CLOs test limits of ‘high-quality securitisation’

Author: Danielle Myles | Published: 23 Jul 2014
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Could the ECB’s joint consultation with the BoE benefit CLOs?
June was a record-breaking month for collateral loan obligation (CLO) issuance in Europe. That dealflow could be further buoyed if CLOs are classified as 'high quality’ under the recently closed European Central Bank (ECB) and Bank of England (BoE) securitisation consultation.

Commentary on the discussion paper, titled The case for a better functioning securitisation market in the EU, has focussed on how asset-backed securitisation (ABS) can improve small and medium-sized enterprises’ (SME) access to finance.

But attention has now turned to the prospects of other types of ABS in their quest for 'high quality’ designation and the preferential regulatory treatment likely to come with it.

It is these instruments – and CLOs in particular – which will test the regulatory understanding of 'high quality’, and reveal the central banks’ true intentions for the consultation.

Arguments for

"If the question is whether some securitisations are better quality than others, then CLOs should fall into the higher quality bracket due to their structural robustness and the structure of the senior secured loans which underpin them," said Nick Voisey, director at the Loan Market Association (LMA) which filed a comment letter with the regulators.

Voisey noted CLOs’ low default rates compared to other types of securitisations. European leveraged loan default rates are also significantly lower than SME defaults.

KEY TAKEAWAYS

  •   The comment period for the BoE and ECB discussion paper on reviving securitisation closed earlier this month;
  •   There is debate as to whether CLOs should qualify for any 'high quality’ designation and the regulatory treatment that comes with it;
  •   CLOs have very low default rates – even during the crisis;
  •   But the prevalence of open-market CLOs with a fluid underlying asset pool makes it difficult to assess their quality against given criteria;
  •   The fact the consultation is issued by central banks – which have clear policy objectives – means they could prioritise ABS that has a direct link with the real economy, such as SME-backed deals.

Jacky Kelly, partner at Weil Gotshal & Manges in London agreed that as CLOs of senior leveraged loans performed well during the downturn, from a statistical perspective there is no reason not to include them in any designation.

Another argument for CLO designation is that investors have the benefit of publicly accessible information on the underlying. "There is a relatively liquid market for senior secured loans which leads to transparency," Kelly added.

But the focus has been on low default rates and high recoveries when there is a default.

The fact that any 'high quality’ designation could, inadvertently, be taken by investors as approval of the credit makes it even more important for qualifying instruments to have a strong track record.

"It might be dangerous if a bracket was seen to be a quality stamp which was not based on robust historical performance and an awareness of a resilient structure," said Voisey.

Arguments against

There are, however, structure and market-based issues that could work against CLOs’ bid for 'high quality’ designation. They are similar to the reasons why CLOs did not make the list of instruments eligible for the prime collateralised securitisation (PCS) label in 2012.

As with the PCS label, the BoE and ECB’s difficulty will be that the vast majority of post crisis – or CLO 2.0 – deals are actively managed. The manager is not the originator, but a third party collateral manger that actively manages the underlying collateral.

"Making a fulsome assessment of static and fully ramped up CLOs is all well and good, but the analysis becomes a little more complicated when you look at the current crop of deals which are hugely actively managed," said Jonathan Walsh, global securitisation head at Baker & McKenzie.

The eligibility criteria upon which the manager’s buying and selling of loans must be based is signed off by a credit rating agency. But this increases the number of variables, making these structures are still more difficult to assess against any 'quality’ criteria.

"I think the nervousness stems from the fact that you are backing the structure, quality of the collateral manager, quality of the eligibility criteria, and a pool that may change from time to time," said Walsh.

Elephant in the room

The unspoken question in the debate, is the extent that political objectives attached to SMEs will drive the outcome of the consultation.

It’s notable that the discussion paper was issued by entities responsible for promoting their economies; not their respective financial regulators

"The central banks’ intervention must be justifiable in terms of their monetary policy mandates – this leads them to focus primarily on asset classes that have an obvious connection with the real economy," said Linklaters’ Nicola Kemp.

While SME loans clearly fall into this category, there is less political ambition to have large-cap corporate lending kick-start the real economy.

In recent weeks, however, there have been signs that the ECB may push its SME funding agenda through other avenues.

Its paper from earlier this month, titled SME Access to Finance in the Euro Area: Barriers and Potential Policy Remedies, contained little reference to neither ABS nor the securitisation discussion paper.

The Bank also has high hopes for its targeted longer-term refinancing operations (TLTROs). The latest series will see the ECB lend eurozone banks €700 billion ($945 billion) – with interest payable in arrear in 2018 – to on-lend to corporates.

The BoE/ECB comment period closed on July 4. The central banks are still analysing the responses and will make a joint announcement on the outcome.

See also
LCR and 'high quality securitisation’ to align
What assets should be 'high quality ABS’
Is US securitisation going back to 2005?