Regulators want banks and asset managers that arrange deals for collateralized loan obligations to have some skin in the game

Loan Rules Raise Squawks

Lenders, Managers Say Keeping Skin in the Game Could Hamper CLO Market

STEPHANIE ARMOUR

Nov. 28, 2013 8:46 p.m. ET

WASHINGTON—An attempt by regulators to prevent the kind of lax underwriting that exacerbated the financial crisis is running into resistance from corporations, investors and asset managers who said new rules will cripple a $300 billion market for loans to U.S. companies. Regulators want those who manage or arrange collateralized loan obligations, or CLOs, to retain some of the loans’ risk on their books. Policy makers said requiring such skin in the game will ensure loans sliced, packaged and sold to investors are of high quality and help protect against default.In a collateralized loan obligation, a company that generally has a lower credit rating gets a loan from a group of banks, known as a syndicated loan. CLO managers buy pieces of these loans, pool them together into a CLO and then sell slices of debt to investors based on different risk and return profiles.

CLOs are the second-biggest source of financing for syndicated loans, which provide nearly $2.8 trillion in financing to U.S. companies. Investors are lured to CLOs as they typically offer higher returns than corporate bonds and other loans.

Among those that have benefited from CLO financing are Wendy’s Co. WEN -0.35% , H.J. Heinz Co., Dunkin’ Brands Group Inc., J.C. Penney Co. JCP +7.69% , AMC Entertainment Holdings Inc., and United Airlines, according to industry representatives.

“The public hasn’t largely heard of CLOs, but they’re an important part of the economy overall and the single-largest lender to corporations beside banks,” said Josh Terry, head of structured products at Dallas-based Highland Capital Management LP, the largest CLO manager in the U.S. with about $18 billion in assets under management.

This summer six regulators, including the Federal Reserve and the Securities and Exchange Commission, proposed that managers who put together CLOs for investors buy and hold a 5% interest in the loans underlying the securities. Alternatively, those who arrange the loans, including banks, could retain at least 5% on their balance sheet. Banks and CLO managers would be banned from hedging or selling off risk for at least two years, mimicking a similar restriction that applies to banks and other firms that sell mortgage- and other asset-backed securities.

The proposal is an outgrowth of the 2010 Dodd-Frank law, which required risk retention for all asset-backed securities as a way to limit shoddy loans.

Market participants insist the risk-retention rules will hamper a vital source of funding for U.S. companies. They argue CLO managers, and the banks arranging the loans, will be unable or unwilling to retain a 5% stake that can’t be hedged or sold for even a short period.

CLO managers, who invest money on behalf of customers, would struggle to retain 5% of the loans, which may be between $400 million and $900 million, Mr. Terry said.

Banks said they would be hard-pressed to retain 5% on their books given regulatory pressure to mitigate risks and the additional capital they would need to hold against such an asset. In a letter to regulators last month, Wells Fargo WFC -0.09% & Co. said the requirement to retain exposure to a borrower that can’t be hedged or sold “is generally inconsistent with prudent lending practices.”

The companies that rely on CLO funding have also expressed concern. SeaWorld Entertainment Inc. SEAS +0.17% Chief Financial Officer Jim Heaney, in a letter to regulators last month, said “CLOs provide an important engine for our businesses, and we are concerned that the re-proposed rules will have adverse consequences on this valuable form of financing.”

A spokesman for the Federal Deposit Insurance Corp., one of the regulators behind the plan, said the agency doesn’t comment on proposals during the rule-making process. The Office of the Comptroller of the Currency said it is in the process of considering comments.

In its August proposal, regulators said the plan could benefit commercial borrowers and wouldn’t cause significant disruption to the CLO market. Regulators still must approve a final rule that could change based on comments they receive.

CLOs have increased rapidly since the financial crisis as the low-interest-rate environment has pushed investors into securities that offer the possibility of high returns. A total of 98 CLOs closed in the first half of 2013, a 151% increase from the same period in 2012, according to Appleby Global Group Services Ltd.

Some market observers said such heady growth makes CLOs ripe for stronger rules.

“It’s prudent and encourages good underwriting judgment,” said Sheila Bair, former chairman of the FDIC and now a senior adviser at the Pew Charitable Trusts.

Some critics said the proposal may not go far enough given concerns about the quality of CLOs, said Mark Zandi, chief economist at Moody’s Analytics.

“There’s growing concern about the quality of underlying loans,” Mr. Zandi said.

“Bankers will tell you underwriting standards on commercial and industrial lending is down because of CLOs. The concern is we’re going down the same path as 2005 to 2006 with mortgage loans, although I don’t think we’re in the same universe yet. There’s the adage of ‘if it’s growing like a weed, it probably is a weed,’ ” Mr. Zandi said.