Meredith Coffey,  EVP, Research & Analysis, LSTA
Meredith Coffey,
EVP, Research & Analysis,

The U.S. syndicated loan market continues to be sideswiped by regulation — sometimes intentionally and sometimes inadvertently. As of early 2014, there is at least one major leveraged loan issue and two CLO issues in play. On the loan side, leveraged lending guidance continues to sow considerable confusion about what is allowable and what is offside for banks in the leveraged loan market. On the CLO side, a surprising — and unfortunate — interpretation of the Volcker Rule may force banks to divest tens of billions of dollars of CLO notes (almost assuredly at a loss). The Risk Retention Rule lingers out there unfinished, causing CLO managers to wonder when the axe might fall.

The Bank Conundrum: Leveraged Lending Guidance

The Leveraged Lending Guidance was finalized in March 2013 and went live just in time for the Shared National Credit Review in May 2013. Despite being more than a year old as of this writing, there still is mass confusion around what the Leveraged Lending Guidance is supposed to do. Based on conversations with regulators and risk managers, here is what we have gleaned.

First, the Guidance is not a reaction to the market today. Rather, it is the latest iteration of a 20-year process whereby the banking regulators encourage banks — sometimes forcibly — to make prudent leveraged loans. The Guidance appears to focus on two categories of such loans: leveraged loans (which are “onsides” for banks) and criticized loans (which may be “offsides” for banks).

Leveraged loans, which banks are clearly permitted to originate and hold, may be defined in a number of ways. The Guidance notes that common definitions include loans to companies that are leveraged 3x senior and/or 4x total, loan purposes that include buyouts, M&A or dividend payments, or companies that are generally considered to be leveraged.

Criticized loans, which banks may be discouraged from originating or holding, may be identified by characteristics such as:

  • The company cannot show the ability to repay all the senior secured debt or half the total debt in five to seven years from base cash flows,
  • Total leverage exceeds 6x
  • The loans are covenant lite.

So what exactly is the Guidance intended to do? It appears that the Guidance has a dual mandate. The first mandate is prudential; it exists to protect the safety and soundness of the banks. To do this, the regulators inspect loans that the banks hold, and ensure the loans are fairly safe. The second mandate is to ensure that “high risk” loans do not go into the system. To do this, the regulators would inspect the loans that banks originate, even if the loans are completely sold down to non-banks. The high risk loans that the Guidance is targeting seem to be captured by the “criticized loan” definition, i.e., the inability to amortize debt over five to seven years, having leverage of 6x or more, and not having maintenance covenants. Importantly, the leveraged and criticized definitions do not seem to look at the expected loss of the banks’ position, but rather the probability that the company might default. Thus, a small, well-structured ABL loan sitting atop a leveraged capital structure still may be criticized, even though it is a safe loan itself.

But here’s a puzzle: While banks say that the regulators are pressuring them not to originate or distribute criticized loans, the market appears to be awash with them. According to S&P/Capital IQ/LCD, more than one-quarter of large corporate leveraged loans and 40% of LBO loans in the first quarter had leverage of at least 6x. The majority of institutional loans are now covenant lite. How does one reconcile this experience with tough talk from the regulators?

According to market participants, we are in the early days of a new regime. Banks are still determining what is acceptable and how many “offsides” loans they are permitted to underwrite and/or hold. Even as Guidance becomes clearer, banks would have to work through a backlog of (possibly offsides) deals that they have already underwritten. Finally, most market participants say that the banks need to go through another SNC exam to determine just how much they are punished for underwriting or holding criticized loans. Once that cycle has ended in summer 2014, the market may have more clarity on just what is expected from the Leveraged Lending Guidance.

CLOs: Volcker Rule

The Volcker Rule outcome was a surprising plot twist at the end of a busy regulatory year. For those not enmeshed in the drama, here’s the backstory: The Volcker Rule says that banks cannot own hedge funds or private equity funds, which are defined in the Dodd-Frank Statute as 3c-1 or 3c-7 funds. Unfortunately, many CLOs are 3c-7 funds. The Dodd-Frank Act also has a Rule of Construction that says nothing in it shall restrict or limit the sale or securitization of loans. For this reason, the regulators carved out loan-only CLOs from the definition of a “covered” (i.e., impermissible) fund. Unfortunately, 80% of CLO 1.0 and more than half of CLO 2.0 hold at least some non-loan securities; moreover, almost all 1.0 and 2.0 CLOs have baskets for non-loan securities. And, with that, older CLOs become impermissible investments and banks cannot own them. But in fact, banks don’t own CLOs, they invest in CLO AAA and AA notes. Obviously, that’s completely different than being the equity owner of the CLO. Nevertheless, the regulators employed a very broad definition of “indicia of ownership” and decreed that CLO AAA and AA notes are, in effect, ownership interests, and banks either have to bring CLOs into conformance or divest the notes.

This creates a significant problem for banks and for existing CLOs. Namely, U.S. banks own roughly $70 billion of CLO AAA and AA notes, while foreign banks may own another $60 billion. If unresolved, banks would be forced to divest these holdings by the end of the Volcker conformance period (currently July 2015). This, in turn, could lead to a serious disruption of the CLO market. To foreclose the possibility of a fire sale — while accepting that banks cannot own notes of non-conforming CLOs going forward — the industry asked regulators to grandfather existing pre-Volcker CLOs that are at least 90% senior secured loans.

Rather than agreeing to a partial grandfathering, the Fed instead said it would extend the conformance period for two years — from July 2015 to July 2017. This is helpful, but it is not a full solution. There is likely to be approximately $100 billion of pre-Volcker CLOs still outstanding by July 2017 and banks are estimated to hold roughly $45 billion to $50 billion of CLO AAA and AA notes that still would have to be divested. While this is a better situation than divesting more than $100 billion of notes by July 2015, it still requires a material sale of assets in a relatively short period of time.

As of mid-April 2014, the industry was working with the regulators to fine tune their proposal to avoid a material disruption of the CLO market. However, one trend has already emerged from this process: New U.S. CLOs are likely to be Volcker compliant, either by utilizing 3a7 structures or (more often) limiting collateral to loans.

The Looming Threat: Risk Retention

While the Volcker Rule is wrapping up, Risk Retention seems no closer to resolution than a year ago. Motivated by the performance (or lack thereof) of sub-prime RMBS and CDOs of RMBS, §941 of Dodd-Frank sought to use risk retention to align the incentives of “securitizers” with those of their investors. The very language of §941 indicated that this was meant to mitigate moral hazard in “originate to distribute” securitizations; the securitizer — that entity that “initiates or originates an ABS by selling or transferring assets, directly or indirectly, to the Issuer” — must retain 5% of the credit risk of the assets.

While the concept of alignment of interest is noble, the application of this particular form was disastrous to CLOs. Open Market CLOs do not have a securitizer as defined by Dodd-Frank. There is no entity that initiates or originates a securitization by selling or transferring assets. Instead, an Open Market CLO acts as an investment fund; a CLO manager is hired to purchase assets from a number of individual banks on an arm’s length basis and to actively manage the portfolio during a multi-year reinvestment period. The Dodd-Frank definition of securitizer simply does not correspond to Open Market CLOs. In their attempt to deal with this, the regulators identified the CLO manager as the “sponsor” as that entity selects assets for purchase, and then manages the portfolio going forward. Because the regulators tagged the manager, he or she would need to purchase and hold $25 million of notes of any new $500 million CLO that he or she does.

Sadly, this simply isn’t feasible on the scale that would be required to maintain the market. There are currently $300 billion U.S. CLOs outstanding. Thus, to replace the full CLO market, managers would need to somehow find $15 billion of capital to purchase and retain 5% of the notional amount of replacement deals. This is an extraordinary amount of capital for thinly capitalized asset managers; while large sponsor-affiliated or bank-affiliated managers may be able to maintain some of their CLO business, smaller independent managers mdash; who are actually the most numerous — may be squeezed out. In fact, Oliver Wyman has estimated that risk retention would reduce CLO formation by 60% to 90%. While companies might be able to replace CLOs, Wyman suggested it could cost borrowers $2.5 billion to $3.8 billion in interest costs per year.

With risk retention bad for the CLO market, the loan market and borrowers alike, the industry has been working to find a solution for the last several years. The latest attempt is the “Qualified CLO” or “QCLO.” The concept here is that if a manager is running a high quality CLO that is subject to a number of constraints, the retention amount would be reduced from 5% of the total deal to 5% of the equity. For a $500 million CLO with a $50 million equity slice, this would translate to $2.5 million. It’s certainly not peanuts, but it is something that many managers may be able to endure.

The proposed QCLO is defined by six strict, interlocking requirements. First, the assets that the CLO holds must be higher quality: at least 90% senior secured loans, no ABS investments, no derivative investments, etc. Thus, the riskiness of the assets is relatively low. Second, the CLO portfolio must be well diversified. Thus, even if some of the assets default, the overall portfolio would remain strong. Third, the CLO structure must be conservative, with at least 8% equity. Fourth, the manager must be aligned with the investors. This is achieved by at least 50% of the manager’s fees being subordinated to the rated debt payments, the equity being able to fire the manager and the manager purchasing and retaining 5% of the equity. Fifth, the manager must be a registered investment advisor, and therefore subject to SEC regulation and supervision. And, finally, the CLO must be subject to extensive transparency and disclosure requirements.

This approach would achieve many of the objectives that the regulators are seeking: It would encourage higher quality underwriting; it would further fortify already sturdy CLO structures; it would provide even more extensive investor disclosure; it would even further align the interests of CLO managers and all their investors. Ultimately, the QCLO should be a solution that works for both the industry and the agencies.

Looking Ahead: Unsteady Future?

Five years on, it is sometimes easy to forget that there was a financial crisis that nearly brought the world to its knees. In the wake of such an event, it is hardly surprising that a new regulatory regime would emerge. The challenge for the loan and CLO market is that much of the regulation is meant for other products and is, in turn, an awkward fit. As a result, the market may face serial frictions and dislocations as the rules are implemented. So buckle up, it may be a turbulent few years.

Meredith Coffey is executive vice president, running the research and analysis efforts at the Loan Syndications and Trading Association (LSTA). Coffey co-heads the LSTA’s regulatory and CLO efforts, which help facilitate continued availability of credit and the efficiency of the loan market. Prior to joining the LSTA, Coffey was senior vice president and director of analysis focusing on the loan and adjacent markets for Thomson Reuters LPC.