Small CLO Managers May Have Trouble Complying With Risk Retention Rule

While several strategies have reportedly emerged to help small CLO managers who may be having trouble complying with the new risk retention rule, which was finalized in October 2014, but how effective these strategies are in achieving that goal remains uncertain, according to an announcement from Fitch Ratings.

While the number of issuers in the CLO market increased by 65 percent in 2013, with 47 new mangers entering the market from the start of 2013 until October 2014, Fitch said it expects the number of small CLO managers to decline this year due to industry consolidation in anticipation of the risk retention rule going into effect in 2016.

Investors of CLOs of smaller managers must also consider that smaller managers with limited resources may underutilize governance, risk management, investment processes, and operational controls. Smaller CLO managers may also be more vulnerable to business concentration and smaller asset bases, and they may lack a clear distribution network, according to Fitch.

To address these considerations, the market increased the number of backup managers added to less experienced issuers of newer CLOs, which in many cases are large, frequent CLO issuers. These backups are expected to be named as replacement mangers when a breach is committed, or where there is "cause" as defined in the collateral management agreement, according to Fitch. The effectiveness of using these backup managers remains a question mark, however, since regulators have not stated whether the backup managers will be subject to the risk retention rule.

"In our view, new managers with adequate administration capabilities, thorough indenture review procedures, advanced portfolio setup procedures and strong modeling tools can limit these operational risks," Fitch said in the announcement. "We recommend investors monitor managers' compliance with their investment guidelines."

The risk retention rule was originally proposed in August 2013 and finalized in October 2014. The final rule defines a qualified residential mortgage (QRM) and exempts securitizations of QRMs from the risk retention requirement, and it aligns the QRM definition with the CFPB's definition of a qualified mortgage. Agencies must also review the definition of a QRM no later than four years after the rule's effective date respective of the securitization of residential mortgages – and every five years thereafter. Additionally, each agency can request a review of the QRM definition at any time under the new rule.

The final rule was issued jointly by several government agencies, including the Federal Reserve, FHFA, HUD, and FDIC. It is scheduled to go into effect one year after publication in the Federal Register for residential mortgage-backed securities and two years after publication for all other types of securitization.