Saturday, February 8, 2020

Leveraged Loan CLOs and Rating Agencies - Policy Solutions

Over the last couple of years, financial market commentators have become concerned that leveraged loans and Collateralized Loan Obligations (CLOs) are becoming the newest “financial weapons of mass destruction”.  The fear is that mispricing and over-production of these assets could lead to a bubble that would ultimately take down our financial system – just as subprime mortgage backed securities did a dozen year ago.

Further, critics worry that rating agencies – still following the traditional issuer-pays model – lack the incentive to protect us from a leveraged lending meltdown. Instead, agencies are thought to be engaged in a "race-to-the-bottom," lowering their rating standards to enable (or keep) even the less credible corporate borrowers in the Investment Grade category.

If SEC-licensed Nationally Recognized Statistical Rating Organizations (NRSROs) – or so-called credit rating agencies -- are not up to the task, investors could turn to non-licensed analytics firms to more objectively evaluate leveraged loans and the securitization vehicles that house them.  Outside of the market for debt and credit-based financial products, we see many types of ratings published by non-licensed providers. For example, Consumer Reports assigns ratings to a wide array of products, US News ranks colleges and Yelp assigns ratings to service establishments. These systems are imperfect and sometimes deservedly attract criticism, but no rating system is perfect and the widespread use of these assessments suggests that users find them valuable.

The main barrier to entry for non-NRSROs that would want to assess leveraged loans and CLOs specifically is lack of access to data, and this is an issue that the SEC could rectify. The leveraged loans at the center of CLOs are often borrowings made by privately held companies – including holdings of private equity firms – that are not required to make their financial statements public. Only current investors and the rating agencies hired to rate these entities can see these financial statements.

The SEC could simply require all such companies that borrow on the leveraged loan market, subject to a minimum borrowing size, to file their 10-Q and 10-K statements on the EDGAR system. That way independent firms could assess their financial status and estimate default probabilities and expected losses on their loan facilities.

Second, CLO issuers should be required to post both their loan portfolios and details of their capital structures on EDGAR as well. In such a scenario, CLOs could no longer be exempted under Section 4(a)(2) of the Securities Act and sold as Rule 144A private securities. Instead, they would be regulated as public securities.

Finally, many CLOs have complex rules governing how proceeds from the collateral pool should be distributed among the various classes of noteholders and the firms – like the asset manager – that provides services to the CLO deal. These “priority of payment” provisions are outlined in dense legalese included in the CLO's offering documents. Rather than compelling investors and analysts to decipher these legal provisions, issuers should be required to code them as computer algorithms which would also be published as part of the deal’s disclosure. CLOs could then operate like any other “smart contract,” easing the work of deal participants and third parties who need to analyze the many “what-ifs” that can occur over the life of a transaction.

Leveraged loans and CLOs may or may not be the ticking time bomb that will blow up our economy. One way to limit the potential for bubble-creation is to remove dependence on parties (like the incumbent credit rating agencies) that are financially motivated to provide high ratings, thus prompting issuers and other market participants to seek out their services. Thus, our solution is, in short, to make these transactions more transparent, so that other third parties can access information on the securities and analyze them in a cost-effective manner.

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