Published by Gbaf News
Posted on February 27, 2018
8 min readLast updated: January 21, 2026
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By Phil Milburn, fund manager at Liontrust Asset Management
Now if that catchy title does not tickle your fancy then you are still a functioning human and have not descended fully into the world of being a bond geek! However, the ruling does have some small ramifications for the US high yield bond market and is a sign of the retrenchment in regulation we are witnessing in the US.
The court ruling
On the 9th February 2018, the US Court of Appeals for DC ruled in favour of the Loan Syndications and Trading Association (LSTA) that the credit risk retention rules enforced by the US Securities and Exchange Commission do not apply to open-market CLO (collateralized loan obligations) managers. I have handily included a link to the full ruling for those suffering from insomnia:
The background to this is the regulatory reaction to the subprime crisis of 2007-9. It was patently clear that the originators of subprime securitizations did not have their interests aligned with either investors in the various tranches of the securitizations or, indeed, the mortgage holders themselves. The Dodd-Frank Act sought to address this by requiring any securitizer to retain at least 5% of the credit risk for any asset; this would give them “skin in the game” and therefore aid in the alignment of interests.
The LSTA successfully argued that managers involved in open-market CLOs, where all the constituents are purchased from secondary sources as opposed to originated by the manager, should be exempt from the credit risk retention rule. The fact that the Court of Appeals agreed unanimously suggests that this is a done deal and, in my opinion, is a good example of US regulation now becoming a little more lax.
The economic agency problem
Do I agree with the ruling? By the letter of the law yes, but by the spirit of the regulation no. In my opinion the “skin in the game” problem has two parts to it, or as economists like to call it the economic agency problem.
The first agency problem is that of adverse selection where there is an asymmetry of information between buyers and sellers; the classic example normally involves higher risk people, such as smokers or adrenaline junkies, being more likely to seek out life insurance. During the subprime boom the buyers of securitizations were being adversely selected against by the originators. Regarding adverse selection, I agree with the Court ruling as open-market CLO managers have no more or less information about the loans they are buying than the rest of the market, and crucially cannot stuff their CLOs full of loans they are trying to get off their own balance sheets.
However, there is also the agency problem of moral hazard. In my life insurance example an adrenaline junky may feel more confident about taking excessive risks in the knowledge that their life insurance will take care of their family should an accident happen. The world of finance remains rife with moral hazard with the costs of excessive risk taking being borne by investors rather than fund managers. In the case of open-market CLOs, I believe that the lack of credit risk retention leaves investors more vulnerable to moral hazard risk; long term reputational risk being the only significant barrier to prevent the CLO manager from pushing the risk envelope too far in order to make the maths of a transaction work.
I am a huge believer in incentive structures being able to influence peoples’ behaviour. For fund managers we should invest in our own products. We should share the pain of losses when investors do and experience the service that our companies provide. When incentives between the fund manager and the client are aligned this can give you confidence that we will always act in your long term best interests.
The implications for US high yield
Moving back from my soap box to the Court ruling, the main ramification for US high yield is a small decrease in anticipated supply of bonds. When companies are raising leveraged finance they can choose between the loan or bond routes, or a combination of the two. CLOs represent between 57-60% of the leverage loan buyer base, an easing of conditions for CLO origination will obviously increase demand for loans. Not that this credit risk retention rule was particularly onerous with $118bn of CLOs formed from 95 managers in 2017. The stronger demand for leveraged loans will crowd out some of the high yield bond supply. At the margin, it is also likely to lead to a deterioration in standards for investors with corporate issuers, egged on by investment banks, playing the loan and bond markets off against each other. Adverse selection anyone?
By Phil Milburn, fund manager at Liontrust Asset Management
Now if that catchy title does not tickle your fancy then you are still a functioning human and have not descended fully into the world of being a bond geek! However, the ruling does have some small ramifications for the US high yield bond market and is a sign of the retrenchment in regulation we are witnessing in the US.
The court ruling
On the 9th February 2018, the US Court of Appeals for DC ruled in favour of the Loan Syndications and Trading Association (LSTA) that the credit risk retention rules enforced by the US Securities and Exchange Commission do not apply to open-market CLO (collateralized loan obligations) managers. I have handily included a link to the full ruling for those suffering from insomnia:
The background to this is the regulatory reaction to the subprime crisis of 2007-9. It was patently clear that the originators of subprime securitizations did not have their interests aligned with either investors in the various tranches of the securitizations or, indeed, the mortgage holders themselves. The Dodd-Frank Act sought to address this by requiring any securitizer to retain at least 5% of the credit risk for any asset; this would give them “skin in the game” and therefore aid in the alignment of interests.
The LSTA successfully argued that managers involved in open-market CLOs, where all the constituents are purchased from secondary sources as opposed to originated by the manager, should be exempt from the credit risk retention rule. The fact that the Court of Appeals agreed unanimously suggests that this is a done deal and, in my opinion, is a good example of US regulation now becoming a little more lax.
The economic agency problem
Do I agree with the ruling? By the letter of the law yes, but by the spirit of the regulation no. In my opinion the “skin in the game” problem has two parts to it, or as economists like to call it the economic agency problem.
The first agency problem is that of adverse selection where there is an asymmetry of information between buyers and sellers; the classic example normally involves higher risk people, such as smokers or adrenaline junkies, being more likely to seek out life insurance. During the subprime boom the buyers of securitizations were being adversely selected against by the originators. Regarding adverse selection, I agree with the Court ruling as open-market CLO managers have no more or less information about the loans they are buying than the rest of the market, and crucially cannot stuff their CLOs full of loans they are trying to get off their own balance sheets.
However, there is also the agency problem of moral hazard. In my life insurance example an adrenaline junky may feel more confident about taking excessive risks in the knowledge that their life insurance will take care of their family should an accident happen. The world of finance remains rife with moral hazard with the costs of excessive risk taking being borne by investors rather than fund managers. In the case of open-market CLOs, I believe that the lack of credit risk retention leaves investors more vulnerable to moral hazard risk; long term reputational risk being the only significant barrier to prevent the CLO manager from pushing the risk envelope too far in order to make the maths of a transaction work.
I am a huge believer in incentive structures being able to influence peoples’ behaviour. For fund managers we should invest in our own products. We should share the pain of losses when investors do and experience the service that our companies provide. When incentives between the fund manager and the client are aligned this can give you confidence that we will always act in your long term best interests.
The implications for US high yield
Moving back from my soap box to the Court ruling, the main ramification for US high yield is a small decrease in anticipated supply of bonds. When companies are raising leveraged finance they can choose between the loan or bond routes, or a combination of the two. CLOs represent between 57-60% of the leverage loan buyer base, an easing of conditions for CLO origination will obviously increase demand for loans. Not that this credit risk retention rule was particularly onerous with $118bn of CLOs formed from 95 managers in 2017. The stronger demand for leveraged loans will crowd out some of the high yield bond supply. At the margin, it is also likely to lead to a deterioration in standards for investors with corporate issuers, egged on by investment banks, playing the loan and bond markets off against each other. Adverse selection anyone?
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