A new front is opening in the fight to reform financial reform, as managers of collateralized loan obligations protest proposed regulations on risk retention.
CLO managers and their advocates say that rules now out for comment by the Securities and Exchange Commission, bank regulators and other agencies go beyond the provisions that are authorized by the Dodd-Frank law, and may in fact mean the exact opposite of what Congress intended. In the meantime, industry lobbyists are meeting with legislators and regulators in an attempt to push aside the most onerous provision, which could require CLO managers to put up 5 percent of the capital for the debt vehicles that they build.
CLO managers argue that the rule should not apply because of the nature of the instruments, and they warn that the rules, if left unchanged, could cause the demise of CLOs and the subsequent loss of loan financing for future buyout deals.
“If these rules remain unchanged, there will be no more CLO formation when these rules become effective,” said Bram Smith, the executive director of the Loan Syndication and Trading Association a New York-based trade group representing the commercial lending industry. Added Elliot Ganz, the LSTA’s general counsel: “It will literally shut down the CLO market. It is an existential threat to the market.”
The comment period on the rules ends June 10. Once the agencies review the comments and issue final rules, they take effect two years from that date. The threat arises as the CLO market is attempting to climb out of a hole that dates to the financial crisis of 2008 and 2009. Credit Suisse Asset Management and BlackRock Financial Management have recently launched $400 million vehicles, and market watchers predict the CLO market could reach $10 billion to $15 billion this year. At the same time, buyout shops are waging a rear-guard action to win exemption from becoming registered financial advisers.
On the CLO front, the pivotal issue resides in an obscure footnote in a 243-page document on risk retention. Footnote 42 identifies CLO managers as the sponsors of the securities, requiring them to hold retain 5 percent of the securities rather than selling them to investors. As Russ Morrison, of the Springfield, Mass.-based leveraged lender Babson Capital Management LLC, put it: “If we were issuing a $500 million CLO, that might mean that I have to find a way to own $25 million of that exposure, maybe from the AAAs all the way down to the equity strip.”
As a practical matter, CLO experts say, none but the largest managers would have the capital to put into the securities. But more to the point, they say, CLO managers should be viewed less as sellers of these securities and more as buyers of the loans that the securities contain.
In contrast to the “originate to distribute” model, in which the underwriter of residential mortgages, for instance, makes the loans planning to bundle them and sell them to investors, the CLO manager negotiates to buy individual commercial loans from lenders, Smith said. And while a residential mortgage-backed security may contain tens of thousands of undifferentiated loans in a static pool, the typical CLO includes only 200 corporate loans in a dynamically managed portfolio.
CLO investors thus have the ability to conduct their own due diligence on the loans that underlie the CLO, Morrison said. “There is a lot of transparency in our business. The investors in my CLOs can see every single company. Many of our companies are public companies and have public information available. My investors could do their own research to understand the performance of those underlying companies.”
Some in the industry argue that the SEC and other regulators have overstepped their authority under Dodd-Frank. As David Thatch, a partner in the securitization practice group of the law firm White & Case and author of one such report, put it: “They’ve overstepped their authority because they’ve assumed that being a purchaser is the same as being a seller or transferor. That’s just not consistent with what the act was about.”
For now, the CLO industry is concentrating on the rule-making process, meeting with regulators and preparing their comment letters on the proposed regulations. If they are unsuccessful, Thatch predicted the struggle would turn to the courts, probably in lawsuits brought by smaller players in the market. BlackRock, a giant multi-strategy money manager, could do something else, he said. “The little guy is more affected by it. They don’t have alternative business models.”
Representatives of the LSTA met this month with staffers of the SEC and other agencies, and Ganz termed the meetings encouraging. “They want to hear these arguments. They want these arguments articulated in a way that if the arguments make sense, they have something to hold onto in constructing a carveout.”