Regulation of the financial industry has been a consistent focus in our nation’s capital since the financial crisis in 2008. The new administration’s efforts to fix the Dodd-Frank Act has become a major priority for legislators, and any alterations to the Act will significantly impact the leveraged loan market and businesses’ access to capital.
Below you will find important information and updates regarding regulations, legislation, or other policy developments that could influence leveraged loans. Check back often to get the latest on new developments or sign up for our newsletter.
The risk retention rule imposed by the Dodd-Frank Act was implemented on December 24, 2016. The rule requires a CLO manager to purchase and retain 5% of the value of any new CLO. This is akin to requiring a mutual fund manager to buy $5 of Apple stock for every $100 of Apple stock it buys for its clients. The mutual fund manager would quickly run out of money and would no longer be able to offer mutual funds to its investors.
The same is true with CLO managers. Risk retention strains the manager’s ability to continue to offer CLOs to their investors due to limited available funds, thus shrinking the amount of credit available to American businesses. Even the agencies that wrote the rule acknowledged that risk retention would shrink the amount of credit available to American businesses from CLOs.
This potential impact on the market is now a reality. According to the Wall Street Journal, new regulations on the leveraged loan market have partially caused a drop in CLO issuance, reducing available funding for businesses. CLO issuance slumped 54% from last year, meaning they are investing in fewer loans and as the article states “companies are feeling the squeeze.”
While it’s still too early to gauge risk retention’s full effects on loan issuance, legislation is already underway to improve the rule before loan availability is severely impacted.
The CHOICE Act
The CHOICE Act would repeal and replace portions of the Dodd-Frank Act including risk retention for all assets other than mortgages. Though it is expected to pass in the House within the next few months, any legislative fix is likely to take some time.
The Expanding Proven Financing for American Employers Act – H.R. 4166
What It Does:
This bill was introduced by Representative Andy Barr (R-KY) and Representative Dave Scott (D-GA) and passed in the House Financial Services Committee by a bipartisan vote of 42-15 on March 2, 2016. While a new bill would need to be introduced into the House in this session, if passed by Congress, it would establish a Qualified Collateralized Loan Obligation or QCLO. Essentially, if a CLO meets criteria established in the six areas below, the manager would be allowed to retain 5% of the equity of a CLO, rather than 5% of the full amount of the CLO.
1. Asset Quality
2. Portfolio Diversification
3. CLO Capital Structure
4. Alignment of Interests of the Manager and Investor
5. Manager Regulation
6. Enhanced Transparency and Disclosure
This is a bipartisan, commonsense solution to risk retention that upholds the intentions and values of Dodd-Frank by ensuring managers have “skin-in-the-game” and that their interests are aligned with investors. Additionally, the QCLO would also be workable for managers who function similarly to a mutual fund manager and do not have the capital required to retain 5% of the full value of the CLO.
Recently, Lana Deharveng, a senior analyst with Moody’s, published a report titled “Qualified CLO Bill Offers Indirect Credit Positive Effects for CLOs.” According to Moody’s:
“The Barr-Scott bill’s lower risk retention requirement would significantly reduce the financial burden for managers of bringing new deals to market,” says Moody’s senior analyst, Lana Deharveng. “This would encourage new CLO issuance, thereby adding liquidity to the leveraged loan market. It would also formalize objective credit criteria for qualified CLOs, which in turn would discourage the issuance of riskier types of CLOs.
“The reduced financial burden would allow less-capitalized managers to comply with the retention rules and issue new CLOs, and could allow other managers to issue a greater number of CLOs without external financing, Deharveng says in “Qualified CLO Bill Offers Indirect Credit Positive Effects for CLOs.”
If a new CLO bill were approved by the House Financial Services Committee, the bill would then move to the full House of Representatives for a vote. Congress has a busy docket with Affordable Care Act replacement and the CHOICE Act, so it’s hard to predict when a bill will actually move to the House floor.
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