Response to discussion on simple standard and transparent securitisations
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Management of a CLO portfolio is subject to collateral quality tests, overcollateralization tests and concentration limitation tests (the “Tests”) – these are rigorous rating agency tests measuring over-collateralisation and various portfolio characteristics which the manager is required to comply with in order to continue to be able to reinvest in new assets. These portfolio-level tests are already industry-standard and are particular to managed CLOs as opposed to securitisations of static portfolios. The CLO manager has to meet the Tests on an ongoing basis. The Tests and strict trading rules imposed on CLOs means that active management of the portfolio has a very limited effect (positive or negative) on the most senior tranches of a CLO.
The Tests also allow the CLO manager to provide detailed and transparent disclosure to investors on a monthly basis in respect of the portfolio. They cover data such as diversity of obligor by industry and geography, weighted average spread on the assets, weighted average fixed rate coupon, weighted average rating and weighted average life of the underlying assets.
Unlike traditional asset-backed securities, the underlying portfolios of CLOs are typically not purchased from one originator or seller but are typically sourced in the primary or secondary market by regulated investment managers who are independent of any originator or seller of the loans. The CLO manager is able to independently assess the quality of the portfolio and is free of the negative incentives which can arise in an originate-to-distribute securitisation model. This adds an additional level of credit analysis which is not a feature of other types of securitisation.
Risk-reducing characteristics of managed CLOs
We cannot stress too heavily the fact that the assets in a CLO portfolio are only a part of the performance of the CLO itself. As we state above, CLOs give investors the ability to invest in the loan market with the benefit of structural enhancements and active management which significantly reduce risk to the senior noteholders when compared with a direct investment, or with a static loan portfolio. The exclusion of managed portfolios fails to recognise the weight that should be given, uniquely in this asset class within the securitisation space, to structural deleveraging and active management.
Structural deleveraging
In summary, structural deleveraging in a CLO interrupts the normal priority of payments in the event that the quality of the portfolio falls below a certain level. The debt coverage tests measure the amount of over-collateralisation in the CLO. In a managed CLO transaction, there is typically a maximum of 7.5% CCC (or below) rated assets in the portfolio. If these low-rated assets rise above that percentage, those assets will be treated as valued at market value rather than at the usual par value in meeting the debt coverage tests. If the debt coverage tests fail as a result, no interest can be paid out on the junior notes, the majority of the CLO management fees and all receipts from the assets will go to pay principal on the senior notes sequentially until the pool complies again with the coverage tests. The same applies to failure of the coverage tests as a result of defaulted assets. Thus the senior notes benefit both from the credit enhancement provide by the junior tranches and the protection of senior income and principal prior to any default. In a static-pool securitisation, whilst mechanisms may be built in to ensure excess income supports deficiencies on the senior notes, this is not done on a managed basis. This structural deleveraging was partly responsible for the subsequent upgrades on many of the AAA CLO tranches which were downgraded by S&P in 2009.
In addition, post the expiry of a CLO reinvestment period, to the extent that portfolio collateral is repaying and the manager is unable to reinvest these proceeds (the circumstances are usually related to note ratings or certain test compliance), these proceeds are ultimately repaid to note holders in order of seniority. This is another mechanism by which structural deleveraging can occur and is an inherent characteristic across European CLO 1.0 and 2.0 structures.
In addition to those protections, we would suggest that a CLO which complies with the following criteria should be included in any “high-quality” class of ABS which receives preferential regulatory treatment:
(a) the securitised exposures must be managed on a continuing, discretionary basis by:
(i) an EEA investment firm which is required to be regulated in its home member State and which is subject to the Markets in Financial Instruments Directive (“MiFID”) or an affiliate thereof; or
(ii) a firm authorised under the Alternative Investment Fund Managers’ Directive (“AIFMD”) or an affiliate thereof; or
(iii) a firm or an affiliate thereof which would fall within (i) or (ii) above if its head office was situated in the EEA and which is subject to equivalent regulation in relation to the conduct of its business and its management of conflicts as a firm established in the EEA (for instance investment advisors registered under the US Investment Advisers Act of 1940, as amended);
(b) the CLO manager of the securitised exposures must undertake to the investors in the securitisation to comply with the regulatory requirements applying to it in relation to the management of conflicts of interest, in connection with its management of the securitised exposures (i.e. compliance with MiFID and/or AIFMD or equivalent regulations outside the EU);
(c) the securitisation must contain provisions whereby the interests of the CLO asset manager are appropriately aligned with the interests of the investors during the whole life of the securitisation. It is recognised that this may be achieved by a material part of the manager’s compensation for carrying out its duties being structured as an incentive fee, which will only become payable upon appropriate performance thresholds of the securitised exposures having been met;
(d) Investor reports should be provided monthly;
(e) In addition, the following portfolio characteristics could be provided for in a definition of CLOs to ensure that only certain types of structures would actually constitute a CLO:
(i) it contains a high percentage of senior secured loans and bond loans to corporates;
(ii) it does not contain any asset-backed securities or synthetic securities; and
(iii) it is managed by an independent investment firm or an affiliate thereof which satisfies paragraph (a) above and who independently reviews, and individually selects, each asset to purchase in the primary or secondary market (with no obligation to purchase from any individual bank or originator) ;
The assets in a CLO portfolio are purchased according to the eligibility criteria, which specify the conditions for individual loans, such as jurisdiction, rating, non-convertibility, tax and regulatory conditions etc., and as at the effective date the portfolio profile and collateral quality tests must be satisfied. CLO managers may also only invest in assets during the reinvestment period if following investment, the portfolio profile and collateral quality tests remain satisfied or if not satisfied, they must be improved following such reinvestment. These tests ensure diversification of assets by industry, limit maximum concentration in a single borrower or borrower type, and ensure quality of loan covenants etc. The active management of the portfolio ensures the continued compliance with these tests. Thus CLOs have built-in protection for the quality of the assets in the portfolio.
Criterion 3: (True Sale): This criterion is unclear and we do not believe it reflects the intention of its inclusion. The key concept here is that the assets should be isolated from the insolvency of the seller. Given the differing legal regimes of various jurisdictions and the numerous methods of transfer available, we would suggest that the requirement be re-phrased such that assets are transferred by way of a “true sale” (or similar isolation) such that the assets are isolated from the creditors of the seller including upon an insolvency of the seller.
Criterion 4: Homogenous in terms of asset type, currency and legal system: We do understand the need of a homogenous pool of assets however this requirement should be met by asset-type groupings, in the case of CLOs, corporate debt. We do not agree that there needs to be homogeneity in currency and legal system. Within the EEA itself there are different currencies and legal systems.
In particular, there is a real danger that securitisations which are not Qualifying Securitisations are seen as sub-standard by the market and thus discourage investment in securitisations which fall outside of the Qualifying Securitisation designation.
The appropriateness of a framework which certifies some transactions as Qualifying Securitisations depends on the consequences of such a certification. An implicit regulatory stamp of approval will inevitably mean that investors rely to an extent on that stamp as a representation that the product is lower-risk, particularly if the associated capital risk-weights are lower than other similar products without such a stamp. This could actually result, not in investors taking necessarily better investment decisions, but instead investing in a smaller universe of securitisation instruments. The resulting positive correlation in an investor’s portfolio could mean potentially greater losses should default levels in an asset-class increase.
There is already concern in the market that the regulatory capital treatment of securitisations is unduly harsh and in some instances higher than a regulated entity holding the individual assets comprising the securitisation portfolio. Given the very low default rates for European CLOs the regulatory capital treatment of a “AAA” rated tranche of a CLO should not be treated as materially worse than a “AAA” tranche of a Qualifying Securitisation.
Question 2: Should synthetic securitisations be excluded from the framework for simple standard and transparent securitisations? If not, under which conditions/criteria could they be considered simple standard and transparent?
We do not have a view as to whether synthetic securitisations should be excluded.Question 3: Do you believe the default definition proposed under Criterion 5 (ii) above is appropriate? Would the default definition as per Article 178 of the CRR be more appropriate?
Our view is that the default definition should be consistent with the CRR definition. The market benefits from consistency across regulatory frameworks.Question 4: Do you believe that, for the purposes of standardisation, there should be limits imposed on the type of jurisdiction (such as EEA only, EEA and non-EEA G10 countries, etc): i) the underlying assets are originated and/or ii) governing the acquisition process of the SSPE of the underlying assets is regulated and/or iii) where the originator or intermediary (if applicable) is established and/or iv) where the issuer/sponsor is established?
Underlying Portfolio: We are of the view that such limitations should not be included. Portfolio diversity should be encouraged. Limiting the jurisdiction of the underlying portfolio would inhibit portfolio diversity. In addition, geographical limitations do not reflect underlying credit quality particularly where such limitations are arbitrarily drawn based on geography or economic groupings. However, if such limitations are included EEA and non-EEA G10 countries should be included.Question 5: Does the distribution of voting rights to the most senior tranches in the securitisation conflict with any national provision? Would this distribution deter investors in non-senior tranches and obstacle the structuring of transactions?
In CLOs, certain types of decisions such as the ability to accelerate and enforce are rights which vest solely with the most senior tranche of notes. Some decisions such as optional redemption of the structure are left to the vote of more junior classes of notes. In a CLO any exercise of an optional redemption by junior classes of notes requires that there are sufficient proceeds to repay all interest, principal and expenses which are senior to the most junior class of unrated debt. This ensures no optional redemption is exercisable by the most junior class of notes unless all rated debt can be repaid. If all decisions are left solely to the senior tranches, this could have negative consequences for the market. In order to obtain AAA ratings there must be a market for more junior classes in order to provide the subordination necessary to support the AAA rating. In addition, certain actions related to key “money terms” of a securitisation require all classes to vote. Disenfranchising junior classes in these instances, would allow the more senior classes of notes to unilaterally modify the economics of a securitisation with no consideration of the effect on more junior tranches. A prohibition on junior classes voting would diminish the appeal of the more junior classes of notes.Question 6: Do you believe that, for the purposes of transparency, a specific timing of the disclosure of underlying transaction documentation should be required? Should this documentation be disclosed prior to issuance?
Offering documents which comply with the Prospectus Directive are required to describe all material terms. While we do not object with the premise of making the transaction documents available (CLO transactions documents are made available to the market following the closing of the transaction), the practicalities of distributing these prior to issuance would be problematic. As is the case with most transaction timelines, documents are being negotiated and agreed up to the issue date of the securities. Investors are required to make their investment decision based on the offering document. Issuer, arrangers and collateral managers are required to include full, accurate and complete disclosure in the offering document. This is the case in Europe and the United States. Securitisations have multiple documents comprising many pages. Providing investors with the documents prior to issuance could distract investors from a full and complete review of the offering document which not only describes the material terms of the transaction in great detail but also highlights material risks which investors should be aware of. It should also be noted that under the European Credit Rating Agency Regulation, it has been proposed that transaction documents be posted to a public website set-up by ESMA. Again any such disclosure should be required after the transaction has closed.Question 7: Do you agree that granularity is a relevant factor determining the credit risk of the underlying? Does the threshold value proposed under Criterion B pose an obstacle to the structuring of securitisation transactions in any specific asset class? Would another threshold value be more appropriate?
We do not believe that imposing a large exposure limit is helpful. It is important to note that granularity of a portfolio does not necessarily equate to better credit quality. A granular portfolio of poorly underwritten assets does not create a less risky portfolio. CLOs are already subject to large loan exposure limits in the various tests which the CLO must satisfy (typically such limit is set to approximately 3%).Question 8: Do you agree with the proposed criteria defining simple standard and transparent securitisations? Do you agree with the proposed credit risk criteria? Should any other criteria be considered?
Criterion 2: We do not share the view that a securitisation should be excluded on the basis that it is actively managed. A regulated CLO manager adds an expertise to the transaction and monitors each credit in the portfolio. A CLO manager performs in depth credit analysis on each asset. The CLO manager has knowledge and experience in corporate credit and represents the CLO on creditor committees and in work-out scenarios. These are regulated entities responsible for ensuring the CLO can repay its obligations to investors. We also disagree that active portfolio management adds a layer of complexity to a transaction. Investors investing in CLOs analyse both the Tests (as defined below) and the performance of the CLO managers in the same way and with the same rigour that they analyse a static portfolio of assets. There is a great deal of information available to investors on past performance of CLO managers as well as their approach to credit selection and work-outs. This information is widely available from a variety of public sources.Management of a CLO portfolio is subject to collateral quality tests, overcollateralization tests and concentration limitation tests (the “Tests”) – these are rigorous rating agency tests measuring over-collateralisation and various portfolio characteristics which the manager is required to comply with in order to continue to be able to reinvest in new assets. These portfolio-level tests are already industry-standard and are particular to managed CLOs as opposed to securitisations of static portfolios. The CLO manager has to meet the Tests on an ongoing basis. The Tests and strict trading rules imposed on CLOs means that active management of the portfolio has a very limited effect (positive or negative) on the most senior tranches of a CLO.
The Tests also allow the CLO manager to provide detailed and transparent disclosure to investors on a monthly basis in respect of the portfolio. They cover data such as diversity of obligor by industry and geography, weighted average spread on the assets, weighted average fixed rate coupon, weighted average rating and weighted average life of the underlying assets.
Unlike traditional asset-backed securities, the underlying portfolios of CLOs are typically not purchased from one originator or seller but are typically sourced in the primary or secondary market by regulated investment managers who are independent of any originator or seller of the loans. The CLO manager is able to independently assess the quality of the portfolio and is free of the negative incentives which can arise in an originate-to-distribute securitisation model. This adds an additional level of credit analysis which is not a feature of other types of securitisation.
Risk-reducing characteristics of managed CLOs
We cannot stress too heavily the fact that the assets in a CLO portfolio are only a part of the performance of the CLO itself. As we state above, CLOs give investors the ability to invest in the loan market with the benefit of structural enhancements and active management which significantly reduce risk to the senior noteholders when compared with a direct investment, or with a static loan portfolio. The exclusion of managed portfolios fails to recognise the weight that should be given, uniquely in this asset class within the securitisation space, to structural deleveraging and active management.
Structural deleveraging
In summary, structural deleveraging in a CLO interrupts the normal priority of payments in the event that the quality of the portfolio falls below a certain level. The debt coverage tests measure the amount of over-collateralisation in the CLO. In a managed CLO transaction, there is typically a maximum of 7.5% CCC (or below) rated assets in the portfolio. If these low-rated assets rise above that percentage, those assets will be treated as valued at market value rather than at the usual par value in meeting the debt coverage tests. If the debt coverage tests fail as a result, no interest can be paid out on the junior notes, the majority of the CLO management fees and all receipts from the assets will go to pay principal on the senior notes sequentially until the pool complies again with the coverage tests. The same applies to failure of the coverage tests as a result of defaulted assets. Thus the senior notes benefit both from the credit enhancement provide by the junior tranches and the protection of senior income and principal prior to any default. In a static-pool securitisation, whilst mechanisms may be built in to ensure excess income supports deficiencies on the senior notes, this is not done on a managed basis. This structural deleveraging was partly responsible for the subsequent upgrades on many of the AAA CLO tranches which were downgraded by S&P in 2009.
In addition, post the expiry of a CLO reinvestment period, to the extent that portfolio collateral is repaying and the manager is unable to reinvest these proceeds (the circumstances are usually related to note ratings or certain test compliance), these proceeds are ultimately repaid to note holders in order of seniority. This is another mechanism by which structural deleveraging can occur and is an inherent characteristic across European CLO 1.0 and 2.0 structures.
In addition to those protections, we would suggest that a CLO which complies with the following criteria should be included in any “high-quality” class of ABS which receives preferential regulatory treatment:
(a) the securitised exposures must be managed on a continuing, discretionary basis by:
(i) an EEA investment firm which is required to be regulated in its home member State and which is subject to the Markets in Financial Instruments Directive (“MiFID”) or an affiliate thereof; or
(ii) a firm authorised under the Alternative Investment Fund Managers’ Directive (“AIFMD”) or an affiliate thereof; or
(iii) a firm or an affiliate thereof which would fall within (i) or (ii) above if its head office was situated in the EEA and which is subject to equivalent regulation in relation to the conduct of its business and its management of conflicts as a firm established in the EEA (for instance investment advisors registered under the US Investment Advisers Act of 1940, as amended);
(b) the CLO manager of the securitised exposures must undertake to the investors in the securitisation to comply with the regulatory requirements applying to it in relation to the management of conflicts of interest, in connection with its management of the securitised exposures (i.e. compliance with MiFID and/or AIFMD or equivalent regulations outside the EU);
(c) the securitisation must contain provisions whereby the interests of the CLO asset manager are appropriately aligned with the interests of the investors during the whole life of the securitisation. It is recognised that this may be achieved by a material part of the manager’s compensation for carrying out its duties being structured as an incentive fee, which will only become payable upon appropriate performance thresholds of the securitised exposures having been met;
(d) Investor reports should be provided monthly;
(e) In addition, the following portfolio characteristics could be provided for in a definition of CLOs to ensure that only certain types of structures would actually constitute a CLO:
(i) it contains a high percentage of senior secured loans and bond loans to corporates;
(ii) it does not contain any asset-backed securities or synthetic securities; and
(iii) it is managed by an independent investment firm or an affiliate thereof which satisfies paragraph (a) above and who independently reviews, and individually selects, each asset to purchase in the primary or secondary market (with no obligation to purchase from any individual bank or originator) ;
The assets in a CLO portfolio are purchased according to the eligibility criteria, which specify the conditions for individual loans, such as jurisdiction, rating, non-convertibility, tax and regulatory conditions etc., and as at the effective date the portfolio profile and collateral quality tests must be satisfied. CLO managers may also only invest in assets during the reinvestment period if following investment, the portfolio profile and collateral quality tests remain satisfied or if not satisfied, they must be improved following such reinvestment. These tests ensure diversification of assets by industry, limit maximum concentration in a single borrower or borrower type, and ensure quality of loan covenants etc. The active management of the portfolio ensures the continued compliance with these tests. Thus CLOs have built-in protection for the quality of the assets in the portfolio.
Criterion 3: (True Sale): This criterion is unclear and we do not believe it reflects the intention of its inclusion. The key concept here is that the assets should be isolated from the insolvency of the seller. Given the differing legal regimes of various jurisdictions and the numerous methods of transfer available, we would suggest that the requirement be re-phrased such that assets are transferred by way of a “true sale” (or similar isolation) such that the assets are isolated from the creditors of the seller including upon an insolvency of the seller.
Criterion 4: Homogenous in terms of asset type, currency and legal system: We do understand the need of a homogenous pool of assets however this requirement should be met by asset-type groupings, in the case of CLOs, corporate debt. We do not agree that there needs to be homogeneity in currency and legal system. Within the EEA itself there are different currencies and legal systems.
Question 9: Do you envisage any potential adverse market consequences of introducing a qualifying securitisation framework for regulatory purposes?
We have concerns over the possible “cliff effect” of classifying certain types of securitisations as simple, standard and transparent (“Qualifying Securitisations”).In particular, there is a real danger that securitisations which are not Qualifying Securitisations are seen as sub-standard by the market and thus discourage investment in securitisations which fall outside of the Qualifying Securitisation designation.
The appropriateness of a framework which certifies some transactions as Qualifying Securitisations depends on the consequences of such a certification. An implicit regulatory stamp of approval will inevitably mean that investors rely to an extent on that stamp as a representation that the product is lower-risk, particularly if the associated capital risk-weights are lower than other similar products without such a stamp. This could actually result, not in investors taking necessarily better investment decisions, but instead investing in a smaller universe of securitisation instruments. The resulting positive correlation in an investor’s portfolio could mean potentially greater losses should default levels in an asset-class increase.
There is already concern in the market that the regulatory capital treatment of securitisations is unduly harsh and in some instances higher than a regulated entity holding the individual assets comprising the securitisation portfolio. Given the very low default rates for European CLOs the regulatory capital treatment of a “AAA” rated tranche of a CLO should not be treated as materially worse than a “AAA” tranche of a Qualifying Securitisation.