By Dan
Nossa and Ethan Post*
Collateralized Loan Obligations (CLOs)
are a type of Collateralized Debt Obligation
(CDO) created by pooling large commercial loans
and debt instruments. This pool is divided into
various tranches with different risk–return
characteristics and interests in each tranche
are then sold, mostly to institutional
investors.
Historically, CLOs have been
popular with investors because of their greater
diversity and potential to outperform
standard market benchmarks. Although CLO
issuances tumbled during the recession amidst
fears of leverage and securitized loans,
pre–existing CLOs were safe during the
recession, with only two of an estimated 630+
CLOs defaulting on cash payments to investors.
This steadiness through the recession is likely
due to the fact that CLO pools are generally
made up of higher–quality debt instruments, not
junk bonds or sub–prime mortgages.
Since
the height of the recession, CLO issuances have
soared – 2013's $82 billion in new issuances is
the third largest year on record for CLO
issuances and over $40 billion has already been
issued in 2014. This surge is all the more
impressive given the looming specter of
Dodd–Frank's Volcker Rule and risk retention
requirements.
Dodd-Frank's risk
retention mandate represents the largest single
challenge to the CLO market. By requiring
managers of CLOs to retain a five percent
interest in the CLO, the risk retention rules
may tend to prevent small to mid–size managers
from entering or remaining in the market,
thereby reducing competition and decreasing the
supply of CLO financing. On the bright side,
regulators have already proposed an alternative
method of satisfying this requirement that may
be more beneficial to CLOs and have discretion
to exempt certain classes of high–grade CLOs
entirely – as they have already done for certain
classes of residential mortgages.
Also
part of Dodd–Frank, the Volcker Rule seeks to
prevent banks from trading in proprietary funds
for their own accounts and to restrict banks'
ability to own interests in private equity and
hedge funds. An unintended consequence of this
rule would also prevent banks from holding
interests in CLOs which include certain kinds of
bonds in their securitization pool. CLO managers
have already begun adapting to meet this
challenge, structuring new CLOs so as to hold
only loans, with the option to include bonds if
the regulations change in the future. In
addition, the U.S. House of Representatives has
recently passed a bill that would allow banks to
continue to hold pre–Volcker Rule CLO interests
containing bonds. The CLO market thus seems
capable of prevailing in the face of the Volcker
Rule headwind.
While the CLO market is
certainly facing its share of regulatory
challenges, the industry has demonstrated an
ability to adjust to regulatory changes while
simultaneously maintaining the fundamental
soundness of the CLO as an investment asset and
should continue to thrive in the post-recession
world.
If you have questions about this
e-Alert, please contact
Dan
Nossa (
dnossa@jw.com or
713.752.4365).
*Law student not yet
admitted to the Bar 
