The National Association of Insurance Commissioners, which proposed the change, also wants to create its own methodology for calculating these capital charges. It argues that the three big rating agencies — Moody’s, S&P and Fitch — are inconsistent and unreliable.

Critics of the NAIC’s plans argue that the group is not set up to provide its own capital-charge framework, and point out that the person driving this proposal is an aggrieved former rating-agency employee with an axe to grind.

They also say the rules would ultimately put extra pressure on the leveraged loan market, at a time when buyside demand is already depressed. CLOs are arguably the most important buyer of leveraged loans, representing more than two thirds of the market.

“If we lose this fight, it is highly likely that CLO formation disappears substantially,” said Paul Forrester, partner at Mayer Brown. “This is a big deal.”

Lynchpin investor

Insurance companies are an important part of the CLO machine, which in turn feeds demand for leveraged loans. They held $216bn of CLO investments at the end of 2021, roughly a quarter of the outstanding CLO market, according to data from Bank of America.

When they buy CLO tranches, insurance companies have to pledge a certain amount of capital in reserve against those investments. The new rules, proposed over the summer, would increase those capital charges for junior CLO debt.

The National Association of Insurance Commissioners (NAIC), which sets the standards for state insurance regulators across the US, says this would reduce “regulatory arbitrage”. It argues that investments in CLO debt should carry the same capital charge as the underlying corporate loans.

Many market participants say this argument does not take into account a fundamental selling point of CLOs: that they are specifically designed to mitigate the risks of investing in leveraged loans directly.

By raising the costs of investing in CLOs, the new charges could push insurance companies away from the asset class — especially in mezzanine debt, where they are one of the most dominant buyers. This could make it harder to form new CLOs, weighing on demand for leveraged loans.

“Anything that makes it less attractive for insurance companies to invest in CLOs makes it harder for us to raise money,” said a CLO manager of the proposed rules. Another market expert said the proposals could create a “pinch point” in demand for mezzanine CLO debt.

The NAIC’s focus on capital charges reflects a recent boom in CLO investments among insurance companies. Insurers piled into the CLO market in 2019 and 2020 — although that enthusiasm tailed off slightly last year.

Still, insurance companies hold around 40%-60% of outstanding AA, A and BBB rated CLO bonds, and slightly less than 20% of CLO equity and BB bonds, according to Bank of America research.

Some industry participants suggested that while the NAIC’s proposed rule was unlikely to freeze the market for CLO debt, it would definitely make it more expensive to issue — which would be unwelcome after months of widening spreads.

“Not having insurance companies doesn’t mean there’s no one to buy CLO debt,” said a partner at a large credit firm. “I think there is enough demand, but it would probably mean spreads move wider.”

Even so, the potential rule change is an unwelcome development for CLO managers: they need insurers much more than insurers need them.

CLOs are a fraction of insurance companies’ overall investments — just 2.7% of total cash and assets at the end of 2021, according to the NAIC. If investing in the asset class becomes significantly more expensive, they might simply decide the market isn’t worth their attention.

“That’s the last thing we need in the current economic environment,” said a CLO manager.

Fees please

Another big sticking point about the new proposal is that the NAIC wants to create its own methodology for determining capital charges.

Currently, capital charges for insurers investing in CLOs are based on ratings issued by Moody’s, S&P and Fitch. Under its new proposal, the NAIC would create its own methodology for calculating those capital charges.

Sources said this part of the NAIC’s proposal seemed like a play to generate fees from the CLO market.

“The NAIC action will create an additional layer of cost, as the issuer will ultimately have to bear the cost of both the rating agency fees and the NAIC fees,” said one CLO manager. “The land grab is the NAIC accruing fees unto itself.”

When approached for comment by 9fin, the NAIC said it was too early in the process to determine whether their in-house ratings would carry a fee.

In its proposal, the NAIC suggested the current way that capital charges are calculated involves an over-reliance on credit rating agencies — a hangover from the last financial crisis, where the rapid deterioration of highly rated RMBS led to questions over whether their ratings were reliable.

“They feel there are different methodologies from different agencies that can lead to different outcomes,” said Luke Schlafly, global head of insurance investment solutions at PineBridge Investments. “An NAIC capital treatment framework would treat them exactly the same.”

Different agencies do indeed give different ratings: we’ve written in the past about the “Fitch premium” in the high yield bond market (see this report for more) and there are plenty of examples of varying rating outcomes in leveraged loans and CLOs as well.

Several credit market sources, however, suggested that it was odd of the NAIC to criticize ratings agencies for having different approaches.

Disagreement is generally seen as healthy, they pointed out; it would be more concerning if all three agencies had identical methodologies and their ratings moved in lockstep. Moody’s declined to comment, and S&P and Fitch did not respond to requests for comment.

Still, the NAIC suggests that its Structured Securities Group could use its own stress scenarios to assign its own NAIC Designations to eliminate these discrepancies.

However, there is also an unavoidable personal aspect to the NAIC’s argument: its Structured Securities Group is led by Eric Kolchinsky, who left Moody’s in 2009 after making public criticisms of the rating agency’s methodologies.

He later filed a lawsuit against his former employer, alleging the rating agency had damaged his reputation through media statements. Kolchinsky ultimately lost the case several years later; he did not respond to 9fin’s requests for comment for this article.

Practicalities

Putting aside the potential for personal bias, some are skeptical about whether the NAIC’s would have the capacity to manage the workload of calculating charges itself.

Rating agencies have legions of staff to assess new loan deals, and even so there are times where they have had to draft in staff from other departments to manage demand.

“A lot of people are looking and wondering, are they set up to do that?” said Schlafly at PineBridge.

Other industry insiders suggested that after creating its own methodology, the NAIC could potentially outsource the day-to-day evaluation of capital charges to a third party. The NAIC told 9fin that if its proposal is approved, the endeavor would be “fully staffed”.

Practical questions aside, many in the CLO industry argue that the NAIC isn’t factoring in the ways that CLOs mitigate the risk of raw leveraged loan investments: overcollateralization, portfolio tests and active management, to name a few.

Others point out that CLOs have generally performed well through past crises. Bank of America described the potential increase in capital weightings on CLO equity investments as “prohibitive and at odds with their historical performance”.

Meredith Coffey, executive vice president of research and public policy at the Loan Syndications and Trading Association, noted that default and loss rates are dramatically lower in CLO bonds that in equivalently rated corporate loans.

“Comparing CLOs to equivalently rated corporate credit is not an apples to apples comparison,” she said.

Workarounds

The NAIC has acknowledged some of the industry’s concerns around its proposal, and softened the timeline for the potential rollout of any proposals.

After pushback, the NAIC said it had extended a comment period on the proposals through late 2022. Any discussion of the NAIC’s methodology of implementing the proposals, if approved, would be possible through mid 2023.

Full implementation would not happen until late 2023 at the earliest, and most likely not until 2024. The NAIC said that market participants should keep an eye on the next national meeting, to be held in Tampa from 12-16 December.

So there’s still a lot of room for things to shake out, and many industry participants who are at the coalface of new deal creation are not too concerned about the overall impact.

“Bigger picture, I don’t think it changes demand,” said a CLO debt and equity investor. “It will shape-shift a bit. Demand will be there to feed the beast, it will just be in a different form.”

After all, the CLO industry was pretty successful in mitigating the impact of risk retention. Indeed, market participants have already speculated on ways that insurers could mitigate higher capital charges.

One way, according to BofA researchers, would be for insurance companies to pool their CLO equity investments in a separate fund and retain an LP interest in it. The LP interest would attract a 30% risk-based capital charge, unlike the NAIC’s proposed 75%-100% charge.

The changes would also reduce capital charges for some higher-rated CLO debt, such as triple-A tranches; however, most insurance companies’ investments in CLOs are targeted towards middle of the capital structure.

For some people, the NAIC’s proposal is just another example of how CLOs are misunderstood because of their perceived association with collateralized debt obligations — one of the agents of the 2008 financial crisis.

John Kerschner, head of US securitized products at Janus Henderson Investors, said there was a mismatch between how CLOs are viewed compared to other securitized products.

“Most people understand the rationale behind securitizations backed by car loans, or house loans or office buildings,” he said. “But for some reason, they do not respond rationally to a similar structure, but backed by corporate loans.”