EU Report on CLO Rating Risks

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The European Securities and Markets Authority has published a report highlighting certain issues related to rating-collateralized loan obligations. ESMA launched a review in May 2019 on the arrangements that the three main credit rating agencies (Fitch Ratings, Moody’s Investors Service and S&P Global Ratings) have adopted to assign and monitor credit ratings on CLO instruments issued and rated in the EU. The review is part of ESMA's work on identifying vulnerabilities to financial stability arising from leveraged loans. Leveraged loans are of concern because of: (i) the excessive level of financial leverage of some corporate issuers; (ii) the weakening of underwriting criteria applied by lending entities; and (iii) the expected evolutions in the credit cycle.

The report sets out certain risks and regulatory concerns arising from those arrangements as well as ESMA's expectations of CRAs, which include that CRAs:

  • have consistent communications between the different internal teams of a CRA to ensure a holistic assessment of a CLO's creditworthiness;
  • have systems and processes that ensure the independence of their rating process;
  • monitor for operational risks that could arise from their dependency on models and data provided by third parties;
  • ensure transparency to market participants on the limitations of methodological approaches and that any developments in those approaches are free of commercial interests; and
  • continue to monitor market trends and perform a thorough analysis of all developments in CLO contractual arrangements, particularly in view of recent trends that weaken investor protections.

View ESMA's statement.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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