The leveraged finance market might be forgiven for feeling a little persecuted of late. In addition to new lending guidelines that might kill off a lot of business for the banks, proposed risk-retention rules state that CLOs must retain a 5% stake in any securities that they sell. Completing the triple-whammy of hostile regulation is the Volcker Rule, under which CLOs have found themselves caught in legislation aimed at hedge fund activities because many contain some securities in their asset pools. Under Volcker, banks would be barred from holding such investments.
The impact of the Volcker Rule was clear for all to see in January when US CLO issuance slumped to $3.08 billion, its lowest monthly level since July 2012, according to JPMorgan. The CLO market in the US had surged ahead last year on the back of rampant demand for floating-rate credit, fuelling the rise in covenant-lite lending and attendant concerns over market discipline. CLO issuance for 2013 was $82 billion – a 49% increase on 2012.
It is little surprise that the January slump was so stark – banks hold around $70 billion of CLO debt on their books.
Under attack
"This is just the latest regulatory attack," fumes a US-based CLO manager. "In January CLO production was a quarter what it was in 2012. CLO spreads have continued to widen and the CLO arbitrage is challenged. It is very unfortunate for the CLO market, particularly in the light of the fact that performance has been stellar. Getting a US bank to commit to triple-A liabilities today is a Herculean effort. If as a CLO manager you have to rely on non-banks and foreign banks for the triple-A part of the structure it is very difficult – you can’t do it without US bank investors."
There is little doubt that the impact of the Volcker Rule on the CLO market is not what the regulators were aiming for.
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| Derek Bush, partner at Cleary Gottlieb’s US financial institution practice |
"With funds activities there are still a ton of questions on what is in and out of the Volcker Rule," says Derek Bush, partner at Cleary Gottlieb’s US financial institution practice, who has been advising large US and non-US banking organizations on implementation of the final Volcker Rule. "Congress meant the regulators to focus on banks’ involvement with private equity and hedge funds, but now securitization has been caught up in this. No one would have said that owning a bond in a securitization vehicle is the same as investing in a private equity fund." The CLO market has, however, been impressively quick at finding ways around the rule and by late February there had been a considerable recovery in new monthly issuance to $5.9 billion, bringing CLO supply for 2014 to $9.5 billion from 20 deals. New deals are either scrapping bond buckets or issuing under Rule 3a7, which restricts the ability to buy and sell assets in the pool.
"The Volcker Rule is meant to address ownership interests not debt securities, and the regulation mainly defines ownership interests based on economic exposure," says Bush. "But the regulation also looks to consent rights, and so an issue therefore arises in a CLO if the investor has consent rights over the manager. But there is scope to allow CLO activities under the rule as it stands. There are ways to deal with those consent rights."
However, as Euromoney went to press the CLO market was waiting for news following the House Financial Services Subcommittee meeting on February 26: Fed chair Janet Yellen was quoted mid-month as saying that clarification on CLO treatment under Volcker would come "reasonably soon".
In mid-January regulators exempted banks’ existing holdings of CDOs backed by trust-preferred securities (Trups) from the rule, conscious of the losses that would be imposed on smaller banks by having to dispose of these securities. The CLO market is hopeful that a similar exemption can be made for them.
"The regulators have issued guidance about Trups CDOs and are likely to issue guidance on CLOs as well," reckons Bush. "They have a lot of leeway to revise the rule or interpret the rule to solve this issue."
Even if the treatment of CLOs under the Volcker Rule is softened, the impact of new leveraged lending guidelines on the banks could have a serious impact on deal formation as the year progresses.
"The loans affected by the guidelines are the bread and butter of the CLO market," warns the CLO manager. "The average leverage of a first-lien covenanted loan can comfortably get into the high threes or low fours [which would breach the guidelines]. Today the CLO arbitrage available does not afford you the luxury of building a book around BB-rated loans. Single-B rated loans are the deals that make the arb work and they can very easily get to four turns of leverage."
