Japan mulls looser rules on CLOs in potential US market boost

Japan is considering looser rules on domestic investors’ purchases of bundled corporate loans, potentially averting a blow to the $750bn market.In draft regulations published late December, the nation’s financial regulator suggested imposing onerous capital requirements for local institutions to buy collateralised loan obligations from firms that don’t retain a stake in the products. The move raised concerns, particularly in the US market, because Japanese investors like Norinchukin Bank are among the biggest buyers of CLOs.But in a question-and-answer document later sent to some market participants and seen by Bloomberg, the Financial Services Agency offered a reassuring message: Purchases of CLOs may be exempted if the buyers provide documentation proving that the originators pulled them together from the open market rather than loans of their own, and that the quality of the assets is “not inappropriate,” according to the Q&A, which hasn’t been made public.“The majority of European and US CLOs qualify as open-market CLOs and an exemption for such transactions would generally permit Japanese investors that are already active in the CLO markets to continue their investment program without additional constraint,” said James Warbey, a lawyer at Milbank in London who has studied the original proposal.Issuance of CLOs in the US hit a record $130.4bn last year, powered by investors’ thirst for yield. Institutions in Japan, where yields on government bonds have been near zero in recent years, have emerged as some of the biggest buyers of the securities, which are made up of loans to companies with low credit ratings or high indebtedness.Under the FSA’s initial proposal, Japanese investors would effectively be limited to buying only products where the originator keeps at least 5% of the underlying assets.Transactions that don’t meet the so-called risk retention rule would require investors to set aside more capital against potential losses.However, the draft rule also states that Japanese investors wouldn’t incur the extra capital charge if they can prove that assets backing the securitised products were not originated “in an inappropriate manner.” The Q&A document was intended to elaborate on that potential loophole.The FSA remains concerned that strong credit ratings alone aren’t necessarily enough to demonstrate the quality of open- market CLOs, government officials said, asking not to be identified because they are still deliberating on the rule.Open-market CLOs consist of loans that asset managers acquired from sellers, and are different from those made by banks from loans on their own balance sheets.Global policy makers and bankers have raised concerns about a buildup in leveraged loans that underpin CLOs, after banks were stuck with billions of dollars in unsold debt last month.If the FSA goes through with the exemption, CLO arrangers will probably make the necessary adjustments, according to Milbank’s Warbey. “I anticipate that CLO managers would cooperate to ensure that the documentation allows Japanese investors to demonstrate the appropriate quality of the underlying assets,” he said in an e-mail.Japanese banks held about a 10th of a global CLO market worth about $750bn in 2017, mainly in highly rated products, according to a Bank of England report published in November. Norinchukin – an agricultural lender that was burned by investments in securitised products during the global crisis – owned ¥3tn ($27bn) of CLOs as of March 2017, its latest annual report shows.US and European regulators have already introduced risk-retention rules for securitised products to avoid a repeat of the global financial crisis by ensuring arrangers have “skin in the game.” In the US, however, a court ruled in February last year that open-market CLOs were exempt from the requirement.That case was brought by the Loan Syndications and Trading Association, an industry group that has also been asking the Japanese regulator to loosen the proposed restriction. The LSTA is preparing a letter to the FSA outlining why open-market CLOs shouldn’t be subject to the new rule, Elliot Ganz, general counsel for the New York-based group, told Bloomberg this month.An FSA representative declined to comment on the proposed rule. The consultation period ended this week and the regulator is expected to finalize the provision by March 31. It won’t apply retrospectively, so Japanese financial firms won’t incur any extra capital burdens on their existing CLO holdings.