Wall Street's Hot CLO Machine Freed From Post-Crisis Rules

(Bloomberg) -- The biggest buyers of risky corporate loans are exempt from post-crisis rules that would have required them to hang onto some of the securities they were selling to investors, a U.S. appeals court ruled on Friday, giving new fuel to one of Wall Street’s hottest businesses.

The buyers, known as collateralized loan obligation managers, don’t have to follow the regulations that apply to issuers of asset-backed securities and related instruments, according to the ruling from the U.S. Court of Appeals for the District of Columbia. The rules, known as "risk retention," were designed to help prevent a repeat of the subprime mortgage bond crisis.

The decision may make it easier for money managers to assemble collateralized loan obligations, which would in turn increase investor demand for corporate loans that fund private equity buyouts and other highly leveraged acquisitions. Bigger managers and lenders had created new vehicles that allowed them to meet the requirements, but smaller CLO managers had struggled under the rules.

Rising Issuance

CLO issuance was around $120 billion last year, up 65 percent from 2016, according to data compiled by Bloomberg. Those sales helped lift new leveraged loan borrowing last year to around $312 billion, up from about $202 billion the year before. This year, it’s unclear whether there will be enough of the risky loans created to satisfy potential CLO demand.

The Loan Syndications and Trading Association sued the Securities and Exchange Commission and the Federal Reserve in 2014 to exempt CLOs from risk retention rules. It argued that the rules don’t apply to open market CLO managers, because the asset managers don’t own or make the loans they are bundling into bonds, unlike, for example, a bank that packages credit card debt into bonds. 

The LSTA lost its first round in federal district court. The higher court ruled that CLO managers are more like mutual fund managers, that give directions to a special-purpose vehicle regarding which loans to hold, and receive compensation based on the performance of the asset pool over time.

"The LSTA is delighted with this result, which vindicates our analysis of the clear statutory language and reflects the reality that CLOs have performed very well for more than 20 years, including through the financial crisis," Elliot Ganz, the trade group’s general counsel, said in a statement.

Judith Burns, an SEC spokeswoman, declined to comment.

Preventing Repeat

Risk-retention rules, which went into effect on Dec. 24, 2016 for commercial-mortgage bonds, asset-backed securities and similar products, were designed to prevent lenders from making risky loans, packaging them into bonds, and sticking investors with all of the losses when the securities sour. The rules came after subprime mortgage bonds triggered trillions of dollars of losses for banks and investors during the last financial meltdown.

The new regulations, based on the Dodd-Frank financial overhaul law, required issuers to hold onto 5 percent of their securitized deals, giving them exposure if the securities deteriorate.

Many of the larger CLO managers had established ways to deal with the regulations: they set up separate new vehicles that would retain risk and issue CLOs. The risk-retention rules posed more of a threat to smaller CLO managers who didn’t have the ability to easily raise the large sums needed to comply with the regulations.

The ruling should be effective immediately, unless the agencies involved ask for a stay, said J. Paul Forrester, a partner at law firm Mayer Brown in Chicago.

--With assistance from Sridhar Natarajan Ben Bain and Andrew Harris

To contact the reporters on this story: Lisa Lee in New York at llee299@bloomberg.net, Sally Bakewell in New York at sbakewell1@bloomberg.net, Andrew Harris in Washington at aharris16@bloomberg.net.

To contact the editors responsible for this story: James Crombie at jcrombie8@bloomberg.net, Dan Wilchins, Rick Green

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