Proposed regulations requiring managers of collateralized loan obligations to keep "skin in the game" might not take effect until 2016, but their impact could be felt much sooner.
Analysts at Barclays think that new CLOs could be structured so that they can be called relatively quickly, allowing skittish managers to exit ahead of the rules.
Risk-retention rules from the Dodd-Frank Act, originally proposed in 2011, decreed that CLO managers must hold on to 5% of these deals. There were three general ways to meet this, including holding 5% of each tranche issued, 5% of the first-loss tranche or through a cash-reserve account.
Commentators raised concerns that this would shut a number of managers out of the market, and in doing so, make financing more expensive for noninvestment-grade companies.
Regulators offered an exception in late August, but market participants agree that it is pretty much unworkable, especially for banks involved in these transactions. That means many current CLO managers would need to raise capital in order to comply.
The comment period for the new proposal will last until Oct. 30, and there is still a chance there will be constructive changes. However, if that doesn't happen, the risk-retention requirements will go into effect two years after final publication of the rules. "Unless the rules are relaxed further before they take their final form, we expect the CLO market to begin to contract once risk retention takes effect," Barclays analysts said in research published Sept. 13.
While the long-term outlook for CLO issuance is cloudy, near-term demand is strong. In fact, with rates headed higher, investors are clamoring for assets such as loans and CLOs that have floating rates. Barclays expects issuance to exceed $65 billion for 2013 as a whole, and other estimates range as high as $70 billion. That would represent a roughly 30% increase over 2012, although much of this will effectively refinance older CLOs that are nearing the end of their investment lives.
If anything, Barclays says, the proposed rules could pull issuance forward, as CLO managers are motivated to get as many deals as possible done before risk retention takes effect. The catch: these deals are likely to have shorter periods in which they cannot be called, so as to allow managers to avoid the proposed rules.
Barclays noted that CLO non-call periods have hovered around two years since 2010, but said they could contract to allow new vehicles to be refinanced before risk retention takes effect.
"While longer reinvestment periods are always desirable for CLO managers, we would not be surprised to also see an increase in reinvestment periods as the deadline for risk retention approaches," the analysts wrote.
Regulators went to great lengths to provide an exception, at least for CLOs that acquire their collateral from third parties in the open markets. It does not apply to CLOs that obtain the majority of their assets from entities that control or influence its portfolio selection, which are known as balance sheet CLOs.
This exception allows the lead arranger of a loan to retain the risk instead of the CLO manager. However, a deal using this exemption would have to contain only eligible loans and therefore would have a much more limited universe.
A deal using this exception would also be prohibited from owning bonds or other assets, further limiting the selection of assets. Many recently issued CLOs allow for as much as 10% of their portfolios to be allocated to bonds.
But the primary reason the exception is considered unworkable is that it places an unrealistic burden on banks that originate loans and syndicate them to investors.
"Expecting the lead arranger to agree to covenants maintaining a 5% stake in the specific tranche that is unhedged plus an initial hold of 20% of the credit facility is not practical," Barclays said in separate report published on Sept. 6.
"While in a time of significant stress, it is feasible that a bank would be open to such an arrangement for a few specific transactions, we do not expect enough deals to fit this criteria for a functioning CLO market to exist based on these exemptions."
It was once common for U.S. banks acting as lead arrangers to retain stakes in noninvestment grade loans that they syndicate to other banks, CLOs and other institutional investors. As Fitch noted in a report published Sept. 17, that was partly because broader market demand was limited, and partly because high-yield assets did not incur regulatory penalties.
But in recent years the healthy demand for loans from nonbank investors has transformed the role played by banks in this market. "As new loan activity has remained strong in 2013, banks have increasingly shifted their focus away from holding loan positions to serve primarily as facilitators and distributors in the market," Fitch ratings noted in research published Sept. 17.
New capital regulations have also shifted banks' focus toward participation principally as facilitators in the leveraged loan market, Fitch said.
"That said, we have observed some banks, particularly smaller ones, increasing the allocation of their investment portfolios to CLOs with the intent of both increasing the floating rate position of their portfolios and also improving overall yields. As a result, some credit risk from leveraged loans offloaded at origination by some banks has resurfaced in other banks via the use of CLO structures."