Last week we covered the SEC's proposed risk retention rules for securitized assets such as collateralized debt obligations (CDOs) and mortgage backed securities (MBS). One of the reasons why these types of structured deals are so complex is because they are divided into many different securities, called 'tranches,' with different levels of risk. We explained tranching in our post, What is a CDO, Anyway?
The new proposed rules require sponsors of securitizations to keep at least 5% of each tranche, known as a 'vertical slice,' or keep 5% of the equity tranche, or a 'horizontal slice.' The idea is that if issuers have 'skin in the game,' they are less likely to misrepresent the riskiness of the underlying assets or otherwise create unfavorable terms for investors.
However, these rules provide an additional option for collateralized loan obligations (CLOs). Instead of holding a slice of the securitization, they can simply hold a percentage of each underlying loan. According to Creditflux, this might not be a viable option:
The new proposal introduces an alternative to this form of risk retention for CLOs. It would allow a deal to tick the skin-in-the-game box if the arranger of each loan in the CLO retains a 5% stake in that loan. However, in a note published yesterday RBS researchers say this is not a viable option for CLOs. “Loan arranging banks do not typically retain any portion of the leveraged term loan tranches bought by CLOs,” says the note. “Rather, they participate in the revolver or create a separate tranche to retain.”We bring this up because CLOs are currently being issued in relatively large amounts, so any regulatory treatment which may change their risk profile could affect many investors.