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US CLO Managers Face Risk Retention Uncertainty at Home and Abroad
Practical Law Legal Update w-002-7439 (Approx. 4 pages)
US CLO Managers Face Risk Retention Uncertainty at Home and Abroad
by Practical Law Finance
| Law stated as of 06 Jul 2016 • USA (National/Federal) |
US CLO managers are encountering a lack of clarity on certain aspects of US risk retention compliance, which will be required by the end of 2016. The uncertainty is contributing to a steep reduction in US CLO issuances this year. Challenges presented by new proposed European risk retention regulations are also hampering US CLO managers.
On June 30, 2016, Reuters reported that US collateralized loan obligation (CLO) are encountering a lack of clarity on certain aspects of US risk retention compliance, which will be required by the end of 2016. The uncertainty is contributing to a steep reduction in US CLO issuances this year. Challenges presented by new proposed European risk retention regulations are also hampering US CLO managers.
US risk retention rules went into effect for residential mortgage-backed securities (RMBS) on December 24, 2015, and go into effect for all other asset-backed securities (ABS), including CLOs, on December 24, 2016. These rules require that sponsors of ABS transactions, which include CLO managers, retain 5% of the credit risk of any asset pool that makes up a securitization (see Practice Note, ABS Risk Retention Under Dodd-Frank).
Uncertainty Regarding US Retention Rules
In order to retain the requisite risk, managers may purchase 5% of the credit risk by, among other methods:
- Purchasing the interest directly.
- Purchasing the interest through a majority-owned affiliate (MOA)
- Purchasing the interest through a capitalized manager vehicle (CMV), which is a stand-alone management company capitalized by the CLO manager and third-party investors, to which management of the CLO is assigned.
(For details on MOA and CMV CLO structures, see Legal Update, C-MOA Structure May Facilitate CLO Risk Retention Compliance.)
However, it is unclear whether significant investment by a third party to meet the 5% retention requirement would violate either the requirements or the spirit of the rule.
In the US, there is concern over:
- Whether US regulators will request that managers invest a larger portion of their own money to meet the risk retention requirement, if their investment is currently bolstered by third-party funds.
- What happens if a manger finances its investment using borrowed funds and subsequently defaults on its payments to its lender (and/or if the lender forecloses on the CLO interest).
According to Reuters, this issue was first addressed by a December 2014 European Banking Authority (EBA) report, which pointed out that while certain structures were technically legal under EU regulations, they did not follow the spirit of the risk retention requirement. The same concerns persist in the US, and federal regulators have yet to issue guidance.
This uncertainty has contributed to the decline of US CLO issuance in 2016, valued at $25.7 billion as of June 30. This is down 58% from the same period in 2015. At least part of the decline is due to the pending risk retention requirements and the associated uncertainty surrounding third-party investment in the required retained risk.
European Risk Retention Proposals
US CLO managers also often look to Europe to expand their markets and find buyers. However, the EU has proposed new regulations that would rework EU risk retention rules in two notable ways, including by:
- Prohibiting US CLOs from selling their products in the EU by requiring an originator or sponsor to be a European-regulated entity. As a result, US CLOs that are regulated by the SEC or prudential bank regulators would no longer be EU risk-retention compliant, and would prohibit US CLOs from selling their financial products in the EU.
- Under a June draft report, proposing to increase the risk retention requirement from 5% to 20% of the CLO's credit risk.
For more information on EU current and proposed risk retention requirements, see Practice Note, Securitisation: regulatory framework and reforms: Risk retention.
This Update is based on material provided by the Reuters news service (http://www.reuters.com) , which provides news and analysis for domestic and international issues.