CLO Risk-Retention Rules are More Successful Than They Seem

Sunday, October 8th, 2017 at 4:25 pm, by Zach Amron

In the wake of the Financial Crisis, Congress passed The Dodd–Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111–203, H.R. 4173). Among other things, Dodd-Frank mandated that the constellation of relevant regulators[1] design and implement risk-retention rules for securitizations. Lax underwriting standards in mortgages was a key driver of the crisis and many observers believed that “significant informational gaps and misaligned incentives between sponsors of and investors in residential mortgage-backed securities (“RMBS”) led to and promoted excessive risk-taking in the origination of mortgages that were packaged into RMBS in the years leading up to the financial crisis.” If securitization sponsors were better positioned than investors to police underwriting practices, then the natural solution was to take steps to align the economic incentives of securitization sponsors and investors. Though adopted with RMBS in mind, Dodd-Frank’s risk-retention rules applied to all asset-backed security (“ABS”) structures, including collateralized loan obligation (“CLO”) vehicles, which primarily hold corporate debt.

In the context of CLOs, risk-retention rules meant that a CLO’s collateral manager would be required to retain either a 5% vertical slice of the securitization (i.e. own 5% of each tranche) or the 5% first loss tranche (i.e. would be wiped out if the CLO lost 5% of its value). The below is an example of the capital structure of a typical CLO:

Unlike RMBS securitizations, CLOs do not typically buy whole loans (i.e. an entire mortgage) but rather bonds or syndicated loans that have been rated by a credit rating agency and which represent only a portion of outstanding indebtedness, reducing their role in the origination process and thus the need to ensure their alignment with investors. Prior to the implementation of the risk-retention rule, CLO managers were generally not in the business of raising long term capital to support their risk positions and many publicly worried that the CLO industry, an important financing source for corporate debt, would buckle under the cost of complying with the new rule.

Fast forward to today. Even as the risk retention rules have come into effect, CLO issuance has held steady, as shown below:

As Bloomberg’s Lisa Abramowicz explains, “an entire ecosystem has been created around financing the portion of risk in each deal that needs to be retained. Fund managers have created risk-retention funds that have lured billions of dollars from big institutions around the world.” To satisfy risk retention requirements, outside capital, primarily in the form of private equity funds, has stepped in to fund the first loss piece.

It might seem odd that CLO managers would solicit investments from risk-retention funds, given that the entire purpose of the risk-retention rules was to align the incentives of manager and investor by requiring managers to put up their own money. Bloomberg’s Matt Levine explains the phenomenon, saying:

“the CLO manager” is a flexible concept. A CLO manager is a company, not a human… [N]o company can ever really “retain the risk”; a company is just a set of legal instructions for apportioning money. Instead, the company’s investors “retain the risk,” in the sense that, if the company loses money, it was their money that it lost. So you just find investors who want that risk, and you sell them shares in the CLO-manager company (or a fund that buys shares in multiple CLO-manager companies), and then they have the risk. That you retained. For some value of “you.”

In other words, investors have effective structured around rules requiring CLO managers to retain risk. Rather than keeping skin in the game as Dodd-Frank envisioned, managers are simply selling off the first loss tranches to investors.

What does this tell us about the efficacy of Dodd-Frank? On the one hand, it seems perverse that “the risk-retention rules, which were meant to cut down on the abuses of structured finance, created more structured finance.” However, by requiring the whole first loss piece to be owned by a single investor, Dodd-Frank has also created incentives for equity owners to engage in serious collateral monitoring. Sponsors may not hold the risk themselves but unifying the equity tranche under a single owner, Dodd-Frank has incentivized these owners to care a lot about collateral quality. As Abramowicz observes, “some of these investors wouldn’t have otherwise invested in CLOs, particularly the riskiest slices of them, because those pieces are often sold in small increments and sometimes aren’t worth the time of big investors.” By mandating a concentration of ownership of CLO equity, Dodd-Frank increases the value of collateral monitoring for these sophisticated investors by ensuring that they can invest enough money in a given securitization to make collateral monitoring worth their time. This has positive spillover effects for investors in the senior tranches, who can free-ride off of the work being done by the equity holders and thus worry less about sloppy underwriting. This is what skin in the game was intended to create: an alignment of incentives to ensure that ABS securitization sponsors would be careful about the collateral selected. While the form it takes might look like a perversion of the rules, Dodd-Frank, at least in the CLO industry, has succeeded.

[1] The U.S. Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Department of Housing and Urban Development.