With the comment period for proposed rules to implement the Dodd-Frank Act now nearing its extended deadline, many investors remain palpably distressed over certain aspects of the proposal. The discomfort is well-founded. While underpinned by good intentions, the proposed regulations cast a broad net and would have unintended consequences — including compromising the viability of an entire well-performing asset class.
Of particular concern are proposed risk-retention rules designed to protect investors in structured finance securities by requiring sponsors of such securitizations to retain 5% of the credit risk of securities sold to third parties. The goal is to align the interests of investors and originators of structured finance securities under the theory that having “skin in the game” will prevent the monumental lapses in underwriting standards that helped precipitate the recent crisis.
Although some managers retain more than 5% of the equity, most do not. There is a concern that this requirement would exclude many good managers who have clients willing to buy the equity. Also, even for large managers, many do not have capital investment programs and rely on affiliates to invest. Affiliate investments might not count under the proposed rules.
Structured finance is an umbrella term for securitized investments with vastly different characteristics ranging from structures, manager incentives and the nature of the underlying collateral — from credit cards and equipment leases, to commercial and residential mortgages, to student loans. This proposal makes a lot of sense for large pools of homogeneous assets that have been directly originated by a sponsor that possesses critical information about the assets in the pool. However, a one-size-fits-all regulatory scheme for all types of securitizations might not make sense, particularly when the asset class is transparent, actively managed and heterogeneous.
Lumped in with these for the purposes of the risk-retention rules are collateralized loan obligations, or CLOs, which are securities backed by traditional bank loans to corporate borrowers. Although a relative newcomer in the scheme of things — actively issued since the late 1990s — CLOs have become established as a resilient and mature asset class that many institutional investors have added to their portfolio allocation strategy. The CLO market was estimated to total $330 billion as of April 15 by J.P. Morgan.
While most structured finance securities are “originate-to-distribute” products where assets are pooled and then transferred to third parties, CLOs are unique in that the portfolio of loans in the underlying collateral pool are purchased in the secondary market, are actively managed and have performance-based fee structures. Risk retention is thus an inherent feature of CLOs. At any time during the specified reinvestment period, the manager is free to sell underperforming assets and reinvest the proceeds in other loans. The obvious risk-mitigation benefit of active management is not available to investors in other structured finance securities — a point made by the Federal Reserve Board in last year's “Report to the Congress on Risk Retention.”
In CLOs, a portfolio of 100 to 200 loans is actively managed, similar to a typical investment portfolio. The individual loans can be sold and new loans purchased in the syndicated bank loan secondary market. So one loan exits the pool and another is purchased. These trades are done by the manager, within the portfolio's expected risk and return ranges.
Transparency is another differentiator. Since the underlying collateral consists of traditional loans to companies, and many of those companies are publicly held, investors have greater visibility into the CLO's portfolio than any other type of structured finance security. In structured funds backed by hundreds or thousands of residential mortgages, for example, it is very hard for investors to see the actual mortgages and perform due diligence. Residential mortgages also don't trade in a secondary market like traditional bank loans, a clear advantage for investors in evaluating their current value.
The premise implied by the proposed rules — that the interests of investors and CLO managers are not adequately aligned — is unsupportable. Under a three-tier fee structure, CLO managers are paid not upfront but during the life of the CLO — and only if the CLO performs. Controlling CLO investors who aren't happy with their managers can replace them. Moreover, many CLO managers are registered investment advisers with a fiduciary responsibility to actively manage the loans in the CLO's portfolio in their investors' best interests.
Throughout the financial crisis, CLOs suffered from association with another form of structured finance security, collateralized debt obligations or CDOs, which included pools of subprime mortgages that imploded along with the housing market and helped crash the global financial system in 2008. But corporate bank loans are not subprime mortgages and CLOs have performed as expected. As the Federal Reserve Board has noted, CLOs suffered only a few actual defaults through the crisis despite widespread ratings downgrades.
In fact, the performance of the bank loans underlying CLOs was both predictable and transparent. Default and recovery rates were consistent with previous recessions and have quickly returned to pre-crisis levels. Similar to the high-default rate period of 2002-2003, CLO structures proved again that they protect debt investors while still providing appropriate returns on equity capital. Babson Capital's research has been unable to find a single AAA or AA cash-flow CLO that has incurred even one dollar of principal loss. Ratings agencies are now upgrading CLO tranches: Between January 2010 and April 2011, S&P and Moody's reported more than 1,600 CLO rating upgrades vs. fewer than 30 downgrades.
A likely outcome of imposing the 5% risk-retention rule on CLOs will be dramatically fewer CLOs, as all but the largest managers find it unfeasible to keep so much capital on the sidelines to satisfy the rule.
So, rather than protecting institutional investors, the rule could unnecessarily limit their ability to access an asset class that performed as predicted during the crisis and emerged intact, unlike other structured asset classes that incurred significant losses, even at the AAA rated level.
This may reduce the flow of capital to U.S. corporations and increase borrowing costs as companies look increasingly to the high-yield bond market for capital.
Adding investor protections in the wake of a global financial crisis might seem to be a logical course of action, but any proposed regulation should face a needs-based test framed by these two questions: Will the new rule actually benefit the investors it purports to protect? And in the absence of such a rule, have investors been harmed?
In the case of CLO investors, the answer to both questions is no.
Matthew P. Natcharian is managing director and head of structured credit for Babson Capital Management LLC, Springfield, Mass.