CLO Headaches Loom With EU Ban on Caymans Over Money Laundering

(Bloomberg) -- European regulators are creating trouble for managers of U.S. collateralized loan obligations that typically sell some of their bonds to investors in the region.

In the coming weeks, the European Union is likely to add the Cayman Islands to its list of jurisdictions that have “strategic deficiencies” in areas including anti-money laundering and counter-terrorist financing regimes, according to a January note from law firm Clifford Chance. That effectively blacklists them for European investors, the note said. 

The problem: most U.S. CLOs are issued using entities domiciled in the Cayman Islands. If the Cayman Islands are blacklisted, any U.S. CLOs that are routinely offered to EU investors in addition to the typical American audience -- nearly one-third of U.S. deals, by some estimates -- will need to find an alternative home to for issuing. Otherwise, managers will have to limit their deals to U.S. investors. 

The leading alternative jurisdictions to set up CLO special purpose vehicles are the island of Jersey, a self-governing dependency of the U.K. off the coast of France, or Bermuda.  Deals are already in the works using these new locations as offshore SPVs, and will be issued soon, according to CLO lawyers.

“In the coming weeks, we’ll see the first deals priced with Jersey or Bermuda-based SPVs” from managers that want to sell their deals into Europe, Nick Robinson, a partner at Allen & Overy who is focused on CLO deals, said in an interview. “A number of deals are in the launch stage. Of course, deals not marketed to Europe can stay in the Cayman Islands.”

The Ministry of Financial Services & Commerce of the Cayman Islands said in a press statement in January that it was working with the EU to be removed from the list of jurisdictions viewed as being a high risk from the standpoint of money laundering activity.   

Moving SPVs

On Jan. 7, the European Commission adopted a draft regulation adding the Cayman Islands to its list of countries with strategic deficiencies in their AML regimes, according to the law firm Cadwalader. Article 4 of the EU Securitisation Regulation provides that securitization special purpose entities may not be established in any country on that list. 

“The application of Article 4 of the EU Securitisation Regulation to EU investors is unclear, but the general consensus is that EU investors should not invest in Cayman-domiciled securitization vehicles while the Cayman Islands are on the list,” Cadwalader attorneys wrote in a Jan. 27 article.

In addition to new deals, refinanced CLOs that are to be sold to European investors also need to be re-domiciled, lawyers say, and the jurisdiction needs to be changed before the refinancing closes, which can lead to a time crunch.

“To the extent that those CLOs sold to EU investors are refinanced, they’ll need to be moved, which increases costs and time,” said Robert Villani, structured credit partner at Clifford Chance.

The British Virgin Islands, another perceived tax haven that is creditor friendly, was briefly considered as an alternative jurisdiction for CLOs, Robinson said, but was dismissed because there had been AML investigations in that country as well.

One other option that has been used, especially for a few middle-market CLO deals, is to register the SPV domestically as a Delaware LLC, Robinson said, although that means the transactions would need to have somewhat simpler structures. 

CLOs have been one of the hottest sectors in the credit markets for several reasons, including the fact the securities are floating-rate and may protect against rising yields during a rate-hiking cycle. Investors have also become more comfortable because the product had stellar performance through the pandemic downturn. 

The outsized demand brought new sales of U.S. CLOs to a post-financial crisis record in 2021, with numbers close to $184 billion, according to data compiled by Bloomberg.

Relative Value: CRT RMBS

• Credit Risk Transfer RMBS bonds are Angelo Gordon’s favorite relative-value play right now, TJ Durkin, the head of structured credit at AG, said in a phone interview
• “In CRT, you’re seeing a massive move on where primary deals are clearing,” Durkin said. “It doubled in spread for some parts of the capital structure -- in less than 60 days. Buyers, in some cases, are naming their own spreads”
• An example of the widening: STACR 2022-DNA2 M2 priced at +375 on February 7, and STACR 2021-DNA7 M2 priced at +180 back in November, Durkin said
• As far as fundamentals are concerned, inflation is good for these assets, Durkin added. “Home prices are trading on existing seasoned book, meaning lower implied LTV, which is good from a credit perspective. Wage inflation is clearly extremely positive, but it’s a balancing act and we’re watching it closely: what are household expenditures? Gas? Food? We have to make sure the pendulum doesn’t swing too far”
• “Prices can’t go up forever without impacting performance,” Durkin added

Quotable

Regarding subprime auto ABS and consumer unsecured deals: “New players came in last year chasing yield at the bottom of the capital structure,” said Angelo Gordon’s Durkin. “They were overexcited about performance assumptions, in our opinion. We’ve stayed away. 

“There have been some assumption changes. Perhaps they were buying at a 10% cumulative loss, but it’s historically been 15%. Everyone was geared up on stimulus euphoria, and maybe overexcited on expectations of defaults. We’d want to see a lot more spread widening or price dropping, or perhaps that’s happening because default assumptions turned out to be closer to what we thought it was. We have to get back to ‘normal’ first.”

What’s Next?

ABS transactions in the queue for next week include North Mill (equipment ABS), Vertical Bridge (cell tower ABS), and VFI Corporate Finance (equipment lease ABS)

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