The US CLO and CMBS markets in particular have been preoccupied by risk retention this year, and have endlessly debated the merits of the rule since the final version was published in 2014.
Having to retain 5% of a securitization will almost certainly shrink the market somewhat. But as well as potentially boosting credit quality of the underlying collateral, the rule should weed out some competition, creating a less crowded field for the issuers that remain and aligning their businesses more with the interests of investors.
Investors said they are keen on the measure, and many US CLO managers, as well as some CMBS issuers, have structured compliant deals ahead of the implementation date. These deals have generally been well received, proving that the “skin in the game” tenet at the core of the rule can be a selling point.
So while any potential regulatory relief under the Republicans next year would probably aid some CLO managers, the thinking is that the rule will in fact do what it was intended to — strengthen underwriting and align interests.
With deal arbitrage challenged and loan prices increasing across the board, the temptation for some CLO managers may be to compromise on credit quality in order to make deals more lucrative in 2017. Taking skin in the game is therefore an opportunity for other managers to demonstrate their confidence in the quality of their own investment decisions.
Managers speaking with GlobalCapital throughout the year have taken this into account and have been opting to take a horizontal risk retention approach, retaining an interest in the first loss piece of a deal. This, they said, persuades investors that the collateral is sound, as well as providing attractive returns for the manager who no longer needs to raise as much equity from an outside sponsor.
It is not to say that all of the proposals for risk retention are constructive.
The European “simple, transparent and standardised” framework for ABS, which passed committee in the European Parliament last week, would raise the risk retention requirement from 5% to 10% of a total deal, if issuers take the vertical slice approach. European issuers have been living with 5% since 2012, have grown used to it and accepted it, while deals issued since then have mostly performed in line with expectations.
Raising the requirement to 10% is therefore seen as overly punitive and unnecessary, but the market is generally happy with the idea that managers hold a 5% stake in a securitization. The basic retention requirement has ensured discipline on the part of underwriters, and curtailed some of the behaviour that led to the financial crisis.
For US issuers, regulatory relief is a possibility under President Trump and a GOP Congress, but even so, don't expect the end of retention structures.
The industry might not say so publicly, but the market consensus is that the rule is mostly a good thing. Issuers, especially those able to access the most attractive funding levels from investors, will continue to appreciate the alignment of interests which risk retention provides, whatever the political weather.