Opinion & Analysis

Risk Retention Rule Putting Brakes On CLO Market

Fueled by demands for yields, robust growth expected to cool

by Kyle Shafman, Analyst, and Ron D’Vari, CEO, NewOak

NewOak is an independent financial services advisory firm built for today’s global markets. Visit newoak.com. Reprinted with permission.

Following the Great Recession, the collateralized loan obligation (CLO) market has experienced a remarkable recovery, with new issuances hitting a record high of $137 billion in 2014, according to figures from Bloomberg[1].

These record numbers have been driven by investor demand for higher yields offered by AAA CLOs and a robust leverage loan market in the United States. The CLO market’s strong performance has continued through the first quarter of 2015; however, JPMorgan expects new issuances to slow over the next three quarters, as the market prepares for the new risk retention rule (RR rule) set to go into effect in 2016[2].

The final RR rule required by Section 941 of the Dodd-Frank Act was adopted by the Federal Reserve and five other federal agencies in October of 2014 after an extensive comment period. Regulators believe that the RR rule will encourage sponsors of asset-backed securities (ABS) to more closely align their interests with the interests of their investors.

In the case of CLOs, the manager or a majority-owned affiliate of the manager, will be designated as the “sponsor” under the rule and is required to retain, vertically or horizontally, 5% of the value of the liabilities of the CLO. The final RR rule defines the vertical requirement as 5% of the face value of each tranche and the horizontal requirement as 5% of fair value of all ABS interests in the CLO. Also included in the final rule is an “arranger option” that would exempt the CLO manager from the risk retention requirements so long as the CLO contains a tranche of only a syndicated loan whereby the lead arranger holds 5% of the face amount and acquires an initial allocation of 20%.

This approach has been categorically dismissed as unworkable due to current market practices, leaving the onus of compliance squarely on the CLO managers. As a result, many CLO managers are scrambling for solutions to financing the risk retention requirements given many of them lack the balance sheets necessary to carry the burden.

Consternation within the CLO market is expected to continue over the coming months as managers grapple with the final RR rule and attempt to sort through the outstanding issues left unaddressed by the federal agencies. Forecasts for CLO issuance in 2015 are expected to drop from a record high to $70-$80 billion as the market adjusts its practices to comply with the final RR rule[3].

Additionally, as the banks have retrenched since the recession, many small- and medium-sized enterprises (SMEs) have sought financing through alternative means. A decrease in the issuance of CLOs could have the unintended consequence of further reducing the financing options available to these SMEs at a time when capital investment and job creation are desperately needed to support the ongoing economic recovery. 

Also Considered:
CCAR-BHC scenario design challenges

Regulators believe that the RR rule will encourage sponsors of asset-backed securities (ABS) to more closely align their interests with the interests of their investors

Comprehensive Capital Analysis Review (CCAR) requires bank holding companies (BHCs) to develop and implement a BHC-specific stress scenario applicable to how they operate their business lines and manage their portfolios. In turn, BHCs are required to create their own BHC-specific scenarios reflecting their unique key risks and vulnerabilities.

The key elements are:

  • 1) scenario design and severity;
  • 2) variable coverage; and
  • 3) clear scenario narratives.

CCAR requires a number of specific scenarios: a) two Fed-specified scenarios of “adverse” and “severely adverse”; b) one BHC scenario; c) and one scenario reflecting an unexpected and instantaneous default of a firm’s largest counterparty as of a date to be specified by the Fed.

The BHC scenario has to be more severe in aggregate than the Fed’s severely adverse scenario. The sourcing of expert opinions and conducting of expert surveys must follow a disciplined process. The expert process involves thoughtful questionnaire design, a well-rounded expert panel, fully documented credentials and rationale.

The expert process involves pre-modeling and post-modeling expert panel workshops. BHCs should design an ongoing monitoring process with adequate internal change control. The expert process steps have to be fully identified, justified, documented, evaluated and well supported. BHC scenario design and severity processes should engage key internal process owners such as capital planners, risk managers, lines of business and general management.

In designing the BHC scenario for CCAR, BHCs must develop a host of relevant and feasible scenarios that capture their key risks under a variety of adverse conditions, including ones that are instantaneous and unexpected. These scenarios should be incorporated into the business-as-usual capital planning processes.

BHCs must identify any important business activities that could be vulnerable and may not have been captured by the general stressed macroeconomic scenarios. The idiosyncratic stress scenarios should address key revenue vulnerabilities and sources of loss and significant operational risks. The combined idiosyncratic factors and macroeconomic stress incorporated into the BHC scenario should lead to substantial strain and a significant reduction in capital ratios relative to the BHC’s baseline projections.

Idiosyncratic stresses should capture key trading strategies, sector exposures, counterparties, geographies and operational events. BHCs with significant regional and industry concentrations should include these in their firm-specific scenarios. A best-in-class practice for scenario design can produce a comprehensive set of factors with a clear and transparent link between them and sources of financial and operational risks to the BHC.

Clear narratives help make these links more transparent and hence more manageable. With all of these requirements for identifying and owning their idiosyncratic attributes, it’s hard to imagine a BHC staking its future on a canned third-party vendor’s black box stress test model.

 

[1] "Leveraged Capital Special Report." Bloomberg. January 20, 2015. Accessed May 10, 2015
[2] Haunss, Kristen. "Blackstone's GSO Leads $15 Billion of CLO Sales in Record Month." Bloomberg.com. April 15, 2015. Accessed May 11, 2015
[3] "Leveraged Capital Special Report." Bloomberg. January 20, 2015. Accessed May 10, 2015