On August 28, 2013, six federal regulatory agencies (among them, the SEC, Federal Reserve, OCC and the FDIC (collectively, the “Agencies”)) released a 499 page second risk retention proposal (the “Second Proposal”). The Second Proposal covers risk retention for securitizers of all asset-backed securities, but also contains changes aimed directly at CLOs. For CLOs, the rules include both familiar provisions found in the first risk retention proposal (introduced in 2011) and new proposals, some of which are directed at alleviating the substantial burdens the Agencies themselves recognize the Second Proposal imposes on CLOs. Some of the proposals include new combinations of previously proposed forms of retention, new measurement metrics and holder eligibility criteria, hints at how grandfathering will be treated, a projected cash flow test for first-loss holders and an (likely ineffective) open market CLO option. The provisions outlined below do not reflect all changes found in the Second Proposal, but instead are meant to highlight some of the developments CLO participants may find important.
The Agencies target more flexibility in the Second Proposal. For example, the Second Proposal gives retention providers the option to satisfy their retention requirements by holding any combination of vertical (5% of the par value of each tranche issued by the CLO) and horizontal interests (5% of the par value of the CLO in a first-loss tranche). The ability to mix and match interest strips gives retention providers greater latitude to align their risk retention obligations with their appetite for risk.
The Second Proposal attempts to reflect market realities by making adjustments to the way the 5% requirement is measured and holder eligibility. While the first proposal linked the calculation of 5% of the “credit risk” to the par value of the obligations issued, the Second Proposal introduces a new “fair value” metric which is a more appropriate economic measurement of risk retention and more consistent with market practice. For example, the “fair value” can take into account, among other things, the expected default, prepayment and recovery rates of the CLO interests. Similarly, in an effort to more accurately reflect the intent of the Agencies, the Second Proposal no longer restricts transfers of interests required to be held for retention purposes to “consolidated affiliates,” but instead can now be held and transferred to any “majority-owned affiliate.” This distinction was made to avoid a situation wherein the retention provider’s economics are not shared with its consolidated affiliates (under GAAP).
The jury is still out, but it looks like existing CLOs will walk. Two questions on the minds of many CLO participants are: (i) whether existing CLOs will be exempt from the retention restrictions and (ii) when those restrictions will come into effect. While there was no direct discussion of how existing CLOs will be treated, the Agencies' comments intimated their intention to exclude CLOs existing before the effective date of the regulations. This is significant, and also is in contrast to how the Agencies’ European counterparts seem to be intending to treat CLOs subject to the new European Credit Requirements Directive IV, which is not expected to provide an out for existing CLOs. The Second Proposal broke no new ground with respect to when the retention regulations will become effective, which will be two years after the final regulations are adopted.
The change to the projected cash flow test is unworkable for most CLOs. The Second Proposal contains a change to the projected cash flow test intended to reflect the reality that the first-loss tranches in some securitizations (including CLOs) often do not distinguish between principal and interest payments. However, in practice the change could potentially bar any payments to investors in the first-loss tranche of a CLO due to the fact that the “cash flows” to subordinated noteholders are measured against “principal payments” on the secured notes. This is problematic because managed CLOs do not typically make scheduled principal payments to secured notes until after the reinvestment period.
Finally, in the Second Proposal the Agencies do attempt to offer an olive branch to CLO securitizers by providing for an alternative means of satisfying retention requirements. Under the so called “Lead Arranger Option,” open market CLO securitizers may have their retention obligations fulfilled by the “lead arranger” of the underlying asset so long as certain requirements are met, including, among other things, that (i) the “lead arranger” holds 5% of the value of each tranche issued that will be securitized (until the earliest to occur of repayment, maturity, default, etc.), (ii) the “lead arranger” has certain consent rights contained in the underlying documents and (iii) the CLO’s assets consist solely of “senior, secured syndicated loans” acquired in the open market. As already noted by many commenters, while this option appears to be an attempt by the Agencies to make the proposed rules less onerous for CLO securitizers, it falls short due to the realities of the lending market, especially with respect to lead arranger economics and operations.
While the Second Proposal also comes with a comment period in which commenters may venture to persuade the Agencies that certain provisions of the Second Proposal are in need of repair, some market observers are skeptical about whether regulators will heed the warning signs. However, if the final regulations are published substantially unchanged, the effect could be dramatic for the $285 billion CLO market (as recently reported by Thomson Reuters LPC).