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CLOs score another victory against regulation

Kristen Haunss
·4 mins read

By Kristen Haunss

NEW YORK, Oct 1 (LPC) - Managers of US Collateralized Loan Obligations (CLO) have scored yet another win in their battle toward deregulation, giving them a timely boost amid the global pandemic that has rattled the markets and created a challenging environment for the asset class.

A revised Volcker Rule, a key component of the sweeping financial reform bill Dodd-Frank, took effect Thursday, opening the door for CLOs to hold high-yield bonds, which can boost returns and buttress issuance. The original so-called covered fund portion of the regulation prohibited banks from investing in the structured product if it owned bonds.

President Donald Trump promised to dismantle Dodd-Frank, signed by President Barack Obama in 2010, which banned banks from speculating with their own money. In the almost four years since he took office, the CLO market has seen many restraints removed through regulatory rollbacks and the courts.

"It's been a major change to financial regulation that has flown largely under the radar because it wasn't the repeal of Dodd-Frank; there wasn't one marquee legislation," said Lee Reiners, executive director of the Global Financial Markets Center at Duke Law School and a former examiner at the Federal Reserve Bank of New York. "Instead, Trump appointees have been effective and savvy at using their rulemaking authority with surgical precision to dial bank and undermine a lot of Dodd-Frank and post-crisis reforms."

CLOs are the largest buyers in the US$1.2trn US leveraged loan market, which companies rely on for financing. The US$699bn US CLO market pools loans of different credit quality and sells slices of the fund of varying seniority. Debt investors receive a coupon plus the London interbank offered rate (Libor), and equity holders are paid the leftover interest.

As the loan and CLO markets have grown in size, so has criticism, including from Democratic Senator Elizabeth Warren and former Federal Reserve (Fed) Chair Janet Yellen, over loosening lender protections, with the Financial Stability Board specifically pointing to banks' exposure to CLOs.

As the coronavirus rattled the US economy, concerns with the asset class amplified, with loan prices in March falling to an almost 11-year low of 77.87 cents on the dollar as measured by the LPC 100, a cohort of the 100 most liquid US loans. Loan prices have since rebounded; the benchmark sat at 95.71 cents Tuesday.

CLO tranche spreads also gapped out earlier this year, and issuance plummeted. CLO managers raised just US$57.5bn of funds in 2020 through September 25, down 34% from the same point in 2019, according to LPC Collateral data.

LIGHT TOUCH

Since the crisis, the CLO market has sought to distinguish itself from its Collateralized Debt Obligation (CDO) counterpart, with CDOs backed by subprime mortgages largely responsible for the financial crisis, spurring legislative reforms.

Dodd-Frank risk-retention rules were intended to align manager and investor interests, forcing CLO firms to have 'skin in the game' by holding 5% of their fund.

The Loan Syndications and Trading Association (LSTA) sued the Fed and the Securities and Exchange Commission (SEC) over the rule in 2014. It took more than three years before the US Court of Appeals for the District of Columbia Circuit ruled in favor of the trade association.

CLOs received more good news when regulators rolled out Volcker revisions allowing banks to invest in CLOs that own bonds. Bonds can offer higher yields than loans, which may boost payments to equity holders.

The average yield for a Single B new-issue high-yield bond in the third quarter was 6.08%, compared to 5.65% for a leveraged loan, according to Refinitiv LPC data.

A boost in interest payments may be a boon for CLOs that have seen US equity cash-flow returns of just 8% this year through July compared to a historical average of 18.5%, according to JP Morgan.

A Fed spokesperson declined to comment. An SEC spokesperson did not respond to a request for comment.

CLO BOOSTERS

Proponents of CLOs say the funds are a crucial funding source for some of the largest companies, and loosening restrictions allow them to extend even more credit.

An LSTA-commissioned study by research firm John Dunham & Associates found the syndicated loan industry contributes more than US$2.7trn in economic output, and lenders and borrowers employ more than 10 million Americans.

"We've made it clear, and many regulators have concluded that they do not think loans are systemically risky," said Elliot Ganz, general counsel at the LSTA. “During this awful pandemic the market is performing exactly in the way we expected it to."

While CLO market participants push for more flexibility even as concerns remain about regulatory pullback, banks arranging and investing in the funds are in a stronger position than 2008.

While some regulations have loosened, strong oversight of the banking community remains, according to Karen Petrou, a co-founder of consulting firm Federal Financial Analytics.

"There will be losses in the banks and the general economy," Petrou said. "None are immune, and none would even suggest they are. They are just trying to do the best they can to be ready." (Reporting by Kristen Haunss; Editing by Michelle Sierra and Chris Mangham)