SEC Regulation of Loans as Securities
One potential reform posed to the panel by the Committee was whether the SEC should have statutory power to regulate securitized instruments. Generally, the panel felt that loans should not be regulated by the SEC, or SEC regulation largely would not have an effect. De Fontenay suggested that, as a practical matter, if loans were treated as securities, they would qualify for exceptions from registrations. In fact, there is likely better disclosure in the debt market than the equity market. Even further, additional disclosure may not have an effect on the leveraged loan market if investors are buying leveraged loans not because of their potential to provide a yield in a low-interest environment, but rather in an attempt to get a AAA rating with a product that actually has some risk (i.e., for purpose of regulatory capital arbitrage).
Rating Agency Regulation
Gerding highlighted the need for disclosure surrounding the rating process. Disclosure may include identifying how the deal was structured to take rating methodologies into account. However, there is danger in having too much disclosure or too much standardization in the rating agency industry. If one were to know exactly what the tests were for ratings, it would be simple to reverse engineer the agency’s methodologies. One solution, Gerding suggested, would be to require ratings from more than one rating agency.
De Fontenay opined that the problem may not be with rating agencies misleading investors into purchasing exceedingly risky loans; rather, the problem could be the regulatory structure that rewards financial institutions for having safe assets on their balance sheets. When faced with this question of whether modifications should be made to the banking regulatory scheme in order to disincentivize banks from only holding AAA debts, Gerding responded that he did not believe this was the sole answer. In response to each of the three Basel decisions, banks have found a way to manipulate rules, noting that capital arbitrage is a recent manifestation of this manipulation.
Increased Disclosure and Information Sharing
The panel stressed the need for increased disclosure and an overall increase in information gathering and sharing between market actors. Institutional investors in CLOs should know whether securities are actively traded, how prices in the secondary market are set, and the extent to which securities are purchased for the purpose of regulatory arbitrage.
Beyond disclosure, there is the need for information sharing between financial regulators. Gerding pointed to FINRA’s TRACE system as a model to improve and promote price transparency in CLOs and other markets. Additionally, he stated that the exception for CLOs in the Volker Rule fueled explosive growth of CLOs. Gerding urged that, until there is ample evidence that the systemic risk from these markets is muted, financial regulators should not expand this exception any further, as the Loan Syndications and Trading Association has advocated. Gerding advised the SEC to help financial regulators develop institutional mechanisms for sustained and deep collaboration in spotting and tracking the emergence of financial risks.
Deborah J. Enea is a partner in the Financial Services Practice Group of Pepper Hamilton LLP. Her practice focuses on leveraged finance transactions where she represents and advises a number of clients on financial services matters.
George Oldfield, an economic consultant, expressed his view of the current state of the market with more skepticism, saying, “I think the market is moving into an area, or a regime, which could provide some concern for regulators, because, in some regards, it resembles the s.” High-risk loans are now securitized, and groups of Colorado state personal loans investors previously abstaining from the market have been able to take interest in corporate credits. Specifically, a potential area of concern is “enhanced CLOs” that are designed to take advantage of failures of other CLOs.