10, 2017 - (article updated October 12, 2017) – On Friday, October 6, 2017, the U.S. Treasury Department released its second report (and Fact Sheet) on right-sizing financial regulation. The LSTA was particularly interested in this report because it tackled rules around securitization, including CLOs and risk retention. We offer two quick takeaways and one observation. First, Treasury recognizes that CLOs and CLO managers are different and recommends that there should be a broad qualified exemption – but not elimination – for CLO risk retention. Second, Treasury’s exemption would come through a “set of loan-specific requirements under which managers would receive relief from being required to retain risk”. Third, readers should recognize how quickly (or not) Treasury’s recommendations can be executed. The CLO risk retention rules were promulgated jointly by the Fed, OCC, SEC and FDIC. The agencies are unlikely to issue a joint notice-and-comment rulemaking until there is new leadership at all of the agencies, which likely will be a 2018 event. Additionally, the notice-and-comment rulemaking process can take more than a year. It is, nonetheless, a very positive and rational step.
First, beginning on p. 91, Treasury notes that securitization has existed as a successful financing tool for centuries. It is true that problems in certain types of securitized products, primarily sub-prime mortgages, contributed to the financial crisis. However, the broad-brush characterization of securitization as an inherently high-risk activity – and the subsequent punitive levels of regulation – has been counterproductive.
When discussing risk retention broadly, Treasury first notes that the Dodd-Frank Act required the agencies to develop underwriting standards for “qualified” commercial loans, auto loans and commercial mortgages that would not need to be subject to risk retention because the assets themselves were lower risk. Treasury comments that the banking agencies did not undertake a sufficiently robust economic analysis on the thresholds when setting exemption requirements for these loans. In reality, very few securitizable loans in these categories could ever meet the exemption threshold.
Bringing this issue home to leveraged loans and CLOs, the agencies’ criteria for exempted qualified commercial loans are draconian. Based on two years of history and two years of projections, the funded term loans must have a total liabilities ratio ≤ 50%, and a debt/EBITDA ratio ≤ 3x, and a debt service coverage ratio ≥1.5x, and a tenor ≤ five years, and must be repaid on a straight-line amortization schedule. In effect, the agencies’ qualified commercial loan is a straight-line amortizing investment grade term loan. First, this loan is practically non-existent. Second, even if it did exist, it likely would have a lower interest cost than the CLO that would purchase it. In addition, the rule requires that any CLO purchasing a qualified commercial loan must be a static vehicle, thus negating the concept of a managed CLO. So that exemption was, to put it mildly, not terribly helpful.
Specifically regarding CLOs, the Treasury report notes that CLO managers do not originate the underlying loans and managers are compensated with management fees contingent on the performance of the underlying loans. Thus, CLO managers are more like asset managers and the imposition of risk retention on managers creates particular burdens as they have limited access to capital for risk retention. The report also notes that the decline in smaller managers could create consolidation or concentration in the numbers and types of issuers able to do CLOs.
So what does Treasury recommend? First, it does not recommend the wholesale repeal of risk retention for CLOs. It instead proposes reopening the rule to comment to refine (and make workable) the exemption of lower-risk assets based on their characteristics. Second, the report specifically recommends that the agencies introduce a broad qualified exemption for CLO risk retention. However, Treasury does not say that CLO risk retention should be eliminated, but rather “right-sized”. Treasury recommends “creating a set of loan-specific requirements managers would receive relief from being required to retain risk.”
The LSTA has been involved in this process for years. Most recently, the LSTA submitted a letter to Treasury in April recommending a review of the risk retention rules. But much earlier – nearly four years ago! – the LSTA submitted a comment letter proposing a more fitting “qualified commercial loan” exemption that defined a “real world” higher quality leveraged loan. That proposal was for a senior secured first lien loan that either had a first lien debt to capitalization ratio ≤ 50% or a debt/EBITDA ratio ≤ 4.5:1. Gaining no traction with that approach, the LSTA, SFIG and SIFMA later recommended the concept of a “Qualified CLO”. The Qualified CLO would be subject to tests in six areas: asset quality, asset diversification, capital structure, alignment of interests, manager regulation, and transparency and disclosure. If the CLO met all the tests, the manager could purchase and retain 5% of the equity, instead of 5% of the notional amount of the deal. In other words, the qualification process was for both the CLO and its assets, and the risk retention was – per the Treasury report – “right-sized”.
So what would be the impact if this went through? Wells Fargo’s Lagniappe observes that any risk retention relief would help the entire CLO market, but would be most beneficial to smaller managers who have had more difficulty complying with risk retention. Wells notes that, if risk retention requirements were reduced or eliminated, large managers that have structured large scale retention solutions may continue to use risk retention funds, as these funds have attracted a new type of equity investor. However, smaller managers that do not have these solutions would likely not purchase and retain 5% of the notional amount of new CLOs. As a side effect, smaller managers would be less likely to issue Euro-compliant CLOs.