Leveraged lending, CLOs, & how a Japanese regulatory proposal could ripple to affect the U.S. CLO Market

The views expressed in this article are solely mine, and do not represent the views of my employer.

For the past year or so, everyone from former Fed Governor Janet Yellen, to the International Monetary Fund have been sounding the alarm on leveraged lending. If you’re unconvinced, just take a look at the $1.3 trillion global market for leverage loans, which has been experiencing a dangerous deterioration in lending standards. And from a November 2018 Financial Stability Report from the Bank of England, we know that a key driver of growth in the leveraged lending market has been increased securitization activity through collateralised loan obligations (“CLOs”). Highly leveraged companies like American Airlines rely on the U.S. CLO market to fund their businesses and acquisitions. At this late stage of the global credit cycle, the situation is precarious and a meltdown could be forthcoming.

And now, a regulatory risk retention proposal from the Japanese Financial Services Agency might unintentionally aggravate the situation.

Leveraged lending is “leveraged” because the loans, usually arranged by a syndicate of banks, are made to companies that are heavily indebted, i.e. the ratio of the borrower’s debt to assets or earnings significantly exceeds industry norms. Now, a CLO is a securitization transaction containing such syndicated and/or leveraged loans made to corporate borrowers and private equity funds. One aspect of CLOs that differentiates them from other types of securitization is that they are often actively managed by collateral managers.

Diagram from Deloitte illustrating CLOs

To put the extent of the issue in context, in the United States, the most highly indebted speculative grade firms now account for a larger share of new issuance than before the crisis.

On 28 December 2018, the Japanese Financial Services Agency (“JFSA”) introduced a proposed risk retention rule as part of the regulatory capital regulation of certain categories of Japanese investors seeking to invest in securitisation transactions, AKA the “Japanese Risk Retention (“JRR”) proposal. Two law firms Anderson Mori & Tomotsune (“AMT”) and Milbank, initially published a report on it, highlighting the potential unintended ramifications of the JRR proposal.

Furthermore, a number of recent Reuters articles have highlighted how potentially concerning the proposal is to liquidity in the U.S. CLO market.

As written in the AMT/Milbank report, the JRR proposal essentially states cetain types of Japanese financial institutions are required to apply increased regulatory capital risk weighting to a securitization exposure unless the originator of the transaction retains exposure to the security equal to 5% or more of the total underlying assets. The originator of the transaction can retain exposure in three main ways:

1. holding equal portions of each tranche (vertical retention);

2. holding all or part of the most junior tranche, equal to at least 5% of the total underlying assets (horizontal retention);

3. or if the most junior tranche is less than 5%, holding both the entirety of such most junior tranche, and equal portions of each of the more senior tranches (combination ‘L-shaped’ retention).

The JRR proposal is driven by the Basel III international regulatory framework, and is also very similar to the European Banking Authority’s (“EBA”) Regulatory Technical Standards laid down in the new EU securitization framework. The EBAs framework aims to address the fundamental issue of the possible misalignment of interests and incentives in securitization transactions, by ensuring that the originators/sponsors/original lenders maintain their ‘skin in the game’ and retain at least 5% of material net economic interest in each securitisation.

Now is the JRR proposal a bad thing? No. As mentioned above, risk retention is meant to reduce the misalignment of incentives, and promote financial stability. So what’s the hype?

Japanese investors have a large presence in global CLO markets. The Bank of England report estimated that Japanese banks hold about 10% of the $750 billion global CLO market.

Figure from the November 2018 Financial Stability Report on Leveraged Lending from the Bank of England

Thus, any proposal that may inadvertently reduce participation of Japanese investors in the global CLO market could negatively affect liquidity. Affected Japanese investors would be limited to buying CLOs only from managers/originators that hold a portion of the underlying asset, and those that don’t would incur high risk-weighted capital burdens.

According to a Reuters article, Japanese investors involved in U.S. CLO markets often buy entire Triple-A tranches so they can set market terms. If the JRR forces a pullback, it may push tranche spreads higher, as other investors stepping in may demand more compensation. This could inadvertantly increase the costs of raising a new fund, and reduce liquidity in the CLO market. Citigroup has predicted that spreads on Triple A CLO tranches will move higher, 140–145 over the course of 2019.

For now, the JRR proposal remains what it is; a proposal. A number of trade associations (see, lobbying) in the U.S. representing funds that originate CLOs are hard at work by trying to convince Japanese regulators not to implement the JRR proposal. However, we know that such proposals like the JRR are intended to make the financial system more resilient, especially in a period of high volatility. As the U.S. Treasury's Office of Financial Research has noted, market risks such as excessive valuations, low risk premiums, and excesses in financial risk appetite and risk-taking, currently remain highly elevated compared to historical averages.

Recently FT reported how the head of one of Europe’s largest managers of specialist loan vehicles addressed a crowd at an upscale cocktail bar in London’s West End. In a classic example of “top of the market” rhetoric, he assured the audience that a significant pick-up in defaults was not on the horizon, by joking: “After all, how can we have defaults when we don’t have any covenants?

The author is an independent writer and at the time of publication had no position in the assets mentioned.

IA & Economics | RA @YaleSOM Program for Financial Stability |@ElliottSchoolGW '18 | #Rstats novice | I write articles for fun.

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