Court Determines that Risk Retention Rules Should Not Apply to Open-Market CLOs
U.S. Credit Risk Retention Rules (“CRRR”), which were adopted on October 22, 2014 and derived from the Dodd- Frank Wall Street Reform and Consumer Protection Act, required collateralized loan obligation (“CLO”) managers to retain 5% risk or “skin in the game” of their CLOs. The rules became effective in late 2016, and as expected, reduced the number of managers who were able to meet the requirements in order to issue a CLO. What was unexpected, however, was the pace at which CLO issuance was able to continue. Larger, more experienced managers were able to identify solutions to comply with the rules and remain in the CLO origination business. As a result, CLO issuance continued in 2016 and 2017 with $71.4 billion and $117.7 billion in issuance, respectively.
The Case and Ruling: Loan Syndications and Trading Association v. Securities and Exchange Commission and the Board of Governors of the Federal Reserve System
Despite the ability for many managers to comply with CRRR, the loan market and CLO market participants have generally contended that, given the nature of CLO transactions, the language and scope of the regulation does not apply to open-market CLOs. The Loan Syndications and Trading Association (“LSTA”) filed suit against the Securities and Exchange Commission, seeking to overturn the application of the rule to open-market CLOs.
On February 9, 2018 the United States Court of Appeals for the District of Columbia Circuit (“the Court”) ruled unanimously in favor of an appeal by the Loan Syndications and Trading Association (“LSTA”), determining that managers of “open-market” CLOs are not “securitizers” under Section 941 of the Dodd-Frank Act and, therefore, are not subject to CRRR.
In support of its ruling, the Court notes three important aspects that differentiate CLOs from other types of entities addressed by Dodd-Frank:
1. CLO manager compensation dependency gives them “skin in the game”.
2. CLOs purchase relatively small numbers of unsecuritized loans on the open market, and the activities of CLO managers present a far weaker version of the opacity that Congress identified in other asset-backed securities (“ABS”) markets.
3. Both the superior incentives and relative transparency of CLOs reduce the likelihood that such financing will generate anything like the decline in underwriting standards that the more famous ABS markets are thought to have brought about.
Appeal Process and Legal Implications
It is believed that there are limited options for the SEC and the Federal Reserve to overturn the Court’s decision. They have 45 days to seek a rehearing or petition the United States Supreme Court to accept the case. The appellate court is not required to consider a request for rehearing, and we think it is unlikely that the government will seek that path given that a rehearing would require the government to demonstrate some important law or fact that the court overlooked. Further, while possible that the government could seek to petition the Supreme Court in order to raise issues that involve interpretation of Dodd-Frank, we believe it is unlikely given the limited number of petitions the Supreme Court grants each year, as well as the current political climate and priorities for the current administration.
We believe the current decision will stand, and that CLO managers of “open-market CLOs” will no longer be required to comply with CRRR. This includes no requirement for a sponsor of the transaction or to acquire and retain an economic interest in the credit risk of the assets in the transaction.
Impact to CLO Market
Until the final resolution of the waiting period and any potential rehearings or petitions, CRRR will remain in effect. Investors should understand that any deals they are currently considering may not be required to remain compliant with CRRR in the future.
Going forward, we believe that this ruling benefits smaller managers, who will now be able to return to the market without the challenges of finding risk retention solutions. This should result in a positive to CLO issuance with some upside to initial 2018 volume estimates. We estimate a moderate impact on CLO issuance volume for 2018, of approximately $10 billion, resulting in an estimated $120- $130 billion of total issuance. Additionally, managers will likely have more incentive to refinance/reset existing deals without the burden of needing to allocate limited risk retention capital to those older, shorter-lived CLOs. We believe that could result in an increase of re-set volume of approximately $35 billion, lifting total re-set volume to $140 billion for the year.
Generally speaking, we do not see any major impact to larger, institutional managers who have been able to raise the capital necessary to comply with CRRR and, in creating those solutions, have created attractive market opportunities for their own businesses. In many cases, such managers may choose to continue to voluntarily maintain “skin in the game” as a commercial benefit to investors, but with the benefit of flexibility in how they do so.
Impact to the Loan Market
With the likely end of CRRR bringing more managers to the market, we believe this increases the demand for loans. We believe this will support the prices for the loan market and, dependent on the volume of new loan issuance, potentially result in continued moderate spread compression for performing loans rated single B and above.
We think it’s important to note, however, that the end of CRRR is simply returning the CLO and loan markets to their natural state (pre-regulation). Even with more managers at the table, we believe the natural course of supply and demand will find its balance, as it tends to do. Part of that balance is due, in large part, to the inherent limitation on CLO managers to only issue when they can produce attractive margins over liabilities. This helps mitigate the impact of increased demand on loan spread compression, as CLOs typically do not issue when loan spreads are not attractive relative to liabilities. As previously mentioned, we believe many managers will continue to maintain some version of voluntary risk retention as a competitive advantage. This will likely affect the types of managers and deals for which investors will have an appetite, as was the case before the implementation of CRRR. This, in turn, will likely determine which managers are successfully able to issue going forward, and as a result, manage the economic balance between CLOs and the loan market.
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General Risks for Floating Rate Senior Bank Loans: Floating rate senior bank loans involve certain risks. Below investment grade assets carry a higher than normal risk that borrowers may default in the timely payment of principal and interest on their loans, which would likely cause the value of the investment to decrease. Changes in short-term market interest rates will directly affect the yield on investments in floating rate senior bank loans.If such rates fall,the investment’s yield will also fall. If interest rate spreads on loans decline in general, the yield on such loans will fall and the value of such loans may decrease. When short-term market interest rates rise, because of the lag between changes in such short term rates and the resetting of the floating rates on senior loans, the impact of rising rates will be delayed to the extent of such lag. Because of the limited secondary market for floating rate senior bank loans, the ability to sell these loans in a timely fashion and/or at a favorable price may be limited. An increase or decrease in the demand for loans may adversely affect the loans.
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