New Japanese regulatory proposal could hit US CLOs

NEW YORK, Jan 18 (LPC) - A new regulatory proposal could curb Japanese investment in US Collateralized Loan Obligation (CLO) funds. Reduced appetite from these major buyers could push CLO pricing higher and hamper issuance after a record US$128bn of US volume in 2018.

The Japanese Financial Services Agency (JFSA) is proposing to introduce risk retention as part of regulatory capital rules for some investors seeking to invest in securitizations, according to a report from law firms Anderson Mori & Tomotsune and Milbank Tweed, Hadley & McCloy.

Japanese investors bought billions of dollars of US and European leveraged loans in 2018 via CLO funds and separately managed accounts, sources said, which supplied welcome liquidity and highlighted increasingly global capital flows.

CLOs are the biggest buyers of leveraged loans, and Japanese banks account for about 10% of the US$750bn global CLO market, according to a Bank of England estimate.

Their possible pullback could boost CLO spreads, which are already at a 15-month high, and even push pricing higher for companies accessing the US$1trn US leveraged loan market, as fewer funds may mean less financing options.

“If Japanese banks are not involved in the market, spreads would widen,” said Laila Kollmorgen, a managing director at PineBridge Investments in Los Angeles. “The question is, would US insurance companies be able to step in? Highly likely, but at what clearing level?”

Public comments are due by January 28 and the final rule is expected to be effective on March 31, according to the law firms’ report.

“The Financial Services Agency, in its supervisory guidelines, has demanded that financial institutions holding securitized products properly manage the risks of such products, including by checking whether the originator has retained any risk,” the JFSA said in an email. “As a result of a recent amendment to the guidance (regulatory notice), we plan to newly introduce a quantitative standard whereby financial institutions must check whether the originator is holding 5% or more of the risk.”

The JFSA said that securitized products that do not meet this standard must, in principle, be assigned a triple risk weighting in the calculation of the financial institution’s capital adequacy ratio. If the standard is not met, the JFSA will not apply the weighting if it can conclude the origination of the underlying assets “conduct appropriately,” the regulator said in the email.

“Market participants are evaluating the impact of the proposal and may seek clarification in the process of the public comments,” Daisuke Tanimoto, a partner at law firm Anderson Mori & Tomotsune in Tokyo and an author of the report, said.

Japanese investors are major buyers of the largest and most senior portion of the CLO, the Triple A slice. A potential pullback is raising concerns that tranche spreads could move higher, as investors stepping in to fill the void demand more compensation.

Spreads on Triple A tranches rose to an average of 121bp in December, the highest level since September 2017, according to LPC Collateral data. Spreads are forecast to move even higher with Citigroup predicting 130-135bp in the first quarter, widening to 140-145bp over the course of the year.

CLOs pay debt investors a coupon over Libor with the leftover interest paid to holders of the most junior portion of the fund, the equity. If Triple A spreads increase, equity distributions could decrease, which would make the economics of new funds difficult.


Retention rules are not new to the CLO market. Both the US and European markets have regulation in place following the credit crisis of 2008 to force managers to have ‘skin in the game.’

US retention rules were introduced as part of 2010’s sweeping Dodd-Frank legislation and went into effect at the end of 2016, but were overturned for CLOs last year, when a US Appeals Court agreed with the Loan Syndications and Trading Association (LSTA) that CLOs should be exempt.

No US CLOs backed by broadly syndicated loans were issued in the second half of 2018 that comply with risk-retention rules, according to JP Morgan, however this could change if Japanese investors request US managers to hold retention going forward. European risk-retention rules remain in place.

“It’s potentially an issue in the US, where risk retention does not apply to most CLOs,” said James Warbey, head of the alternative investments group in London at Milbank and an author of the report. “For the European market, reading the tea leaves…if the manager is the sponsor (under the proposal), it would have zero effect.”

About US$11bn was said to be raised for US risk-retention programs, according to Citigroup estimates. The infrastructure and fundraising for US retention could be revived if required, sources said.

If US CLO managers are forced to agree to the additional expense of holding retention, Japanese investors could have to accept a lower spread, which would boost equity returns. This could benefit managers, who may hold some of the equity in order to be retention compliant.

“We have had high level, very constructive conversations with the JFSA and we intend to submit a comment letter,” said Elliot Ganz, general counsel at the LSTA. “We are hoping that we can present the case that will persuade them that open-market CLOs should not be subject to higher capital charges under their proposal.” (Reporting by Kristen Haunss Editing by Tessa Walsh and Jon Methven)