Revival of Collateralized Loan Obligation Market Seen Slowed by EU, U.S. Regulations

NEW YORK—New issuance of collateralized loan obligations is experiencing a robust resuscitation after collapse of the instrument during the 2007-2009 financial crisis, but sustained market growth has been hampered by European Union regulation and could face additional challenges from pending U.S. financial regulatory changes, lawyers and market specialists told BNA.

A collateralized loan obligation (CLO) is a securitization with underlying assets made up of pieces of large corporate loans. Before the financial crisis, CLOs were popular with investors, with new issuance in 2007 nearly reaching $95 billion, according to Citigroup Inc. data.

CLO investors and promoters alike virtually shunned the instruments during the financial crisis—issuance dropped to just $1.2 billion in 2009—but it is possible new CLO issuance in the fourth quarter of 2012 alone may hit $20 billion, Loan Syndications and Trading Association Executive Vice President Meredith Coffey told BNA Nov. 28.

While she and others said the CLO market is poised to continue its growth trend, an EU directive already has reduced European investor activity in U.S. collateralized loan obligation markets. And implementation by federal agencies of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. No. 111-203) could further constrain market activity, they said.

“I think, from an investor perspective and a market perspective, CLOs make sense, they are proven, and they should continue,” Coffey said. “The question is, does an exogenous factor—like regulation—come in and squash the market?”

Anatomy of the Deal.

Collateralized loan obligations are financial instruments that bundle pieces of corporate loans into special purpose vehicles. Securities, with those loans as underlying assets, are created and sold to eligible investors.

Issuers of CLOs create different tranches of the instruments based on the priority under which a tranche receives payments from the pool of assets. More senior tranches, typically rated triple A to double B by credit rating agencies, receive interest and principal payments first.

That variance in seniority allows issuers to sell some CLO high-grade securities possessing relatively low yields, while selling other securities involving more risk that offer higher yields.

Proponents of the instruments assert CLOs create a market for the sale of business loans—subsequently sold to securitization originators—and thus drive down the cost of borrowing to businesses. The originators, in turn, create financial products that can diversify investor portfolios.

‘C’ Word Unsettled Investors in Crisis.

A total of $29.8 billion of new CLO issuance occurred in 2004; subsequently, issuance of the instrument began to increase rapidly, the Citigroup data said. In 2007, new CLOs totaling $92.65 billion were issued, the data said.

As the financial crisis that began in late 2007 deepened, investor interest in CLOs waned, in part because investors were unsure of how the instruments would perform during that downturn, Pillsbury Winthrop Shaw Pittman LLP partner Jeffrey Stern told BNA in October.

For better or worse, structured financial products—particularly complicated ones beginning with the word collateralized—were perceived as a culprit in the economic downturn, many market specialists said.

“I think a lot of what happened in the CLO space is that people just weren’t differentiating them from collateralized debt obligations of asset-backed securities,” Coffey said. CLOs, she said, “have a really bad acronym.”

“They proved themselves over a several-year period, but when the crisis hit no one quite knew…what was going to be toxic, whether the problems were contained to certain areas,” Stern said.

“I thought the letter ‘C’ would be forever prohibited from structured finance,” Stern said.

CLO Performance in Crisis Said Strong.

Part of the reason for the CLO issuance revival is because, throughout the crisis, the instrument’s fundamental structure was essentially sound and, on a cash-flow basis, the instruments performed comparatively well, practitioners said.

Among other things, CLOs avoided asset-class problems associated with other structured-finance products, such as underwriting deficiencies and creditworthiness ratings issued by credit rating agencies that over time proved to be inflated, they said.

When investors realized the comparatively positive financial performance by CLOs through the crisis, they again became comfortable with investing in the instruments.

“[B]y all reports CLOs have performed beautifully through the capital markets crisis,” Stern said. In fact, Stern said, they provided better and more stable returns for investors than portfolios of loans directly held by investors.

A Nov. 13 Standard & Poor’s report concluded that only three of 493 United States CLO transactions carrying an S&P rating possessed failing subordinate overcollateralization ratios—a ratio calculating a CLO’s available collateral, cash held in principal accounts, and the total outstanding amount of the notes—and only one CLO deal issued during 2007 possessed a failing subordinate O/C ratio.

Robust Rebound Under Way.

Beginning in 2010, investors began returning to the CLO market; issuance that year totaled $4.1 billion. And in 2011, CLO issuance reached about $13.1 billion, according to the Citigroup data.

In 2012, CLO issuance has rapidly accelerated. In the first three quarters of 2012, CLO issuance totaled about $29 billion, and Coffey said it is possible new CLO issuance will reach $20 billion in the fourth quarter of 2012 alone—more than the total new CLO issuance occurring in 2008, 2009, and 2010 combined.

“I think in the United States there is an appetite for this type of debt, and there is a lot of money looking for a place to go,” Thompson & Knight LLP partner William M. O’Connor told BNA Nov. 27. Investors “are looking for a better return than sovereign debt and are willing to assume some of the risk,” he said.

Coffey said the dramatic uptick in issuance is not worrisome—she does not worry, for instance, about a possible asset-class bubble—because she thinks the runup in issuance represents a recovery to more normal levels from severely impaired levels.

And while a significant amount of new CLO issuance is occurring, previously issued CLOs continually amortize or are paid down. According to Wells Fargo & Co. data, outstanding CLO volumes have increased less than $20 billion in 2012, to a current level of about $270 billion total outstanding, according to the data.

EU Regulation Pinches; Others Loom.

While CLOs may have demonstrated their resilience during the financial crisis, an existing EU regulation that entered into force just as the CLO market in the United States began to recover effectively reduced the CLO investor base, and a pending Dodd-Frank rulemaking could further contract the product’s market, practitioners said.

Article 122a of the EU Capital Requirements Directive (2009/11/EC), which entered into force Jan. 1, 2011, prohibits European-based credit institutions from investing in securitization transactions whose originators or sponsors do not retain at least 5 percent of the net economic interest of the transaction or use an alternative, prescribed retention mechanism contained in the directive.

European banks were big buyers of U.S. CLOs before the directive came into force, and some of those buyers have had to exit the market, though some lawyers said the directive permits transactions to be structured in ways allowing third parties to absorb the directive’s risk-retention requirement.

Dodd-Frank Risk Retention.

U.S. regulators issued a proposed rule March 29, 2011, introducing their own credit risk retention program that aims to implement Section 941 of Dodd-Frank.

The Dodd-Frank statutory language generally requires the securitizer of asset-backed securities to retain not less than 5 percent of the credit risk of the assets collateralizing the securities. The section is intended to promote the safety and soundness of securitizations by requiring their promoters to have “skin in the game,” or own a sliver of the deal, to better align the incentives of promoters and investors while assigning to transaction parties accountability for a deal’s asset quality.

The proposed rule—promulgated by the Federal Reserve, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, Housing and Urban Development Department, Securities and Exchange Commission, and Treasury Department—provides market participants with some exemptions while presenting them with several strategies or options to use in order to comply with the risk-retention requirement.

Rolaine S. Bancroft, acting chief of the SEC Office of Structure Finance, said at a Practising Law Institute conference Nov. 30 her agency is waiting for the Consumer Financial Protection Bureau to complete its rule defining “qualified mortgage” before it completes its work (231 DER EE-12, 12/3/12). The CFPB is expected to complete work on that rule no later than Jan. 31, in accordance with a Dodd-Frank deadline.

While the proposed rule’s comment period closed in 2011, the rule has yet to be finalized by federal regulators. “The timing of adoption is still unclear and there is not really any indication about a reproposal,” SNR Denton partner Stephen S. Kudenholdt said at a Nov. 29 Practising Law Institute conference.

U.S., EU Retention Regimes Differ.

A key difference between the European directive currently in force and the proposed but not finalized U.S. rule is that the European compliance obligation is placed on the investor, while the proposed U.S. rule targets the securitization originator or issuer, Clifford Chance LLP partner Lewis Cohen said at a Nov. 29 Practising Law Institute conference.

“The reason this is particularly relevant is that, once the United States and the European Union rules are in effect simultaneously, you’ll have a significant disconnect” which could negatively affect both U.S. and European CLO market participants that want to operate on a cross-border basis, Cohen said.

A Nov. 16 International Organization of Securities Commissions report recommended the creation of a roadmap for global securities regulators in part to support alignment of risk-retention requirements in global securitization markets, while reducing the risk that potential barriers to cross border securitization markets may emerge.

Lawyers also pointed to Dodd-Frank’s statutory language, which states that no less than 5 percent of the “credit risk” of a securitization must be retained. One interpretation of that language is that the 5 percent retention requirement applies only to a securitization’s equity—typically more than 5 percent of a transaction’s total but less than 15 percent—and not the entire size of the offering. Interpreted that way, the risk retention requirement as proposed in the rule would be easier to meet, lawyers said.

Volcker Rule.

Section 619 of Dodd-Frank—commonly referred to as the Volcker rule—prohibits banking entities from engaging in proprietary trading or acquiring or retaining equity, a partnership interest, or other ownership interest in a hedge fund or private equity fund.

The Dodd-Frank statutory language asserts nothing in the measure “shall be construed to limit or restrict the ability of a banking entity or nonbank financial company supervised by the [federal regulators] to sell or securitize loans in a manner otherwise permitted by law.”

While the law is intended to cover hedge funds and private equity funds, the Loan Syndications and Trading Association (LSTA) is concerned federal regulators could, in their Volcker rule regulations, use an expansive definition of funds covered by the law that would capture collateralized loan obligations. For those reasons, the LSTA position is that the Volcker rule should not apply to CLOs.

Skadden Arps Slate Meagher & Flom LLP partner Jim Stringfellow told BNA Nov. 28 “a lot of uncertainties [exist] about the regulatory environment that are very hard to gauge.”

Future of Product Looks Bright.

Many practitioners said there is investor appetite to drive issuance volumes even higher in 2013.

“I think we’ll be at 50 [billion dollars] this year. Next year, maybe $55-60 billion,” Dechert LLP partner John M. Timperio told BNA Nov. 30.

“We certainly think January will be very busy. From what we’ve seen, there will be some deals that flow into January, and we expect January to be a very busy month,” Timperio said.

One reason for the rush to close deals: continued uncertainty regarding European sovereign debt creditworthiness and the ongoing fiscal cliff negotiations in the United States. U.S. economic contraction in 2013 caused by a failure to resolve U.S. fiscal issues would materially impair the CLO market, Timperio said.

“I think a lot of people want to get in front of the uncertainty. And so assuming we don’t go off the fiscal cliff…you may have a very busy first quarter as people try to rush deals out and lock in spreads before anything negative happens,” he said.

The uptick in deal flow also means an increase in legal services. Several lawyers with CLO practices who shifted their practices to other areas during the past few years are now building up their CLO practices again, lawyers said. “Anecdotally, the folks who have securitization practices are starting to pick up steam,” one lawyer who is involved in managing his firm’s legal talent told BNA.

Law firms that were not active in the CLO area pre-crisis have generally not tried to push into the practice area post-crisis, they said.

Lawyers advising CLO market participants include teams at Ashurst LLP, Cadwalader Wickersham & Taft LLP, Cleary Gottlieb Steen & Hamilton LLP, Dechert LLP, Clifford Chance LLP, Freshfields Bruckhaus Deringer LLP, and Shulte Roth & Zabel LLP, sources said.