Risk Retention Rules May Shrink U.S. CLO Market
September 1, 2013
The U.S. market for collateralized loan obligations would shrink by 75% if proposed risk-retention rules are implemented, according to the Loan Syndication and Trading Association.
This conclusion is based on a recent survey of 35 CLO managers with $228 billion in assets in 509 deals. That represents over two-thirds of the U.S. market.
The managers said that, if rules requiring them to retain 5% of a CLO’s value were implemented, the number of deals they managed would drop to roughly 70.
“The rules–which would require a manager to purchase and retain $25 million of notes for every $500 million CLO-would be devastating for the largest as well as the smallest managers,” said Meredith Coffey, LSTA executive vice president. “Fully half the respondents said they couldn’t or wouldn’t issue a new CLO. Over 80% said the rules would shrink the market by 75% or more.”
“We only have to look at the experience in Europe, where CLO issuance has collapsed, to see what risk retention does to a market,” commented Bram Smith, executive director.
The loan association has submitted the survey findings to joint regulators, such as the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Securities and Exchange Commission, the Federal Housing Authority and the Department of Housing and Urban Development.
This forms part of the LSTA’s ongoing effort to work with regulators in developing rules that will allow the market to keep functioning.
The study also demonstrated that funding the retention is not a reasonable solution. Twenty of the respondents said that they could not raise funding. Of the 12 that could raise the financing, just two said that they would actually come up with the funding.
But, even if a CLO manager were willing to fund the retention, it does not seem that such financing would be available. The association also spoke with bankers representing more than half the prime brokerage market and a number of the term lenders. Neither one of these groups seemed to be a realistic route for CLO managers to raise the risk retention financing.
The term lenders generally said they would lend between 50% and 75% of the value of the ‘AAA’ or ‘AA’-rated notes, but nothing further down the capital structure. This would imply that, even with accessible term financing, a CLO manager would still have to provide more than half the required retention out of pocket.
The prime brokerage option is even less attainable, the LSTA survey results showed. Prime brokers indicated that they lend short-term against a percentage of highly liquid securities. First of all, these securities will be subject to the previously mentioned haircuts. They would also be subject to daily margin calls. Additionally, there must be a liquid secondary market where these securities can be traded immediately, and the security must be of a type that the prime lender can lend overnight.
However, this is not an option because CLO securities are not liquid enough.
“While an occasional large, top-quality, diversified asset manager might be able to access some amount of term financing, it is simply not an option for the typical CLO manager,” said Elliot Ganz, LSTA general counsel. “Moreover, the survey indicated that the prime brokerage option was basically a non-starter.”