Banks Told to Keep Skin in Game. They Securitized That TooBy , , and
Bond-retention rule left Wall Street with a big exception
Bankers find investors to hold risk instead of retaining it
Few would argue with the stated mission of The Academy Group: to educate, mentor and find jobs for underprivileged youth.
But along the way, the Chicago non-profit is also doing something a bit less lofty -- helping Wall Street sell collateralized loan obligations, a cousin of those complex debt instruments that went horribly wrong during the 2008 financial crisis.
The foundation and its chief benefactor, the billionaire Mark Walter, committed $160 million for an investment in a Chicago money manager that uses financial engineering to transform junk-rated loans into bonds rated as high as AAA. For the charity, the deal brings the prospect of steady cash flows and, Walter says, a future employer for its graduates. For the CLO manager, it means a deep pocket that enables the firm to comply with post-crisis rules intended to make the instruments less risky.
Across Wall Street, similar symbiotic relationships have sprouted up as the market for securitized products faces new regulations requiring issuers to eat their own cooking. While each situation is a little different, the goal is typically the same: help firms that bundle consumer and corporate loans into bonds to raise the money needed to comply with the rules without forcing them to pay up themselves. And it’s all perfectly legal.
It wasn’t the outcome lawmakers envisioned after the financial crisis, as they hammered out the most significant overhaul of U.S. financial regulations in a generation. Congress sought to promote higher lending and underwriting standards by forcing issuers to retain 5 percent of the debt they package or sell, either by owning half of the riskiest piece of the deals or a portion of each slice. The idea was to align issuers’ interests with investors’ and discourage them from underwriting aggressive loans that could just be dumped on bond buyers.
But by the time the final risk-retention rule was implemented in December, regulators had added one big exception: firms that sell securitized products could use other people’s money to meet the obligation as long as those people have recourse to the issuer.
“It encourages more risk-taking without any penalty,” said Barney Frank, the former Democratic congressman and a chief architect of the reform bill, who blamed regulators for watering down the law. “It encourages people to lend more money than they should, and that can mean losses to individuals and beyond that, if it becomes wide enough, it becomes a systemic threat.”
To critics, the provision has undercut lawmakers’ efforts to curb risk in the $10 trillion market for securitized products, where everything from corporate buyout loans to shopping-center mortgages and auto leases are bundled into bonds. By some accounts, the rule did more to line the pockets of lawyers and consultants as they cooked up new funding vehicles and creative financing to keep the securitization machine humming.
Take, for example, a 10 billion-pound ($12.8 billion) securitization in April by Blackstone Group LP that bundled together mortgages it bought from the U.K. government. The private-equity giant arranged for Goldman Sachs Group Inc. to hang onto the sliver of the securities that allowed it to comply with risk-retention rules. Andrew Dowler, a spokesman for Blackstone, declined to comment on the deal. Simone Verri, Goldman’s head of debt capital markets and structured finance in Europe, said the bankers weren’t “pushing the envelope” because the bank is well-capitalized and a suitable retention holder.
The risk is that such deals weaken protections for buyers of the debt, said Aaron Baker, a London-based credit analyst at Banco Bilbao Vizcaya Argentaria SA. “To the extent that there’s retention creativity, the purpose of the requirement to have skin in the game is diluted,” he said.
Nowhere has Wall Street’s creativity run more freely than in the CLO market, where investors from Beijing to Boston have come for some of the juiciest returns in the fixed-income world.
Unlike CDOs tied to risky mortgages, CLOs weathered the crisis and roared back during the credit boom of the past several years. Since the crisis, almost half a trillion dollars of CLOs have been created, and issuance so far this year is almost double the amount sold during the same period in 2016, according to data from Wells Fargo & Co. A typical leveraged loan in a benchmark index has yielded 2 percent this year. But when bundled into a CLO and leveraged up, the junk-rated portions can pay more than 14 percent, data from Morgan Stanley show.
Firms including Apollo Global Management have been raising money for new entities that would hold the debt they are supposed to keep. Such vehicles are compliant with the rules as long as the CLO manager maintains a majority stake.
The CLO manager that partnered with Walter’s Academy Group, Chicago Fundamental Investment Partners, plans to issue four to eight new deals during the next two years using funds from Academy to comply with the rule, Brad Couri, a managing principal at the firm, said in April. Academy, which took a 25 percent stake in the investment firm, has also agreed to backstop about $1 billion of the top-rated slices of the next four deals. That means the charity would be on the hook to buy the debt in a market downturn.
“The motivation for doing our deal was primarily about helping advance the mission of the Academy Group,” Couri said by email last week.
For Walter, the co-founder and chief executive officer of Guggenheim Partners, partnering with the CLO manager was less about getting a piece of the market and more about finding a “human-capital intensive business” that would be a good fit and possible future employer for Academy graduates. “Risk retention is important to them, but from an Academy point of view, we just gave them capital,” he said.
Securitizing the Skin
Other CLO managers have gotten even more creative. When MJX Asset Management sold a $614 million CLO in April, it carved out a 5 percent slice from each of the different tranches. Then it repackaged that piece into a new CLO-like instrument, which it sold as bonds to investors such as insurers and pension funds. Moody’s Investors Service gave the re-packaged notes higher ratings because buyers have the ability to recoup a portion of the manager’s fees if things sour, people with knowledge of the matter said.
CLO boosters say their market was the least in need of fixing. It was one of the few types of securitized debt to emerge from the crisis largely unscathed. That’s because their products are simpler than the CDOs of the mortgage boom. They’re backed by corporate debt instead of difficult-to-value mortgage bonds. And the company loans are usually the first in line to get repaid when a company goes bust. That, they say, gives CLO investors a lot of cushion to weather the next wave of defaults.
“CLO guys never tried to do what the mortgage guys did -- there was never any attempt to use securitization irresponsibly,” said Mark Okada, chief investment officer of Dallas-based Highland Capital Management, which manages $6.8 billion in CLOs. Okada said Highland has always owned equity in its CLO deals. “The rules weren’t necessary in the CLO space,” he said.
To some veterans of the last crisis, however, these deals are starting to bring back memories of the kind of financial engineering that helped spread losses across the globe when U.S. housing prices plunged a decade ago.
“The question is what you think of financial engineering -- how much energy you want the financial community to put into repackaging and repackaging and repackaging,” said Mark Adelson, a consultant and former chief credit officer at S&P Global Ratings. “You can’t hold it against the bankers for doing something legally to make money. But it’s chasing piles of money around in a circle and some of the activity doesn’t amount to anything more than that.”
— With assistance by Adam Tempkin, and Kenneth Pringle