Leveraged Loan Market Braces for More Dodd-Frank Impact

The leveraged loan market is hoping to dodge another bullet from the Dodd-Frank Act.

Regulators are finalizing rules that could hurt trading in the cash loan market. The industry is one for two on such matters. It caught a break when the final version of the Volcker Rule excluded syndicated loans from restrictions on market making by banks, but loan derivatives will get tougher treatment.

One of the matters at hand is fundamental. Regulators already decided to treat loan-based derivatives the same as securities-based derivatives, which are subject to stricter oversight. But regulators have not determined whether the same will be done in the cash loan market.

The issue stems from the reality that lenders typically have access to information, such as sales projections, that is not public. Other investors in a loan syndicate, such as additional banks or institutional portfolio managers, may not want to receive this information, because having it would restrict their ability to invest in or trade securities issued by the same company. Investors who use loan derivatives and dealers who trade them may not want to receive private information, for the same reason.

As such, the loan market has developed a convention, known as a “big-boy letter,” to deal with the fact that participants who opt not to receive this private information may be at a disadvantage when they do business with those who do have it. Elliot Ganz, general counsel of the Loan Syndication and Trading Association, describes a big-boy letter as “an agreement that it’s OK, based on the fact that we are sophisticated parties in a private market … to deal with you even though I could be at a disadvantage.”

Dodd-Frank rules that have already been finalized raise questions about the enforceability of big-boy letters when it comes to trading certain loan-based derivatives: total return swaps and loan credit-default swaps. These instruments are subject to new anti-fraud requirements that took effect this summer.

“It’s not entirely clear that big-boy letters are enforceable in the context of a securities market, because there’s a concept [in securities law] that you can’t waive that kind of thing,” Ganz said.

Another Dodd-Frank-related proposal could affect trading in the cash market.

The majority of loan trading is done by what’s called an assignment, in which the current holder tells the agent bank that it has sold the loan to the buyer; the buyer essentially “steps into the shoes of the seller,” Ganz says. This type of transaction, which he calls a “clean trade,” would be unaffected by the proposed rules.

But some loan trading works in a very different way. Loan documents often give borrowers the explicit right to consent to, or disallow, the transfer of the loan from one investor to another. When a borrower doesn’t want the loan transferred — perhaps because the buyer is an aggressive fund, or because the borrower simply prefers to deal with a bank rather than an institutional investor — the buyer may purchase it using what’s known as a participation agreement.

When this happens, the original lender remains the lender of record, as far as the borrower knows. What’s being sold are the rights and risks associated with the loan. Any interest paid by the borrower comes to the new investor through the original lender, who acts as an intermediary. (Likewise, in the case of a revolving line of credit, any additional funds the borrower seeks are paid by the new investor via the original lender.)

This type of transaction accounts for perhaps 10% of loan trading in the U.S., and a far larger percentage in the U.K., Ganz says. And loan participation, particularly U.K. loan participations, have many of the characteristics of a swap, as defined in Dodd-Frank. “Consequently, one could conclude that, under Dodd-Frank, it would fall into that category, even though the product is not intended to do what swaps are intended to do, [which is] in general to provide leverage,” he says.

That means loan participations would be subject to anti-fraud regulation and “wouldn’t get done.”

Why is this a bigger problem for the cash market than it is for loan derivatives? The cash market can’t deal with the potential securities liabilities, particularly since participants may not know until after the fact whether a trade is being executed by an assignment or a participation agreement, Ganz says.

“It would be the end of the loan participation market,” he said. “It would be far worse in Europe, but it’s not good for the U.S.,” either.

The LSTA is still lobbying regulators to have loan participations excluded from the definition of a swap and is “pretty hopeful that regulators will come up with the right result,” he says.

Meanwhile, the loan market can take comfort in the fact that regulators chose not to extend to syndicated corporate loans restrictions on banks' ability to make markets in securities.

Many participants may have been unaware this was even a possibility. That's because the Volcker Rule never specifically identified loans as one of the instruments covered by violations on proprietary trading. However, it does say "any other instruments" regulators think appropriate may be covered.

"When the legislation was passed we didn't think it was an issue," Ganz says. "It was only after conversations with some regulators that we got concerned, and then started to weigh in."

He said the exclusion is important because "a bank can underwrite loans, syndicate loans, keep loans in its portfolio — it's a risk banks take on a daily basis." So it doesn't make sense to "require a bank to impose on itself all kinds metrics and compliance tools to make sure it's not making a profit in proprietary trading in the context of market making, when they are entitled to and supposed to take those risks every day."

When the final rule was published and loans were excluded, "we were pretty gratified," Ganz says.