Escolar Documentos
Profissional Documentos
Cultura Documentos
I N T R O D U C T I O N F R O M T H E
C H A I R M A N
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e should hope to never again see a period like this in our careers. Te pain wrought by the fnan-
cial crisis should give us all a new appreciation for Benjamin Franklins observation that an ounce
of prevention is worth a pound of cure. In this case, though, the side-efects of the purported
cure may well be immeasurable.
It could take as long as fve years for the more than dozen regulatory agencies to draft and implement some
250 new rules that will afect our market. How we then adapt to them remains, of course, uncertain. Some are
already causing concern, such as the recently proposed rules on risk retention and qualifed residential mort-
gage standards. Tese could in fact crimp the availability of credit and create undesirable consequences for the
broader economy.
In hindsight, one of securitizations greatest weaknesses was its lack of a priori intelligent design. Rather,
it arose from a patchwork of cross-disciplinary private-sector solutions to ac-
counting, bankruptcy, REMIC and securities law challenges. But stitching to-
gether the disjointed components of securitization left us with unavoidable
imperfections that went largely unnoticed until the crisis occurred.
During our 2011 Annual Conference this past February, I uttered the
wish for a single, enabling act of legislation for securitization to harmonize its
mismatched components into a new and improved model. Someone quipped
we already have one: Dodd-Frank.
We do, though, have the opportunity to create a single, enabling act of
legislation for a diferent fnancial instrument. It is my hope that by the time I
write my next message, Congress will have passed the United States Covered
Bond Act of 2011. Every other well-developed economy either has a legislated
covered bond system or is in the process of creating one.
Te arbitrarily infated capital requirements imposed by the frst Basel
Accord in 1988 motivated banks to securitize to reduce regulatory capital re-
quirements to something closer to economic capital requirements. Later itera-
tions of Basel corrected many of the original faws, such that banks require
less capital to support the types of assets intended for covered bonds. Realigning the regulatory and economic
capital requirements has also left banks less motivated to securitize. Meanwhile, Basel III imposes more strin-
gent liquidity and funding requirements.
Covered bonds can go a long way to addressing these new asset-liability requirements for our banks while
creating a new supply of conservative triple-A bonds for investors and a new channel of afordable credit for
consumers and businesses. Covered bonds can coexist alongside securitization which will remain the supe-
rior alternative for capital and risk management and a redefned scope for the GSEs.
A globally competitive U.S. covered bond framework requires legislation to ensure creditors entitlement
to cover pool assets is unquestionable and unfettered by issuer insolvency. By mandate the FDIC is pro-
grammed to resist such legislation. Its primary duty is to protect the deposit insurance fund, not bondholders.
We should admire how well the FDIC advocates its position. But it is just one piece of a much larger picture
and an existing policy bias should not stymie moves to establish a market that would serve the greater good.
While we can state our case, only our elected representatives can make this happen.
Ralph Daloisio
Chairman of the Board
American Securitization Forum
Cover Story
Introduction fromthe Chairman
Editorial
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34 Are U.S. Covered Bonds Heading Out of the Dark?
though doubts remain, not least about the FDICs position on repudiating
covered bonds if a bank fails. American Securitization gathered a panel of experts to debate the issues.
Crossword Penny Wise
by Chri s Scaraf i l e
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36 Covered Bonds by the Numbers
Not sure how big the market is or who the players are? Check out our handy guide to the covered bond market.
18 Can Securitization Survive Risk Retention?
Most now accept the need for lenders to keep a slice of whatever they sell to the asset-backed market. But as the participants in our
second roundtable discuss, the proposed rules issued by the six U.S. regulators look too harsh. The standards for exempting mortgages
from risk retention are overly conservative and dont address second lien loans. The strictures for all other mortgages are likely to
make securitization an uneconomic funding tool. And other assets, including auto loans, multi-seller conduits and CMBS, are in some
instances being tarred unfairly with the same brush as subprime home loans.
31 Canada Crafts Some Well-Fitting ABS Rules
by Mi chael K. Fel dman
The countrys regulators have taken a more measured approach to overhauling securitization than their U.S. neighbors. Theres still
CLOs Get Back in the Flow
by Nei l O Hara
many feared. Now, with fewer but more experienced managers, deal volume is picking up again. The new challenge is to prove that
CLOs can remain viable as tightening spreads put pressure on investors aversion to bubble-era leverage and as regulators consider
subjecting the product to risk retention rules.
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ASF Goes Proactive
Thats not an accurate representation, of course we have often taken the lead in reshaping the market, with Project RESTART
an apt example. Now were helping to promote crucially important topics such as covered bonds legislation.
6
Contents
Editor: Antony Currie
Email: acurrie@mpacpublishing.com
Journal design: Carolina Zalles
Sub-editors: PJ Johnson, Julian Marshall
Production director: Carolina Zalles
Production and artwork: Clare Brew
Photography: Kelly Shimoda
Crossword: Chris Scarafle
Writers & Contributors
Neil OHara
Michael K. Feldman Torys LLP
Publisher: Matthew Perks
Tel: 845 440 7800
Email: mperks@mpacpublishing.com
Volume 5 - Issue 2
American Securitization is published twice a year
by the American Securitization Forum, Inc.
in partnership with MPAC Publishing.
Te American Securitization Forum (ASF) is a broadly based professional forum
through which participants in the U.S. securitization market can advocate their
common interests on important legal, regulatory and market practice issues.
ASF also provides substantive and timely informational and educational programs
of value to securitization market professionals, including major industry conferences
and topical, issue-specifc workshops and seminars.
Copyright American Securitization Forum, Inc. 2011. All rights reserved.
Materials contained herein may not be reproduced for general distribution,
advertising or promotional purposes without the express consent of ASF.
Te statements of fact and opinion in signed articles are the sole responsibility
of the authors and do not necessarily refect the positions of the ASF,
nor the employers of the authors.
Members of the Editorial Advisory Board
Tom Deutsch, Executive Director
Tel: 212.412.7107
Email: tdeutsch@americansecuritization.com
For information on ASF membership, please contact:
Janet Brathwaite, Executive Assistant
Tel: 212.412.7114
Email: jbrathwaite@americansecuritization.com
Periodicals postage paid at Easton, PA Postmaster:
Send address changes to:
Jennifer Ferrara at
Email: jferrara@americansecuritization.com
ASF Staf Contacts
American Securitization Staf & Contributors
Gloria Aviotti
Alexander Batchvarov
Moorad Choudhry
Cameron L. Cowan
Ralph Daloisio
Tom Deutsch
Joseph M. Donovan
Ron DVari
Christopher T. Flanagan
Greg Medcraft
Tomas E. Plank
Marty Rosenblatt
Michelle L. Russell-Dowe
Professor Steven Schwarcz
Vernon H.C. Wright
Fitch Solutions
Bank of America Merrill Lynch
Royal Bank of Scotland plc
Orrick, Herrington & Sutclife LLP
Natixis
American Securitization Forum
Cohen & Company
NewOak Capital
Bank of America Merrill Lynch
Australian Securities and Investments Commission
University of Tennessee College of Law/
Bingham McCutchen LLP
Marty Rosenblatt
Hyperion Brookfeld Asset Management, Inc.
Duke University School of Law/
Duke Global Capital Markets Center
Vernon H.C. Wright
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he private-label mortgage market will soon have the chance to show how it has changed since the
crisis. At the end of September the limit on jumbo mortgages that lenders can sell to Fannie Mae and
Freddie Mac drops to $625,000 from $729,750.
Te immediate efect, of course, will be higher costs for borrowers. But its the right move. For
starters, the government needs to step back from guaranteeing 95% of all new mortgages at some point. Second,
interest rates are still near historic lows even a one percentage point increase would still make for a cheap
mortgage. And third, at risk of oversimplifying the matter, as a result of the crisis the only people with a chance
of getting a mortgage of $625,000 or more are those who can aford it and who dont need to lean on Uncle Sam
for help.
Tat makes this segment of borrowers the perfect arena for the mortgage industry to prove they can put into
practice the lessons of the housing crash without the safety net of a government guarantee.
Granted, there wont suddenly be a gushing supply of non-agency mortgages for the market to securitize.
Nationwide, the September drop will afect perhaps just 3 percent of new mortgages that were being sold to
the GSEs. Even letting the conforming loan rate fall back to its pre-crisis level would only add a few percentage
points more although in large cities like New York and Los Angeles its likely to have a far greater impact. Small
though the overall impact might be, it should provide a refresher boot camp of sorts for non-agency mortgage
securitization.
Of course, there are a number of challenges, not least growing
fears about the strength of the economic recovery and a housing dou-
ble dip almost fve years after prices frst started falling. Tats likely to
make already chastened lenders tighten their belts further, crimping
loan supply.
Te longer-term danger, though, stems from the continued lack
of clarity on looming regulatory and capital changes. Many in the
mortgage industry are concerned that the proposed rules for risk re-
tention and qualifed residential mortgages are too conservative. As
panelists in our roundtable on page 18 argue, if implemented these
rules may well make the economics of securitization unfeasible for all
but the most pristine loans that meet the QRM standard.
Its right that Washington impose better standards on the
mortgage market. But it bears remembering that around a ffth of
home loans were the problem behind the crash. At times lawmakers
and regulators seem to act as if most mortgages are suspect. Tats
wrong-headed.
Antony Currie
Editor
American Securitization
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e have scored some notable victories in the frst few
months of 2011 ensuring not only that the collective
views of our broad base of members are heard by
regulators working to carry out Congresss will, but also that they
are acted upon.
Being the vocal, timely and infuential voice of the asset-backed
securities market is at present our most important calling. Tere is
nothing more crucial than doing our utmost to ensure that the le-
gal and regulatory framework for securitization is fair, clear, mind-
ful of unintended consequences and well understood by all.
But lobbying Washington is not all we do, of course. ASF also runs a vibrant program of events throughout the year and we have
chalked up some achievements there, too, in recent months.
Elephants in the Room
Te United States is inching towards dealing with one of the biggest issues that will determine how the nation fnances mortgages:
what role should the government play? Februarys report to Congress from the U.S. Treasury and the Department of Housing and Ur-
ban Development entitled Reforming Americas Housing Finance Market is a good starting point. It outlines several potential approaches
for reducing the governments role in, and thus taxpayers exposure to, mortgage fnance.
Much work remains. One of the biggest challenges will be securing the attention of a politically divided Congress as its members
gear up for the 2012 elections. Te chances are that reform will be postponed until at least 2013.
Another aspect of mortgage reform is already much further ahead in the planning stages. Te Notice of Proposed Rulemaking (NPR)
on risk retention in asset-backed securities and standards for qualifed residential mortgages (QRM) was released in March by the six joint
regulators the Ofce of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corp, the Securities and
Exchange Commission, the Federal Housing Finance Agency and the Department of Housing and Urban Development.
It is shaping up to be the busiest year yet for the
American Securitization Forum. Much of that is due
to the responses we are fashioning to the at times
vague legislative designs laid down in last years
Dodd-Frank fnancial reform act.
Tats mortgage reform, right there
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In general, ASF accepts the principle both of issuers retain-
ing a degree of risk in loans they sell into securitizations and of
setting lending standards that would qualify some mortgages for
exemption from the rules.
But ASF and its members have several concerns. Execu-
tive Director Tom Deutsch addressed these in testimony to the
House Financial Services Committee in April. He also partici-
pated in the American Securitization roundtable on risk reten-
tion that starts on page 18 of this magazine.
ASF takes issue with four points. First, that the QRM stan-
dard is too conservative. Sec-
ond, that regulators have made
a mistake by deciding not to
develop a tiered approach
from 0% to 5% risk retention
for those loans that do not fall
under the QRM standard, as
was allowed for under Dodd-
Frank. Tird, that premium
capture plans, if implemented as written, would render non-
QRM securitization uneconomical for issuers. Finally, that regu-
lators want to add servicing rules as part of the NPR. Tis is not
part of their remit under Dodd-Frank, nor is it wise to develop
standards for just one part of the home loan market. All in, ASF
argues, the NPR is too
restrictive and risks
making all but the most
conservative loans ex-
ceptionally difcult to
fnance.
ASF has garnered
strong support for its
views among legislators
and submitted a com-
prehensive comment
letter to the joint regu-
lators in June.
Proactive Agenda
ASF is not just reacting
to legislative and regula-
tory issues, though. We
have also gone on the
ofensive. Perhaps the most obvious example of this is the leading
role that we have taken in advancing plans to develop a legisla-
tive framework for a U.S. covered bond market. We applaud and
support Representative Scott Garrett for his tireless eforts to
keep this matter front and center in Congress, reintroducing in
March the same bill outlining the framework that was eventu-
ally excluded from last years Dodd-Frank Act.
ASF Chairman Ralph Daloisio ofered our support for the
bill and the creation of a covered bond market in testimony be-
fore the House Financial Services Committee in March. He was
also a panelist on our roundtable on covered bonds that starts on
page 35 of this magazine.
ASF still contends that securitization ought to be able to
ofer a better form of all-in fnancing for mortgages: it is, after
all, a tool developed to transfer both credit and interest-rate
risk. But ASFs issuer members need low-cost, efcient ways to
fnance their loans while ASFs investor members need high-
quality investments. Covered bonds ofer a way to achieve both,
if properly devised with a solid legal framework that clarifes,
among other matters, investors
rights in the events of an issu-
ing banks insolvency.
Te other piece of legis-
lation we are supporting is the
Asset-Backed Market Stabiliza-
tion Act of 2011, introduced by
Congressman Steve Stivers in
March. Te aim of this bill is to
reinstate Securities Exchange Act Rule 436(g). Tis was repealed
by last years Dodd-Frank and quickly became the frst obvious
unintended consequence of fnancial reform. Te original act had
excluded Nationally Recognized Statistical Rating Organizations
from being treated as experts when their ratings were included in
a registration statement.
It was an attempt to
hold ratings agencies
more accountable for
their opinions. But it
did not account for how
integrated ratings are
to the process of get-
ting a deal done. As a
consequence, when rat-
ings agencies wouldnt
consent to allow their
ratings into issuing pro-
spectuses last year, the
asset-backed market
faced total shutdown.
ASF was instrumen-
tal in eliciting from the
SEC in a matter of days
a no-action letter granting relief from the repeal. Te SEC ex-
tended the exemption indefnitely last November, allowing issu-
ers to omit credit ratings from registration statements fled under
Regulation AB. But the best long-term solution is a legislative fx
and ASF will continue to promote this.
Te broader question about the role of ratings continues, of
course. And ASF is at the heart of the debate. In March, in a fol-
low-up to an earlier gathering, representatives from the working
group of the ASF Ratings Alternatives Taskforce discussed the
Being the vocal, timely and infuential
voice of the asset-backed securities
market is at present our most
important calling.
One of the major issues ASF has been engaged in
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issue in a meeting with regulators from the FDIC, the Federal
Reserve and the Ofce of the Comptroller of the Currency. ASFs
proposals revolve around the overarching concept of calculating
risk-based capital for securitization exposures.
Small But Important Victory
One important, yet perhaps overlooked, achievement since our
last update in these pages revolves around the FDIC and its
new power granted under
Dodd-Franks orderly liq-
uidation authority (OLA)
provisions. Te concern is
similar to a long-standing
concern ASF and market
participants have had about
FDICs belief that it should
be able to liquidate covered
bonds when a bank fails.
In the case of the OLA,
though, the issue revolves
around the potential for the
FDIC to unwind assets in
securitizations in the event
of the insolvency of non-banks deemed systemically important
enough to require the FDIC to step in to ensure an orderly
liquidation.
ASF has engaged with the FDIC on behalf of its members
to seek clarifcation about inconsistencies between the OLA
provisions and the bankruptcy code dealing with preferential
and fraudulent transfers. In late December last year the FDICs
general counsel issued a letter to ASF acknowledging that the
treatment of the transfers
under OLA is intended to
be consistent with the bank-
ruptcy code. In January 2011,
ASF submitted an additional
request that the FDIC clarify
that its repudiation power
under OLA would be exercised consistent with the bankrupt-
cy code and soon received another letter from the FDICs
general counsel granting ASFs request and allaying our main
concerns. Te FDIC issued new proposed rules in March and
is expected to codify its general counsels interpretation in the
coming months.
Derivative Engagement
ASF is no stranger to derivatives. Until recently, though, we have
not had as much need to engage with regulators on the subject
as we have on other issues. Te derivatives provisions of Dodd-
Frank have changed that.
We have been corresponding with the SEC about the end-
user exception to the mandatory clearing of security-based swaps
and swap participant defnitions, and with the CFTC about swap
participant defnitions and the end-user exception and business
conduct standards for swap dealers and major swap partici-
pants.
We have also taken a leading role responding to proposed rules
various regulators released in April that deal with sections 731
and 764 of the Dodd-Frank Act. Tese mandate capital and mar-
gin requirements for swap dealers and major swap participants in
connection with their non-
cleared swaps. Applying any
of these requirements may
render many structured
fnancings uneconomic as
the special-purpose vehicle
would be required to post
cash and liquid securities
which it does not have. Te
source of repayment for
structured fnancings is gen-
erally the cash fow from the
assets or receivables which is
generated over time.
Continuing battles
Te regulatory issues stemming from the Dodd-Frank Act have
kept us busy. But we have not just focused on these challenges.
Much of our regulatory and legal advocacy stems from other
sources.
At the state level, for example, ASF continues to oppose ef-
forts in the New York State Legislature to pass the Vehicle
Lienholder Accountability Act, which was reintroduced to the
NY State Assembly and Sen-
ate this year after it failed
to pass the Senate in 2010.
Tis year, ASF has submit-
ted a new round of letters of
opposition to the bill as well
as met with the bills lead
sponsors in the Assembly and Senate to explain the bills ad-
verse efects on the auto loan credit market. We will con-
tinue to monitor the progress of this bill in the NY State
Legislature.
And ASF has been involved in the continuing discus-
sions about foreclosure and loan modification practices with
the multi-state group of state attorneys general (AGs) led
by Iowa AG Tom Miller. Last December, ASF investors and
financial guarantors met in Des Moines with AG Miller and
the staff of over a dozen other state AGs. Since that meeting,
ASF has analyzed the state AGs proposed settlement terms
to servicers and produced a one-pager summarizing ASF in-
vestor concerns.
ASF continues to work on other issues of high impor-
ASF welcomes Jim Johnson as managing
director of public policy, based in Washington, DC.
Jim will spearhead the development of ASFs political
action committee and will advance ASF member interests
on securitization-related issues confronting Congress
and federal regulators. Previously, Jim served as senior
counsel to the U.S. Senate Committee on Banking,
Housing & Urban Affairs for the ranking member,
Senator Richard Shelby (R-AL).
ASF is not just reacting to legislative and
regulatory issues, though. We have also
gone on the ofensive.
and sold into the capital markets.
Heading Back and Branching Out
ASF is returning to Las Vegas. ASF 2012 will be held at the
ARIA Hotel in Las Vegas, between January 22-25. Our major
winter conference proves
a success no matter where
we hold it ASF 2010
in Washington, DC gar-
nered plenty of attention,
while the 4,400 registrants
for ASF 2011 in Orlando
made our event the larg-
est securitization confer-
ence in the world for a
seventh straight year. But
there is no facility in the
nation that can equal Las
Vegas for a gathering of
the size the ASF produces
where 5000 hotel rooms
are needed within walking
distance of 300,000 square
feet of meeting space
Its not the only venue
change we have instigated.
We held one of our Sun-
set Seminars in April not
just outside New York, but
outside the country in
London. It was the ideal
location for a panel to
discuss whether global se-
curitization reforms were
converging or diverging.
Wed like to thank SNR
Denton for hosting.
We also moved our
2011 Annual Meeting, to
Washington, DC. We have
expanded it from one day
to two and have brought in
high-level keynote speak-
ers including SEC Chair-
man Mary Shapiro and
Senator Mark Warner.
Were sorry if you
could not attend. But we
look forward to seeing you all in Vegas next January if
not before.
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tance to the industry, such as our advocacy concerning the
FDIC securitization safe harbor, Rule 17g-5, loan modifi-
cation and loss mitigation, tax concerns for securitizations,
and chain-of-title issues. We look forward to continued par-
ticipation from our membership as we tackle these and other
key issues facing the
industry.
ASF Proj ect RE-
START
In January, ASF launched
the ASF Project RE-
START Model RMBS
Repurchase Working
Group to help restore
confdence in the RMBS
market through the de-
velopment of an indus-
try Model Repurchase
Framework comprising a
set of principles that can
be used for future RMBS
transactions. Te Model
Repurchase Working
Group will follow in the
mold of the successful
ASF Project RESTART
Model Representations
and Warranties Working
Group, which released
fnal representations and
warranties guidelines in
2009, and will contin-
ue to meet throughout
2011.
ASF and Standard &
Poors Valuation and Risk
Strategies have continued
development of the new
standardized global code
for identifying critical
information about indi-
vidual loans that are se-
curitized in the MBS and
ABS markets. Te new
global ASF Loan Identif-
cation Number Code is a
fundamental component
of Project RESTART. ASF LINC is a 16 digit identifcation
code which captures the loan type, origination date and country
of origin in addition to randomized alphanumeric data to
create a unique ID for a wide range of assets that may be pooled
The core objectives of the American Securitization Forum
Consensus: To build consensus within the U.S. securitization
industry on issues of broad importance to the industry;
Advocacy: To mount principled and focused efforts to advance
ASFs substantive positions, chiefy by interacting with appropriate
governmental, regulatory, accounting, legislative and other
policy-making bodies; and
Education: To inform and educate not only the securitization
community and related constituencies but also the public at
large, and to sponsor substantive, high quality conferences
and educational programs.
ASF is heading back out west for 2012
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By Neil OHara
A
dd corporate loans to the list of assets that may become
harder to securitize despite proving their resilience
through the fnancial crisis. Credit card and auto-loan
securitizations both fared far better than expected, for example.
But regulatory and accounting changes threatened their useful-
ness. Now its the turn of collateralized loan obligations (CLOs)
to go through the wringer.
New proposed rules are part of the problem: the six
U.S. regulators involved in drawing up the Notice of Pro-
posed Rule-making on risk retention have included CLOs in
the mix. But thats not the only issue hanging over the CLO
markets tepid return to form. While corporate loan-backed
securities performed well over the past few years, many in-
vestors fed the market, or were themselves destroyed. And
the structure has yet to demonstrate, in the wake of the cri-
sis, that it can retain the lower leverage and higher over-
collateralization levels that both managers and investors
currently feel comfortable with and still remain a viable invest-
ment once spreads tighten further.
Te fnancial crisis took its toll on the market
for repackaging senior secured corporate
loans into securities. Investors fed or were
themselves destroyed. But CLOs have proven
to be made of tougher stuf than their CDO
cousins. Te food of defaults many expected
never appeared. Leveraged loan collateral
has performed well, those who stuck with the
market have reaped outstanding returns and
new issues have started to trickle out again.
But to thrive in the future, the CLO market
needs new investors, must demonstrate that
the economics can still work on lower leverage
as spreads tighten and it must stave of
regulatory attempts to impose risk retention
requirements that could stife the market.
Investing in CLOs in the crisis was like sifting gold from dirt
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TesinglebiggestissueCLOshad,though,wasbeingtarred
by the same brush as asset-backed collateralized debt obliga-
tions when the housing market tanked in 2007. It should be
obvious that a diversifed pool of corporate loans has a difer-
ent risk profle from a homogeneous pool of residential mort-
gages.Byearly2009,however,investorswerenotmakingsuch
distinctions: they dumped bonds issued by anything labeled a
collateralizedobligation,nomatterwhattheunderlyingassets
were. But people who sold CLOs were like unfortunate pros-
pectorspanningwithacolander,tossingoutthegoldalongwith
thedirt.
Ofcourse,itdidnotfeellikethatformanyatthetime,given
fearsabouttheparlousstateoftheoveralleconomy.CLOs,af-
ter all, had displayed a large appetite for loans tied to private
equity deals. Buyout frms
took advantage of access to
easycredittodeployhigher
and higher leverage multi-
plesforthecompaniesthey
targetedwhileoferingfew-
er and fewer protections to
lendersandbondholders.
But many such loans
were secured against more
resilient company assets
than home loans proved to be. So while many CDOs tied to
mortgage-backed securities remain deeply troubled, the CLO
structure has proven robust. Te credit support mechanisms
designed to replenish impaired collateral kicked in, default
ratesontheunderlyingloansneverreachedtheextremelevels
impliedbymarketpricesatthelowsandvehiclesthatstopped
distributionstoequityholdershavebouncedbackandresumed
payment.(See box)
TeleveragedloancollateralthatsupportsCLOsperformed
sowellthatthenewissuemarketforCLOsreopenedinMarch
2010, when WCAS/Fraser Sullivan launched the frst U.S.
dealsince2008.CLOsponsorsraised$4.3billionin2010,and
marketobserversexpectanother$10billionto$15billiondur-
ing2011.Tatwouldbecomparabletothesizeofthemarketin
2003,butfarlessthanthe$90billionorsoissuedatthemarket
peakin2007.
Rocketing Spreads
OneofthestructuralfeaturesofCLOsactuallypresentedstal-
wartswithanopportunity.ACLOisnotastaticpool.Itbuys
bankloanstocompaniesthathavespeculativegradecreditrat-
ings(nohigherthandouble-B+byStandard&PoorsorBa1
by Moodys), but borrowers frequently repay these loans well
beforethetypicalfve-orseven-yearmaturitydate.Intheearly
yearsofitslife,aCLOcanreinvestpaymentsofprincipalrather
than return the capital to investors, which creates a need for
CLOmanagers.Whenthereinvestmentperiodends,theassets
become a static pool that amortizes as loans are paid of, after
whichthestructureiswoundupatitslegalfnalmaturity.
Soasspreadsonleveragedloansshotupduringthefnancial
crisis,CLOsthatwerestillinthereinvestmentperiodalmost
all the 20052007 vintages were able to replace maturing
loanswithnewonesthatgeneratehighercashfow.Teliabili-
tiespayafxedspreadoverLibor,soseasonedCLOsmorphed
intogiantATMsfortheequityslice.
Tecashgenerationisasstrongasithaseverbeenforthe
past 18 months, says Greg Stoeckle, head of senior secured
bankloansatInvescoFixedIncome,whichmanages$9.5billion
in CLOs.Tat helped replenish collateral at funds that were
stilltrappingcashandallowedthemtoresumedistributionsto
equityholders.Equityreturnshavebeenatnearrecordlevelsfor
thepast12months.
Ownership of CLO pa-
perhaschanged,ofcourse.
In the 2006-07 heyday,
banks were big buyers, ei-
ther parking them on their
own balance sheets to take
advantageofthelowercap-
ital requirements triple-A
assetsenjoyedcomparedto
loans,orstufngthebonds
into of-balance-sheet structured investment vehicles and con-
duitsthathavesincevanishedfromthefnanciallandscape.To-
day, Ratul Roy, head of structured credit strategy at Citi, says
largeinsurancecompaniesdominatethemarket,luredintothe
triple-A tranches by juicy spreads.It is a new segment, says
Roy.Whatinsurancecompaniesperceivedasapoorassetat25
basispointsoverLibor,theynowseeasanattractivelowcredit
riskproductat120overLibor.Andthatnumberhasshrunk30
basispointssinceJanuary.
Wider spreads mean that CLO economics work at lower
leverage than in 2007. Tats crucial to deal economics because
investors are still showing more caution than at the height of
thebubbleeventhoughtheCLOmarketweatheredtheensuing
stormsowell.Hence,saysRoy,thetriple-Atrancheindealsnow
coming to market has around a ffth more credit support than
beforeat30%-32%comparedwith25%-26%.Teextracushion
is spread over the junior capital but weighted toward the lower
end.
Power Shift
Tats part of a broader shift in the balance of power between
diferentclassesofcapital,leadingtoamoreconservativestruc-
ture all round than the 2006-2007 vintage CLOs. Last years
dealsinitiallyfeaturedaroundeighttimesleverage.Tathasris-
entoaround10timessince,butisstilllowerthanthe12times
leverage reached at the height of the boom. Investors are also
demanding higher-quality collateral focused on frst lien bank
Te buying base will be diminished.
Te amount of new issue CLOs coming on
line is not going to be enough to ofset that
in any signifcant way.
Russell Morrison, Babson Capital
loans, paring back second lien loans to just 5% of the total and
excluding structured debt from the pool entirely.
On top of that, holders of triple-A bonds prefer shorter re-
investment periods to protect against potential deterioration in
collateral quality and provide greater certainty about the fnal
maturity date. Tey also like longer non-call periods to prevent
equity holders from refnancing at lower spreads. Meanwhile,
the equity holders prefer extended reinvestment periods to keep
the leverage high and provide more time to earn excess spread;
they also prefer short non-call periods so that they can refnance
at the earliest opportunity if spreads on CLO paper narrow. For
now, though, the senior noteholders have the whip hand: rein-
vestment periods are typically two or three years instead of fve
or more, with three year call protection. Te triple-A investors
have never had it so good, says Roy.
To seasoned CLO managers like Greg Stoeckle, head of
senior secured bank loans at Invesco Fixed Income, which
manages $9.5 billion in CLOs, the strong performance of
pre-crisis CLOs came as no surprise. A typical CLO has 100-
150 bank loans in its portfolio, the majority of which are to
public companies that must fle fnancial reports with the
SEC. Investors can dig down to analyze the underlying data.
That level of transparency eluded buyers of CDOs which
were often linked to thousands of small home loans, forc-
ing investors to rely on analyzing the credit of the pool as a
whole rather than digging down to individual loan data.
We have the opportunity to conduct due diligence,
which leads to a high level of research going into the individ-
ual asset selection, says Stoeckle. The investment thesis
isnt based on FICO scores or the statistical modeling that
drove a large part of the CDO and mortgage-backed securi-
ties world.
The CLO structure has triggers that suspend distribu-
tions to the various tranches from the bottom up if collateral
quality deteriorates. For example, if the proportion of bonds
rated triple-C exceeds a certain threshold, overcollateraliza-
tion tests impose a haircut on valuations of those bonds
which often curtails payments to equity holders. Cash in
excess of debt service requirements then accumulates in
the CLO to protect bondholders against losses if loans in the
portfolio do default. Payments to equity holders only resume
after a collateral cushion has been rebuilt, the credit quality
of the portfolio exceeds the threshold again, or both.
The haircuts are based on the lower of either market
value as determined by an independent pricing agency or
the assumed recovery value upon default. In late 2008, the
average bid price for the S&P/LSTA U.S. Leveraged Loan
100 Index hit 59 cents on the dollar and the triple-C paper
traded far below the average. It put tremendous pressure
on the haircuts, says Stoeckle. They were much more pu-
nitive than anyone had envisaged.
Figures compiled by Well Fargo Securities show that
the proportion of CLOs failing the minimum overcollateral-
ization test soared from near zero to more than 50% in just
six months, from October 2008 through April 2009. The ra-
tio peaked in June 2009 and then began a long retreat. By
September 2010 it had fallen below 10% and has contin-
ued to decline since then.
Bank loans trading in the low 60s made little sense
to Stoeckle given the historical recovery rate for defaulted
loans in the high 70s or low 80s as a percentage of par.
The mispricing brought new buyers into the CLO market, in-
cluding hedge funds and private equity investors. The infux
became a food after the default rate peaked at 11% well
below pessimists expectations and then began to drop as
fast as it had risen.
Fresh money, and the performance of the issuers, led
to the recovery we have seen in the last 18 months, says
Stoeckle. Prices have rebounded and credit performance
has been very strong. The default rate is now less than 2%,
which is below historical norms.
CLO ratings held up much better than other structured
fnancial assets through the downturn. Credit Suisse esti-
mates that 45.3% of the triple-A bonds were never down-
graded, another 40.9% of triple-A bonds were cut one notch
to double-A and only 1.1% of bonds originally rated triple-A
fell to below investment grade. In contrast, a staggering 77%
of triple-A-rated asset-backed CDO bonds were downgraded
to triple-C or below.
The robust credit performance eventually fowed
through to secondary market prices. Triple-A CLO bonds that
traded at 70 cents in March 2009 were back in the high
80s by the end of that year and at 95 last December. Equity
was the star performer, however, rebounding from pennies
on the dollar to 70 cents or better, a home run for investors
brave enough to scoop up that paper near the bottom.
When the CLO market frst reopened, the sponsor tended
to sell only triple-A and double-A bonds, retaining the rest
of the capital on its own book, but a market for junior capital
soon re-emerged.
We are seeing more multi-tranche deals, where triple-A
and even double-B bonds are getting placed, says Roy. Te
deals still have more subordination and cleaner collateral, and
it is customary for the sponsor to take a large portion of the
equity.
Investors are insisting sponsors have skin in the game, a
feature the regulators will require when the new risk retention
rules are fnalized. On March 29, the six U.S regulators pub-
lished proposals for comment that contemplated a more fex-
ible interpretation of risk retention than a simple 5% vertical
slice, including a horizontal frst-loss slice and L-shaped com-
How CLOs Beat the Crisis Blues
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binations of horizontal and vertical slices. Te likely efect of a
vertical mandate is already clear: in Europe, where a 5% verti-
cal slice is the only option, no new CLOs have come to market
since 2008, in sharp contrast to the U.S. revival.
Back in the United States, the Loan Syndication and Trad-
ing Association (LSTA)
has been leading the charge
against CLOs being caught
up in the risk retention
rules. In testimony before
Congress in April, LSTA
executive director Bram
Smith argued, for example,
that CLOs are managed
by registered investment
advisors and thus should
not be regarded as origi-
nate-to-distribute struc-
tures that some regula-
tors had in mind when
drafting risk retention rules. He also stressed that regula-
tors dubbed CLO managers sponsors in Marchs propos-
als even though they do not ft the literal defnition of se-
curitizer or originator as the Dodd-Frank Act envisioned.
Furthermore, Smith pointed out that CLO managers already
have their incentives aligned with investors as they generally
are remunerated using a three-tier structure that only pays
out most of the fees once noteholders have received all
interest payments.
Historically, most spon-
sors have retained only an
equity interest in CLOs, so
the ability to meet the reten-
tion requirement through a
first-loss slice is critical to
sustaining new issue activ-
ity. An equity interest gives
sponsors a strong incentive
to buy creditworthy loans:
not only are they first in
line to take losses, but they
also forgo any cash flow
if portfolio credit quality
deteriorates, long before
the CLO itself goes into default which has hardly ever
happened.
Tat is why Brian Colgan, senior managing director at MJX,
which manages $4.2 billion in CLO assets and ofers advice
CoreLogicASFad2011finalOL.indd 1 4/26/11 7:25 PM
Te buying base will be diminished, says Russell Morri-
son, head of high-yield investments at Babson Capital, which
hasmorethan$10billionofCLOassetsundermanagement.
TeamountofnewissueCLOscomingonlineisnotgoingto
beenoughtoofsetthatinanysignifcantway.
Backin2007,CLOsowned60%ofallleveragedbankloans,
which at the time was a market in excess of $500 billion. But
theavailablebuyingpowerfromreinvestmentwilltumblefrom
$192billionin2010to$111billionin2012andvirtuallyzero
two years later, according to Wells Fargo Securities. In prin-
ciple,theshrinkageshouldkeeploanspreadsatlevelsthatwill
support the arbitrage trade that underpins CLOs, but wide
spreadsmayalsodetersomeborrowers.
Morrison says:Te market has to identify new investors
who will have to choose the asset class for its characteristics:
foating rate, senior in the capital structure, and an attractive
creditspreadbyhistoricalstandards.
Abigincreaseinfundfowsintobankloanfundscouldtake
uptheslack,however.Investorsanticipatinganendtotheeasy
monetary policy the Federal Reserve has pursued since 2008
have been pouring money into foating-rate funds, supporting
thesecondarymarketpricesoftheleveragedloansCLOsbuy.
SpreadsarestillwideenoughtosupportnewCLOs,however
andbuyerswilllikelybefound.
People are beginning to understand the merits of the as-
set class in protecting their portfolios against interest rate
andcreditrisk,saysMorrison.CLOperformancehaslargely
playedoutasexpected.
to holders of another $14 billion, argues that risk retention
is not needed at all. Te senior-subordinated fee structure
of a CLO aligns the interest of the manager with that of the
investors,hesays.
Conflicts of Interest
Nevertheless, conficts of interest between diferent classes of
capital can occur, and Colgan acknowledges that bondholders
tookexceptiontothewaycertainCLOmanagersactedduring
thecreditcrisis.Forexample,buyingbackbondsatadiscount
boosted overcollateralization for the remaining bondholders,
butinsomecasesthemanagersprimarymotivationmayhave
beentopreservecashdistributionstoequityholdersinclud-
ing themselves. Investors criticized managers for questionable
interpretations of what collateral was eligible for the CLO
pool,too.Investorswilldomuchmoreduediligenceonman-
agers and be more selective for the foreseeable future, says
Colgan.
Teslumpinnewissuesalsopromptedconsolidationamong
CLO managers. Foreign banks in particular have been sellers
Nomura, for example, sold a $5 billion portfolio to Ares
AssetManagementinAprilbecauseCLOsnolongerrepre-
sentaninexpensivesourceoffundingandnewregulatorycapi-
tal requirements have undermined the economics of owning a
CLO manager. Te most active buyers have been traditional
credit managers, including MJX. Others have been getting
involved, too: Carlyle snapped up Mizuhos $1.2 billion CLO
platformaswellasa$5billionportfoliofromStanfeldCapital.
AndBlackstonehasbeenactive,takingBrightwaterCapital,for
example,ofWestLBshandsin2008.
But while CLO assets are concentrating into the hands of
fewermanagers,thetotalassetbaseisshrinking.Pre-crisisvehi-
cleswillsoonoutlivetheirreinvestmentperiods,andmustthen
useprincipalrepaymentstopayofthetriple-Abondholders. C
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Neil OHara is a freelance writer based in Lincoln, Mass.
He is a contributing editor to FTSE Global Markets and
writes for a variety of other publications including On Wall
Street, Wealth Manager and Alpha.
Te views expressed are those of the author and do not necessarily represent the
views of ASF.
Risk Retention
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The six U.S. fnancial markets regulators need to rethink
their proposed rules on risk retention. That, at least, is the
consensus of the panel of experts American Securitization
convened in May to discuss this contentious topic. All accept
that mortgage lenders, at least, should have to keep some skin
in the game for riskier-looking home loans though some note
that would not necessarily have prevented the fnancial crisis.
But, say our participants, the rules as proposed are too harsh.
The standard for exempting loans from risk retention the
so-called qualifed residential mortgage, or QRM is too high.