EU Moves to Close Asset-Backed Bond Loophole in Market Overhaul

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European policy makers are moving to stop sellers of asset-backed securities from skirting rules that put them on the hook for losses along with investors.

Entities that have no other business than securitization will not be considered compliant with European Union rules designed to limit excessive risk-taking by making arrangers keep parts of their deals, according to an undated draft regulation seen by Bloomberg. The European Commission is due to publish its framework on simple securitization on Sept. 30, along with an action plan for developing capital markets.

The proposal takes into account a recommendation by the European Banking Authority to “close a potential loophole in the implementation of the risk-retention regime whereby the requirements could be circumvented by an extensive interpretation of the originator definition,” the commission said in the draft. The EBA criticized deal structures that meet legal requirements without complying with the spirit of the rules.

“There is a large amount of CLO deals currently being marketed and that allows investors to be choosier,” said Christos Danias, managing director of structured credit at Cantor Fitzgerald LP in London. “Until we have full clarity on the types of deal structures that are compliant, CLO investors will only buy bonds they know will definitely meet the grade.”

European policy makers are seeking to promote asset-backed bonds because the debt can spur economic growth by freeing up banks to lend to businesses. While supporting the market, policy makers are also trying to limit risk-taking by ensuring the interests of buyers and sellers are aligned.

Risk Retention

The issue is pressing for collateralized loan obligations because policy makers have said certain structures go against the spirit of risk retention requirements, under which investors are prevented from investing in deals unless the originator or sponsor holds 5 percent of the notes.

There are two ways of meeting the retention requirement. The first involves the CLO manager retaining a portion of the notes, known as sponsor retention. The second route allows a separately capitalized entity that originates or acquires and securitizes the loans to retain the required portion. That means the CLO manager can avoid directly owning any of the deal.

EU efforts to clamp down on originator deals that misuse the retention requirements are disrupting the CLO market, which is on course for its highest full-year sales tally since 20.5 billion euros ($23 billion) was arranged in 2008, according to JPMorgan Chase & Co. 

A previous draft of the commission’s rules deterred investors and stalled sales in the CLO market. Yet tweaks made to the latest draft give investors cause for some comfort, according to Franz Ranero, a London-based partner at Allen & Overy LLP.

Sole Purpose

Having previously said originators will be deemed non-compliant if their “primary purpose” is securitization, the latest draft says originators will not meet the requirements if their “sole purpose” is to securitize assets.

“Responding to advice from the EBA, the European Commission’s aim is to eradicate perceived abuses of the retention requirements by entities which have no economic substance and, as a result, do not comply with the spirit of the rules,” said Ranero. “Changes to the language in the latest draft create a more workable and positive outcome for the CLO industry by not capturing originators who have the requisite substance but nonetheless primarily utilize securitization as their key funding tool.”
Another positive for investors is that there’s an attempt in the latest draft to allow existing bonds to comply with the rules, a process known as grandfathering, that was not provided for in the earlier version, said Ranero.

Blackstone Group LP’s GSO Capital Partners and hedge-fund firm Chenavari are facing delays to deals they’re marketing which use the originator structure as investors await more clarity, according to people familiar with the matter. The transactions are among six CLO deals currently being marketed, which also include deals from Apollo Global Management LLC and KKR & Co., according to data compiled by Bloomberg.