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.

About markferraris
Managing Principal Orchard Street Partners LLC

3 Responses to Will the Euro CLO Retention Rule Have Unintended Effects?

  1. But skin-in-the-game is by no means the only obstacle to successful CLO issuance. The manager will need to find the warehousing capacity, and then find a suitably diverse and good-quality portfolio – both of which would be challenging. The overall universe of European leveraged loans is shrinking , as seen via the European Leveraged Loan Index (ELLI). Most of the deals currently at auction stage are secondary buyouts so there is little brand-new paper entering the market, while the proportion of CCC-rated credits in the Index is currently at 8.6%, compared with 6.63% a year ago, having risen as high as 12.1% in early January.

    • markferraris says:

      We agree with you. However, the need to find warehouse lending is what we might call more of a “business as usual” scenario. Skin-in-the-game just adds to the challenge, making it likely that only the very largest managers will be able to operate successfully. The knock-on effect of all this is that this will ensure an even slower recovery of the bank loan market as even those banks that do originate will be stuck with no secondary market outlet.

  2. Andy Burns says:

    This “originator-securitizer” distinction is problematic in the context of a CDO or CLO as it remains unclear which entity in a CDO or CLO transaction would be the “securitizer” or the “originator.” By way of an example, a “securitizer” who is required to comply with the Risk Retention Requirements could be (i) the CDO or CLO issuer, which is typically a special purpose vehicle presumptively holding all the credit risk and having no independent resources by which it could acquire the retained credit risk (this result may prove impractical), (ii) the provider of warehouse financing, typically the lead underwriting bank (as that person or an affiliate finances and subsequently sells assets into the CDO or CLO issuer), (iii) the collateral manager that initiates or organizes the structuring of the CDO or CLO or (iv) any person who sells assets to the issuer, such as a loan originator into a CLO (which could be expected to adversely affect the syndicated loan market). Similarly, an “originator” could be any entity (i) which makes loans which are sold into a CDO or CLO (which also would have a significant adverse impact on the syndicated loan market) or (ii) the asset manager, arranger or underwriter (in the case of a cash flow CLO) of the transaction. It may be that most CDO and CLO transactions do not have an originator as contemplated by the definition. The ultimate regulatory direction on these definitions and the Risk Retention Requirements will result in a significant shift in the economics of CDO and CLO transactions among these parties, and all potentially affected persons will need to remain alert to the developments as proposed rules are announced in the coming months.

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