‘Skin in the Game’ Rule Unnecessary for CLOs

One of the more controversial provisions of the Dodd-Frank Act is Section 941. This section requires an issuer of an asset-backed security to retain “not less than 5% of the credit risk.” Section 941 was intended to address the collapse in the residential mortgage backed securities market following the subprime meltdown, but it covers other securitization asset classes as well. The theory behind risk retention is that having “skin in the game” will better align the incentives of issuers and investors, ultimately improving the quality of securitized assets. Setting aside whether such a theory has any relation to the recent financial crisis — after all Fannie Mae and Freddie Mac retained 100% of the credit risk on their MBS and that didn’t turn out so well — the residential mortgage market rightly has attracted a unique focus in regulatory reform efforts.

The Dodd-Frank Act requires no less than 49 separate rulemakings in the area of mortgage finance, according to the law firm Davis Polk. While disagreeing on the causes, commentators across the political spectrum assign a special role to residential mortgages in the recent crisis. Few, if any, assign a role to collateralized loan obligations. CLOs are actively managed funds that invest in senior, secured commercial loans to American businesses. Compared to most asset classes, CLOs performed well during the financial crisis, even if new issuance fell for a short time following the crisis. The cumulative impairment rate — losses experienced over the life of the asset — for CLOs over the last 17 years has been less than 1.5%, according to Moody’s. That is trivial. Section 941 provides regulators sufficient discretion to protect investors while leaving the market for collateralized loan obligations largely intact. They should do so.

Given the political environment, the regulators appear to have read the statute very broadly and applied Section 941 to CLOs. What is explicit in Section 941 is that regulators may adopt exemptions or exceptions to the risk retention requirements. The most obvious route would be to define a category of high quality CLO that would be exempt from risk retention. Such has been done for other asset classes. In at least one case, that of residential mortgages, a significant portion of the overall market was exempted. If such can be done for residential mortgages, then a comparable approach to CLOs would appear more than reasonable.

Getting the risk retention rules correct is vital for the proper functioning of capital markets. CLOs are managed by investment managers, who provide advisory services to clients, and are not heavily capitalized like banks. Most simply cannot retain 5% of a CLO that they manage on behalf of their clients. If there is a flight of advisors from this market, CLO financing will dry up.

Why does this matter? The CLO market represents almost $300 billion in financing to American businesses, according to Standard & Poor’s. This is $300 billion used by corporations to create jobs, contributing to economic growth. Almost all the investors in the CLO market are sophisticated institutional investors, such as commercial banks. If we are concerned about the potential impact of CLO losses on systemically important entities, it is worth noting that banks and insurance companies limit themselves almost exclusively to the most highly rated CLO tranches. The riskier tranches are generally held by hedge funds and structured credit funds. The bottom line is that even if CLOs were risky, their highest risk pieces are held by entities that can and do fail at little cost to the larger economy.

The House recognized the importance of CLOs to the economy and recently passed bipartisan legislation exempting certain legacy CLOs from Dodd-Frank’s Volcker rule. Regulators would be wise to craft a workable solution for the risk retention requirements regarding the CLO market. After which they can perhaps turn their attention to dealing with the actual causes of the financial crisis.