One of the culprits of the financial crisis was the 'originate to distribute' model where loans were made expressly to be sold into securitization pools, which meant that the lenders did not expect to bear the credit risk of borrower default. As such, the Dodd-Frank legislation enacted in the wake of the crisis includes rules that require market participants to keep ‘skin in the game’. This is particularly true for securitization where Section 941(b) of the Dodd-Frank Act requires “securitizers” to retain five percent of the credit risk associated with an asset-based securities transaction.
The Managers of CLO’s – or Collateralized Loan Obligations – were not the culprits during the crisis but were nonetheless caught in the net of Section 941 even though CLO managers do not originate assets, but simply perform investment management services and actually already have skin in the game. CLO managers act as portfolio managers for the loan assets in the CLO, and their compensation is highly subordinated and dependent on the CLO's performance. However, CLO managers are included in the final rules and will have to retain the 5% credit risk of the CLOs they manage.
The way to abide by the retention rule is either to purchase 5% of the lowest CLO tranche (known as a horizontal slice) or to buy 5% of each tranche from the most highly rated to the least (known as a vertical slice).
A typical CLO issuance is $500MM, making the bill for 5% retention a cool $25M. While there are large CLO managers (such as Carlyle, KKR, Apollo etc.) who may be able to fund this, many CLO managers are much smaller shops that do not have the available cash to finance such a purchase. With CLOs playing a large role in providing liquidity to the credit markets, industry groups had argued that liquidity would suffer with many CLO managers going out of business under the weight of these risk retention rules.
Under the final rules though, a number of financing options were included, one of which is the ability for CLO managers to finance risk retention securities by borrowing on a full-recourse basis and pledging the retention securities as collateral. The higher tranches of the securities are excellent collateral given that no CLO tranches originally rated AAA or AA have ever experienced a loss. While it would not be possible to get 100% financing given the risk of the lowest tranches, 80% financing of a vertical slice should be very feasible, bringing the $25MM bill down to a more achievable $5MM.
This type of financing provides a potentially huge opportunity for bank lenders, including those who traditionally do not play in the CLO market. While investment banks both originate the type of leveraged loans that wind up in CLOs and also act as CLO issuers, regional banks have not had as much opportunity to participate in this market. The financing needs of CLO managers though should be fair game for a much wider swath of bank lenders.
Doing a back of the envelope calculation, CLO issuance in 2014 was $124B (http://www.leveragedloan.com/us-clo-issuance-hits-record-123-6b-in-2014/) and has been $50b thru June of this year. Let’s say $100B of CLOs are issued in a year – the 5% retention rule requires CLO managers to purchase $5B worth of retention securities and 80% financing of that 5% represents a new $4b lending opportunity to go around.
So the irony is that risk retention – which was going to hurt the bank loan market – may actually end up juicing that market up a bit instead. A certainly unintended effect of regulation but for those who capture this market share, not necessarily a bad one.