Wednesday, September 10, 2014

House Members Urge New Approach to CLOs and Risk Retention Regulations

Leading House Members are concerned about provisions on open market collateralized loan obligations (CLOs) in the proposed Dodd-Frank risk retention rules and their potential adverse effect on credit availability. In a bi-partisan letter to SEC Chair Mary Jo White and Fed Chair Janet Yellen, Rep. Scott Garrett (R-NJ), Chair of the Capital Markets Subcommittee of the Financial Services Committee, and Rep. Jim Himes (D-CT), a leading member of the Committee, expressed specific concern that the approach outlined in the rc-proposal of the risk retention rules requiring CLO managers to retain 5 percent of the CLO's fair value could impede the issuance of new CLOs. With very limited balance sheets, noted the letter, very few CLO managers could retain a 5 percent share of a CLO.

The House members want to ensure that the risk retention requirements are properly tailored to the unique structure of open market CLOs, which are a vital source of corporate finance. The letter was also signed by Rep. Patrick McHenry, Chair of the Oversight and Investigations Subcommittee. Open market CLOs do not engage in originate to distribute securitizations, noted the House Members, and so simply applying the standard risk retention rules designed for such securitizations to open market CLOs does not make sense.

The legislators asked the SEC and Fed to consider a new approach to risk retention that envisions the creation of a qualified open market CLO that would have to meet a series of strict criteria designed to protect investors and to ensure that a CLO's portfolio is conservatively invested, and that the interests of the CLO manager is aligned with the CLO investors. The House Members believe that this approach could provide a workable solution tor most managers of open market CLOs and ensure the continued flow of credit to companies.

This modified risk retention requirement would apply only to CLOs that meet specific criteria. For example, the portfolio would have to consist almost entirely of U.S. dollar denominated senior secured commercial loans and could contain no re-securitizations or derivatives other than basic interest rate or FX hedges. The portfolio would also have to be diversified such that no more than 3.5 percent of a CLO's assets could relate to any single borrower, and no more than 15 percent of its assets could relate to any single industry, thereby reducing the chance that a few individual defaults could cause significant losses for a CLO investor. The borrowing companies would have to be overwhelmingly based in the United States. The CLO's equity would have to equal at least 8 percent of the value of its assets, which would provide, a substantial cushion for CLO debt investors.

Even more, the qualified CLO approach would require managers of open market CLOs to retain 5 percent of the equity of a qualified CLO rather than 5 percent of fair value. In the view of the House Members, this level of retention would still be a significant commitment for thinly capitalized CLO managers, and would still likely force some managers out of the market. However, this approach would allow most CLO managers to continue to participate in this important market, thereby avoiding a dramatic reduction in CLO financing and resulting harms to the public interest.

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