Fitch: Risk Retention Questions Grow for CLOs, Shrink for RMBS

The announced risk retention rules will remove a level of uncertainty that has hung over the U.S. structured finance market since 2011 but raise new questions as to the market's direction going forward, Fitch Ratings says. We expect it to have a profound impact on the CLO and leveraged loan markets. And while the recovery in the U.S. RMBS market still faces other challenges, these rules reduce some uncertainty and support credit availability.

In the short term, all CLO fund managers are expected to accelerate issuance before the rules become effective. Over the longer term, smaller CLO managers will struggle with the economics of the risk retention requirements, raising questions about their current business models. Larger managers will likely be able to cope with the changes, given more diversified business models and more economic access to capital, but may expand their loan product offerings after the rules are implemented.

The 5% risk retention requirement translates to $50 million for every $1 billion of CLO assets under management issued after the effective date of the rule. Loan portfolio managers may elect to transition a portion of their loan management activity away from the securitization markets and toward separate managed accounts, comingled funds and retail funds that do not have these capital intensive requirements and may offer more attractive economics. Fitch expects bankers, managers and lawyers to propose new, innovative ownership structures designed solely to minimize the amount of capital required to manage CLO securitizations in the future.

Fitch expects CLO investors to be affected by the rule as they are forced to reconsider their original CLO investment thesis. Investors that currently invest in CLOs from smaller managers will likely no longer have that option after the rule goes into effect. Other investors will likely be faced with a narrower range of investment opportunities concentrated among a smaller number of larger managers. And investors' risk management requirements on maximum exposure limits to CLO managers will likely further constrain CLO investment choices.

If the U.S. CLO market shrinks due to the increases in capital requirements and reduced demand from CLO investors, funding costs could rise for corporate issuers. Currently, U.S. CLOs represent approximately two-thirds of the buyer base for new term loans and 40% of the institutional loan market's $860 billion of financing.

Contrastingly, Fitch believes the rule reduces uncertainty for RMBS market participants. The final rule effectively aligns the "qualified residential mortgage" definition with the "qualified mortgage" rules released by the CFPB in January and does not include a downpayment requirement or other overlays. The final rule also does not distinguish between "high-priced QM" and "safe harbor QM," with both treated as QRM without any distinction.

Our analysis indicates that the vast majority of post-crisis securitized mortgage production would meet QM rules and thus be treated as QRM and not subject to risk retention. However, securitizations backed by non-QM mortgages will be subject to risk retention requirements. While the U.S. RMBS market still faces obstacles, we believe the final credit risk retention rules are another step forward, as they provide clarity, support credit availability and could encourage new entrants into the market.

Regulators agreed to the rules yesterday. The rules will go into effect for residential loans one year after the announcement and two years after it for all other asset types.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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