Legislation to Wind Down Freddie and Fannie Introduced in US Senate

Bloomberg is today reporting that a bi-partisan bill aimed at winding down the GSE’s Fannie Mae and Freddie Mac will be introduced by Senators Corker (TN) and Warner (VA) later today.

In the latest draft of the bill, Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac would be liquidated within five years. The two companies package mortgages into securities on which they guarantee 100 percent payment of principal and interest on underlying mortgages.

The new legislation would require private financiers to take a loss of 10 percent of the principal underlying securities.  Mortgage industry insiders that have seen the draft have been critical of that “first-loss” provision, as it is referred to in the draft, saying it is too big a change from the current system.

Fannie Mae and Freddie Mac would be replaced by a Federal Mortgage Insurance Corp. to continue existing efforts to build a common securitization platform able to help small lenders issue securities. It also would continue Fannie and Freddie’s existing multifamily guarantees.

We suspect that the games have only just begun for this piece of legislation and who knows what the final version will look like.  However, the movement towards restoring clarity and predictability to the origination and securitization process in the US residential market remains an important objective for all sides.

Will the Euro CLO Retention Rule Have Unintended Effects?

The most talked about topic at this past week’s 2013 Global ABS Conference in Brussels was the status and potential effects of the European Banking Authority’s technical standards on the market for EUR collateralized loan obligations.  Many industry experts see the 5% retention rule being applied to CLO Managers as being an unsophisticated application of the popular notion of “skin-in-the-game” that has dominated new regulations for securitization since the Credit Crisis.

One can argue (as we have repeatedly in this space) that the arbitrary additional level of collateral retention in any asset securitization by the “issuer” makes little sense as the issuer already has significant skin-in-the-game whether it be in relation to its underwriting, its servicing or the future prospects for its business model.  Nevertheless, it has been very popular to suggest that this extra level of asset retention will somehow become a silver bullet to ensure that investors are not taken for a ride.  The idea of this additional “risk retention” first came up in the US markets during the drafting of Dodd Frank and it was popularly spoken about as the big fix to the US RMBS securitization market.

The “standard” has more recently been applied to several other asset classes and one of the more recent structures nominated for this treatment is EUR CLO’s.  We believe that the application is misguided.

Unlike the mortgage-backed markets where it is very common for issuers to be both originators and servicers of the pooled collateral, the typical CLO manager is buying loans in the secondary market, far away from the banks that originate and often service those loans.  Not unlike any other asset manager that buys stocks and bonds on behalf of their institutional clients, the CLO Manager buys and sells based on any number of market forces, not the least of which is the soundness of the underlying underwriting and the performance of the loan.  In that regard, they are more closely aligned with the interests of the investor then it would seem European regulators seem to understand.

If the current retention rules stay in place, we foresee two significant and unintended consequences:

1- Only the largest and most liquid managers will be able to run CLO programs.  This, by itself, is not necessarily a bad outcome as one could argue that by housing these complex structures only with the most sophisticated and well capitalized managers, investors will be more certain of the stability of their investments.  However, what this theory does not contemplate is the fact that these same large managers will, just as in any asset class or investment strategy, have some limits to their appetite for CLO’s.  As a result, it is very likely that this artificially created “clamp” on the CLO market will limit the number of programs disproportionately to investor demand which only leads to less attractive economics for investors.

2- History has shown that the CLO market has become the most effective mechanism for the creation of a broad and sustainable  secondary market for bank loans.  Any artificial limit placed on the abilities of banks to find new investors for their loans will only have a negative effect on banks in the euro zone looking to right their loan portfolios in the short-term and longer term, to provide adequate flows of credit to a recovering EUR economy over the next several years.

We do not agree with those that are pushing for these additional retention rules in any asset class, as we believe that the related counterparties already have significant skin-in-the-game.  We double down on that view when it comes to applying such a mechanism to CLO’s.  If you want to hold someone accountable for the quality of the underlying loans, we believe that responsibility should be placed “back upstream” to the underwriter/originator of the loans.

Hopefully, the EBA finds a way to come in off the ledge on this one.