Euro CLO market fears existential threat of tougher regulation

By Robert Smith and Mariana Ionova

LONDON, June 17 (IFR) - CLO market participants warned that their industry has the most to lose from Europe's proposed tougher securitisation regulation, while fearing they have failed to win round policymakers on the benefits of the asset class for the real economy.

The European Parliament tabled a dramatic tightening of ABS regulation last week, most notably floating a four-fold hike in risk retention requirements from 5% to 20%.

Paul Tang, a centre-left MEP in charge of steering the plan through parliament, spoke at the Global ABS conference in Barcelona on Thursday, where one delegate told him the CLO market would "close down entirely in Europe" if the more stringent retention rules were adopted.

Risk retention, often dubbed the "skin in the game" rule, aims to align the interests of originators and investors. But the CLO industry has long argued that the idea was drafted with other areas of securitisation in mind.

A second delegate told Tang that in contrast to other areas of the market, CLOs are a product "where the collateral manager does not originate the collateral, it simply manages on behalf of all the investors in the deal."

REAL WORLD IMPACT

Speakers at the conference argued that CLOs are a transmission mechanism into the real economy, primarily buying leveraged loans to European companies lacking top-notch credit ratings.

"The CLO market has certainly caused leveraged loan lending to increase," said Jonathan Butler, head of European leveraged finance at PGIM Fixed Income. "And this would kill off loan market growth."

But David Quirolo, partner at Cadwalader, Wickersham & Taft, said it had been hard to get regulators and politicians to see the real world impact of CLOs, despite the efforts of organisations such as the Loan Market Association (LMA).

"One idea has been finding corporate treasurers who access the CLO market and can say it lowers their cost of funding," he said.

The US CLO industry has been much more successful in lobbying their regulators on this point, with the House Financial Services Committee advancing a bill in March to lower risk-retention hurdles for so-called "qualified CLOs."

In testimony before the house, the Loan Syndications and Trading Association (LSTA) argued that a decline in US CLOs could reduce businesses' access to credit.

WIPING OUT DEMAND

The European Parliament's proposal has particularly shocked the CLO industry, which until recently seemed to be nearing a regulatory victory over skin-in-the-game rules.

After a five-year tussle, lawmakers conceded last autumn to potentially allow managers to hold risk through a separate entity, as long as its sole purpose isn't securitisation.

Some questioned the logic behind pushing for higher risk retention while allowing this "originator-style" exception.

"If the EU is looking to tighten or strengthen the structures, it should be... aligning them to make sure the manager is in fact the one that will take the risk," said Eddy Piedra, vice president of leveraged loans at 4086 Advisors Inc.

"But raising the 20% would be an incredible challenge for the economics."

Beyond the risk retention hike, lawmakers also tabled a slew of other controversial ideas with deep potential implications, including restricting who can buy into European securitisations.

The draft proposes limiting the investor base to EU regulated institutions, which would likely bar US and Japanese buyers and wipe out a key source of demand that has helped revive the market in recent months.

Japanese buyers have been aggressive buyers of the ever-crucial senior part of the stack, while US hedge funds have become increasingly important buyers of junior risk, which still struggles to draw European demand.

"It flies in the face of everything that is allegedly being sought to stimulate the market and restart the market," said Alan Kelly, managing director at Apollo Management, who called the proposal "frightening."

IN NEED OF A REBRAND?

One banker at the conference told IFR that he thought politicians such as Tang fundamentally misunderstand CLOs.

"He thinks that they are CDOs," he said. "Which is ironic, because European CLOs were one of the best performing asset classes during the financial crisis."

While Paul Tang did not refer to CLOs specifically in his speech, he did raise the "problems" created by instruments such as "CDO squared", a structure mainly used in the US in the run-up to the financial crisis, which used existing CDO tranches as collateral to create new CDOs.

Franz Ranero, partner at Allen & Overy, noted that when MEP Sharon Bowles spoke at the Global ABS conference in 2013, her "main tip" for the CLO industry to win favour was to rename the product.

"We didn't. But maybe we should have."