In 2007, approximately 60% of the buyers of commercial loans were securitized commercial loan funds, or commercial loan obligations. As a result, CLOs are a critical source of liquidity for U.S. businesses and for the banks that arrange and sell portions of these loans.
Legislation designed to overhaul financial regulation currently provides for mandatory "risk retention" standards to address issues related to the securitization markets.
However, applying these requirements to commercial loans and commercial loan obligations of the type that hold a dominant portion of the outstanding commercial loans today could significantly impair credit availability for many U.S. businesses.
Fraud charges that have been brought by the Securities and Exchange Commission against Goldman Sachs Group over the marketing of collateralized debt obligations before the financial crisis also threaten the nascent recovery in this market, posing real challenges to U.S. companies seeking liquidity.
The Senate bill currently requires a "securitizer" (the sponsor of a securitization transaction) or "originator" (the party that transfers loans to a securitizer) of a securitized loan portfolio to retain, on an unhedged basis, at least 5% of the credit risk associated with each loan portfolio.
The House bill requires that any "creditor" that makes a loan retain, on an unhedged basis, at least 5% of each loan that such creditor assigns, including for purposes of creating a portfolio of securitized loans.
Currently there are no such risk-retention requirements in the securitization or commercial loan markets.
The risk-retention minimums imposed upon any "creditor that makes a loan" may well be too high for the majority of lenders ordinarily constituting members of a commercial loan syndicate. Commercial loans often are too large for a single bank to hold on its own. As such, large commercial loans typically are arranged by banks which then transfer portions of such loans to a "secondary" loan market.
CLOs and other loan funds are the principal buyers of loans in this market, but under internal diversification guidelines they can typically only hold small portions of any one loan. Applying risk-retention standards to loans of this type would significantly reduce the number of lenders with sufficient capability to issue and buy these types of loans.
Broadly applied, risk-retention standards could apply to not just the arranger but also to each other lender, thereby eliminating a huge portion of market participants. The momentum generated by the Goldman Sachs litigation and any related proceedings continues to pick up speed in Washington as the parties debate the merits of more stringent reforms.
Moreover, risk-retention minimums applied to any "securitizer" of a CLO, which typically is the manager or sponsor, could have a negative impact on the formation of new CLOs available to purchase loans because most CLO managers and sponsors are unable to make significant equity investments.
Although risk-retention standards are unlikely to affect the CLOs that exist in the market today, many of which have a limited life and limited ability to invest in future loans, they could impair the formation of new CLOs that many market participants feel will be necessary in the future to help address liquidity needs.
A related concern is the threat of litigation contagion in the market, typified by the SEC's continuing investigation of additional Goldman Sachs CDO transactions as well as similar transactions at Goldman Sachs and other institutions.
Given the large numbers of public and private entities that suffered losses during the credit crisis related to downgrades of securitization facilities, commentators have expressed concern that the industry could see a wave of lawsuits from individual investors as well as state and governmental authorities.
The prospect of such litigation could shake the confidence of prospective CLO investors and thereby dissuade them from forming CLOs.
A healthy secondary loan trading market is critical to allow banks and financial institutions to spread market risk to sophisticated investors, and thereby reduce the systemic risk associated with concentrated loan holdings at large banks and financial institutions.
In addition, without a strong and liquid secondary market, access to capital for U.S. businesses would go down while the cost of available capital would go up.
With major refinancing needs on the horizon for U.S. businesses, imposing additional restrictions on a primary provider of capital availability and liquidity in the commercial loan market could be a severely damaging blow to slowly stabilizing capital markets.
Similarly, a flood of litigation related to the securitization markets could help to squelch a burgeoning recovery before it starts, and in so doing further constrain liquidity for U.S. businesses.