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Regulators announced Monday they would extend the conformance period by two years under the Volcker Rule for banks with legacy collateralized loan obligations, but at least one lawmaker is already saying the agencies should do more.
April 7 -
Creating a one-size-fits-all approach to collateralized loan obligations does not harm Wall Street, it harms American businesses.
April 4 -
The legislation grandfathering certain CLOs and clarifying which commercial loan securities are exempt from the Dodd-Frank Act trading ban were part of a package of bills approved by the House Financial Services Committee.
March 14
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
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
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.
Mark Calabria is the director of financial services regulation at the Cato Institute.