Gunning for the gap

IFR Top 250 2014
9 min read
Joy Wiltermuth

CLO managers have been piling into the primary market in the past few months, racing to close deals before the advent of new regulation that could drastically curtail their business.

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A tug of war has emerged in the CLO markets as managers look to meet requirements aimed at reining in dicier parts of the securitisation market and keep themselves in business.

The fear driving the market is the advent of the so-called risk-retention rule, which would require CLO managers to hold on to 5% of the fair value of each new deal they sponsor. With the implementation of the rule still a few months off, CLO issuance has surged in the three months since March.

Many deals have already scrapped risky features prohibited by parts of the Dodd-Frank Act, but as both small and large issuers try to carve out territory before the rules of the game are set, some are doing so by courting volatility and increased risk.

“There is still a window of time before the new rules take effect,” said Yvonne Fu, a managing director at Moody’s. “But the pending rules have propelled managers into moving some new CLOs forward on the calendar.”

March’s US$11.1bn of new CLO issuance was topped by US$12.3bn in April, according to Wells Fargo data, while May’s tally dipped slightly to US$11.4bn, according to JP Morgan analysts.

There is concern that many managers would not or could not deal with the looming restrictions on their business, and a November study from the Oliver Wyman consultancy warned that the overall CLO market could be slashed by 60% to 90%.

“The consequences could be pretty dire,” Paul Forrester, a partner at Mayer Brown, told IFR. “The market is going to react in ways you didn’t expect. Managers have to do deals and build up scale,” he said.

Not again

The retention rule is clearly aimed at forcing CLO managers to have “skin in the game” and stave off the pump-and-dump tactics common before the subprime mortgage meltdown. In the run-up to the crisis, lenders quickly sold-on shoddy loans – and the risks they entailed – to investors in the form of collateralised debt obligations.

Critics of the new regulation, such as Forrester, point out that, unlike those structures, the new CLOs are not bundles of loans originated with the intent to distribute, and are in fact purchased on the secondary market.

He and others insist that lawmakers, in their reaction to the financial crisis, have unhelpfully lumped both kinds of structures together in one-size-doesn’t-fit-all regulation.

“The market is going to react in ways you didn’t expect. Managers have to do deals and build up scale”

“After three years of intense lobbying, it’s pretty clear it’s only falling on deaf ears,” Forrester said.

According to Thomson Reuters data, the default rate of the loans underpinning the new CLOs sits at a relatively low 1.2%.

Yet with the risk-retention rule looming – it is expected to be finalised in the second half of the year – issuers have been pushing the boundaries to soak up every last dime in the market.

In May, Onex Credit Partners priced a whopping US$1bn CLO – and did so with a third of the underlying collateral still unidentified, Moody’s said.

In effect, this meant that investors in the Triple A piece lent Onex money at just 150bp over Libor while the borrower had just two-thirds of the loans needed to back up the trade.

“Those [types of deals] are not going to perform as well,” one CLO manager told IFR. “It’s bad execution.”

Neither Onex nor Bank of America Merrill Lynch, which arranged the deal, responded to requests for comment.

All in

The Onex trade, the second-biggest CLO deal of 2014 so far, was heard to have been sized to fit investor demand, and that it was not substantially oversubscribed.

Even so, however, such a large trade will have removed much of the investor cash available to the CLO market at a time when many issuers are frantically trying to print new deals.

The size of the Onex deal leaves little left over for the next trade, the manager said – which may be one reason why overall CLO performance in the secondary has been unimpressive.

Prior to the large Onex and another large deal, Symphony, in May, the average CLO size was US$488m between October and March, according to Thomson Reuters data.

But in early June, Apollo Credit Management printed a US$1.5bn CLO, marking a post-crash record. More of these large deals are being prepped though, according to one analyst, amid expectations that issuance will roughly double in the year’s second half to hit US$100bn. That would be the highest 12-month output since the financial crisis.


Despite the surge in activity, spreads on Triple A pieces have not tightened meaningfully in recent months, while recent trades have seen spreads widen out at the bottom end.

Triple B and Double B pieces of new issue CLOs were 10bp–15bp wider in the final week of May and at their widest since the third quarter of 2013, according to JP Morgan.

“Despite new buyers, we haven’t seen tightening,” the CLO manager said.

One reason may be that the market is in flux due to the uncertainty about the pending risk-retention rule, which has yet to take final shape.

On the one hand, managers are rushing to get new deals printed, not least because increasing assets under management is a sound strategy if consolidation in the sector is on the horizon. On the other, new restrictions that limit the traditional US CLO investor base have brought other players – including hedge funds armed with leverage – to the fore.

Already, the Volcker Rule – another piece of post-crisis legislation – bars US banks, the usual buy-and-hold anchors of Triple A paper, from owning CLOs that include non-compliant features such as bond buckets.

This has also helped attract hedge funds, insurance companies and other asset managers to the CLO Triple A space – where a move tighter in spreads on six to eight times leveraged paper could mean as much as a 10% return or more.

Yet that has failed to happen – despite a broader investor base and the cheaper price of secondary loans for CLOs to buy, due to regular outflows of late from leveraged loan funds.

“The main thing you have is an overwhelming supply of CLOs,” said David Preston, a Wells Fargo analyst. “Buyers have so many issues to choose from.”

Another factor for bank investors is that CLOs are estimated to be 20bp–30bp more expensive to own than CMBS, due to new FDIC charges, Preston said.

Still unfinished

One plus for the market is that regulators in April gave banks holding older non-compliant CLOs a grace period until July 2017 to amend those deals or sell out their positions.

And regulators also have yet to finalise the risk-retention rule, leaving some in the market hopeful that lawmakers will back away from at least the most onerous of its provisions.

One suggestion is a so-called “qualified” option that would require a CLO manager to retain only 5% of a deal’s equity, rather than 5% of its notional amount.

On a US$500m CLO, for example, that would mean having to retain just US$2.5m as opposed to US$25m.

And while the CLO industry continues its efforts to convince regulators that it shouldn’t be lumped in with the originate-to-distribute model made infamous by the high-loss subprime mortgage bond sector, it appears to be facing an uphill battle.

“There is still time for this to play out,” said Meredith Coffey, executive vice-president of the Loan Syndications and Trading Association, an industry trade group. “Frankly, if [regulators adopt] the qualified CLO approach, then you wouldn’t have a significant diminishment of the kinds of managers who could do CLOs.”