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A Funny Thing Happened on the Way to a CLO Rule Rollback

A $460 billion market adapted into a system that participants might prefer to keep.

A Funny Thing Happened on the Way to a CLO Rule Rollback

By Lisa Abramowicz

Photographer: David McNew/Getty Images

Wall Street firms have been paying millions of dollars to lobby for significant rollbacks of rules put in place after the 2008 financial crisis. But some of these restrictions can’t be entirely thrown out, even if lawmakers overturn them on paper, because they have already had a lasting transformative effect on markets.

Size of U.S. CLO Market

$460 billion

A perfect example can be found in the $460 billion market of U.S. collateralized loan obligations, which is often conflated with its tainted brother asset class of collateralized debt obligations, which collapsed in extreme numbers during the 2008 crisis. But CLOs are different. They are made up of risky corporate loans that have been bundled together and sliced into bonds of varying risk and return, rather than grouping mortgage debt together. They've survived and thrived since 2008.

But after the financial crisis, CLOs were subjected to some substantial rule changes, most prominently that managers were forced to retain 5 percent of the value of deals they issued. Industry lobbyists have decried the requirements as draconian, threatening that they would crimp a chief source of financing for Corporate America.

This market is now poised on the receiving end of one of the biggest regulatory rollbacks on Wall Street since President Donald Trump was elected in November. Three judges are in a position to throw out so-called risk-retention rules as soon as next month by overturning a decision that upheld the provision, which went into effect at the end of last year.

There's a high chance that these Republican-appointed judges will, in fact, side with the CLO industry and agree that the rule imposes an excessive and inconsistent standard, according to Bloomberg Intelligence analyst Elliott Stein.

But a funny thing happened on the way to this market's death and destruction. Since these risk-retention rules went into effect, CLO sales have actually risen, with the $73 billion of such issuances so far this year already eclipsing 2016’s full-year total, according to data compiled by Wells Fargo & Co.

Not only that, but an entire ecosystem has been created around financing the portion of risk in each deal that needs to be retained. Fund managers have created risk-retention funds that have lured billions of dollars from big institutions around the world. Some of these investors wouldn't have otherwise invested in CLOs, particularly the riskiest slices of them, because those pieces are often sold in small increments and sometimes aren't worth the time of big investors.

Wells Fargo's David Preston estimates that more than $7 billion has been raised for such risk-retention funds since March 2016. It's unlikely that CLO managers will be eager to give up these investors, who seem to like the way this structure works.

That's not to say that scrapping the risk-retention rules would have no effect. Smaller managers would probably have an easier time selling new CLOs. Perhaps, on the margins, the size of the market would grow more than it otherwise would. (And of course, some CLO managers may continue to retain risk to comply with international standards.)

But the CLO market has done pretty well even under the supposedly onerous constraints of risk retention. And it can even claim to be more secure, with managers' interests being more aligned with investors in the securities. This is a prime example of just how malleable and creative markets can be and how regulatory roadblocks have given rise to new ways of doing business that may end up remaining standard practice long after the rules are lifted.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net