US CLO market prepares battle against extinction
* LSTA co-ordinating response to US regulators
* Restricted equity cashflow to impact even large managers
* Bank retention rules viewed as unworkable
By Natalie Harrison
NEW YORK, Oct 4 (IFR) - US CLO market players are poised to ratchet up pressure on regulators to relax proposed rules on risk retention, which they say will drastically shrink the burgeoning market, or even kill it off altogether.
Final credit risk retention rules proposed by regulators on August 28 added additional tweaks, which if applied, are expected to dramatically shrink a market which has hit a post-crisis record of around US$58 billion this year.
The latest proposals, specifying that CLO managers acting as sponsors must retain 5% of the risk in a CLO by either owning a vertical strip or a horizontal equity slice, will also prohibit access to cashflows on the equity until the senior notes have amortized.
In addition, if lead arrangers act as the agent instead, they must now hold the loans for the life of the debt and are not able to hedge that risk.
Both proposals have market participants up in arms.
Concern that smaller managers would not be able to afford to stump up the millions of cash that it would require to retain the risk have been circulating for months already. But the equity cashflow change now suggests that even larger CLO managers will be shut out.
"For players that can afford risk retention, it puts a big dent in their ability to get a deal done. If, as an issuer, I now cannot take cashflow for two or three years, I have to go to my bosses and say, 'Please give me capital' to get the deal done," said one CLO issuer.
The internal rate of return (IRR) for a CLO manager on the equity tranche would drop dramatically, say experts, to high single digits from around 12% to 13% now, making the whole exercise of issuing CLOs an expensive proposition.
"This is a problem specifically for CLOs because of their reinvestment period," said Elliot Ganz, General Counsel of the Loans Syndications and Trading Association (LSTA). "If there is no cashflow to equity for four to five years, this will severely impact the internal rate of return on the equity."
Retaining a pro-rata vertical strip, rather than the equity portion, is not considered a viable option either as the heavy proportion of Triple A debt means that returns are too small.
UNWORKABLE BANK OPTION
Market sources said the LSTA held an internal call with a private working group on Tuesday to help prepare a response to the proposals, while other industry groups are also heard to be holding similar discussions. The LSTA has also requested an extension to the deadline to December from October 30.
LSTA's Ganz declined to comment on the call.
Some experts said that US CLO supply could still top US$70 billion this year as the rules will not be finalised until 2014, and even then will not come into force for another two years.
But the headwinds are serious in the longer term.
The regulators have provided some leeway for CLO managers, by stating that banks can act as the retention agent instead. But experts in the field say this solution is also unworkable.
The lead arranger for each loan purchased by the CLO must retain 5% of each of those loans. The problem here is that banks will likely have difficulty retaining such large portions of loans given their increased capital charges and inability to hedge the risk.
One high yield syndicate banker said the proposals "fly in the face of what Basel 3 and CRD 4 is trying to do."
"If you cannot hedge those loans for five to seven years, you are putting excessive risk on the balance sheet. It also reduces trading liquidity," said a leveraged loan banker.
HEADING FOR EXTINCTION?
Even without these latest obstacles, seen as 90% of the problem for the CLO market's future, concerns have been increasing that supply will start to dwindle anyway unless demand for Triple A tranches can be boosted.
Bankers have been trying to remedy that by developing more innovative structures that include step-up coupons.
The high-yield banker said it was vital to maintain a diversified pool of loan buyers. He described demand for leveraged loans from mutual funds as a roller coaster.
"Even though we have had more than a year of consecutive weeks of inflows, the increases have been small and steady. When outflows do come, they are likely to be huge," he said.
"CLO money is long-term cash that is locked in for 10 years. When you're underwriting deals, this is the kind of money that you can count on."
One big loan investor, however, is convinced that institutional money is here to stay.
"Dodd-Frank seems determined to kill off the CLO market, but there are other pockets of demand. If CLOs go the way the Dodo did, this will be terrible for CLO managers, but not for the market."