Japanese banks inching away from US CLO market

New rules prevent firms investing in CLOs where originator is not obliged to retain risk

US-Japan flags

Increased scrutiny by the Japanese regulator on securitisation investments is forcing banks to reduce their allocation to the US market for collateralised loan obligations, potentially contributing to wider spreads on senior AAA tranches.

A new capital adequacy law, which was introduced by the Japan Financial Services Agency (FSA) at the end of March, has imposed criteria that Japanese banks and other credit institutions (plus some securities companies) must meet on their holdings of CLOs. Banks may be prevented from holding CLOs where the deal originator does not retain some of the risk, while deals that don’t provide enough transparency to investors will be subject to huge hikes in capital requirements.

“Japanese banks continue to invest in the market simply because they need the yield. We estimate that Japanese investors need yields of at least 50 basis points and at home they are getting zero,” says Stephen Caprio, a global credit strategist for UBS. “But I think they’re buying a little more cautiously so that they can get comfortable with their investments.”

The FSA says it has been engaging with banks, especially large groups that could pose a systemic risk, to make sure they maintain a healthy level of oversight.

For CLOs, one of the focus points is how the risk of underlying assets … is spread to investment products such as CLOs and how investors’ portfolios would be affected

FSA spokesperson

“From micro perspective, we’ve been closely monitoring their investment activities and risk management framework in line with risk appetite, and have dialogues to enhance their risk management capability through monitoring large banking groups on an ongoing basis,” a spokesperson says in an email. “For CLOs, one of the focus points is how the risk of underlying assets … is spread to investment products such as CLOs and how investors’ portfolios would be affected.”

The FSA will expect financial institutions to be able to conduct in-depth analyses “on a continual basis”, the spokesperson says. That means banks are likely to need regular updates from CLO managers, whose deal documentation generally allows them to periodically refresh the composition of the underlying asset portfolio in the securitisation.

Big players

As yields on Japanese government securities have fallen into negative territory, Japanese investors have become significant players in global CLO markets, with Wells Fargo estimating that they now account for between 20% and 25% of global outstanding AAA tranches. The size of the total global CLO market is estimated to be $1.1 trillion, with around $1 trillion of this originating from the US. Around 60% of this paper is rated AAA, according to UBS.

Analysts say that by far the largest player in the space is Norinchukin bank, which UBS estimates could hold as much as two-thirds of outstanding notional placed into the Japanese market. Mitsubishi UFG Financial is also believed to be a sizable player in the market, as is Japan Post Bank, although the latter may have scaled back recently. Smaller Japanese firms also invest, but these are far less significant.

With spreads on European CLOs trailing US ones by around 30 basis points (see Figure 1) there has been a tendency for yield-hungry Japanese investors to favour those packaged loans from across the Pacific Ocean. Now, however, investors are having to rethink their allocation strategy as new rules force them to increase the amount of due diligence they perform on securitisation investments.

Some smaller players may be withdrawing from the market altogether, while others are switching their allocations to Europe, where regulatory oversight is more in line with Japanese rules and currency hedging costs are lower due to very low interest rates.

Increased due diligence

Under the new Japanese law, firms can only buy CLOs if the originator of the security retains at least 5% of its fair value, unless the buyer can show the underlying assets were not ‘inappropriately formed’ through ‘in-depth analysis of the quality of the original asset’.

The European Union has risk retention rules governing CLOs but, in the US, litigation by the Loan Syndications and Trading Association (LSTA) resulted in similar rules being overturned in court. Consequently, investors in US CLOs cannot simply assume that deals from this market will be compatible with Japanese law.

The new Japanese regulation also includes provisions that force firms to have proper systems in place to monitor their securitisation investments or face additional capital requirements of 1,250% (essentially covering the entire exposure with capital).

Japanese investors already exercise a high level of scrutiny over their CLO investments, but a source at one US CLO manager confirms Japanese institutions are beginning to make more detailed requests as they start to feel their way around the stricter set of requirements.

Elliot Ganz, legal counsel at the LSTA, says: “US managers are starting to see increasing requests from Japanese investors for more asset-level information, particularly in situations where the underlying assets are stressed. This is still mostly at the margins, but I think you will see this develop further in the coming months and quarters as Japanese investors start interacting more and more with the FSA, and seeking feedback on: is this enough, is this not enough?”

The rationale behind Japan’s new law is to make sure that only those banks with the capacity to understand and monitor complex investments play in the overseas CLO market. As a result, some smaller players may have withdrawn from the market, according to analysts – although evidence of this is hard to come by.

Large CLO investors, by comparison, maintain that they have sufficient due diligence procedures in place not to need to alter their allocation strategies. But Daisuke Tanimoto, a lawyer from Anderson Mori & Tomotsune, argues that even for sophisticated investors, the due diligence process may not be so straightforward. For example, to tell if assets are appropriately formed, banks may need to know the criteria used to review the risk and outlook for the underlying loans.

“This is not easy to check because the criteria used by the originator – a foreign bank – may not immediately be known to Japanese investors. If neither the originator nor the arranger can provide this sort of information to the Japanese investor then, even if the Japanese investor has the capability of carrying out appropriate due diligence, they may not be able to,” he says.

US managers are starting to see increasing requests from Japanese investors for more asset-level information, particularly in situations where the underlying assets are stressed

Elliot Ganz, LSTA

Caprio from UBS agrees, saying smaller banks may find it a high hurdle to prove to the regulator that the quality of underlying loans in the CLO is “acceptable”.

“But even for the larger Japanese banks that can meet that requirement, they still seem to be buying less than they bought in the past.”

Caprio adds that, as a result, managers of CLOs in the US appear to be positioning themselves more for the home market – for example, by selling CLO exposures in a loan format that attracts lower capital charges for US banks than an investment in a capital markets product.

“There has been a little bit of a shift toward trying to get more US banks involved. We have seen some CLOs being structured in such a way so as to make US bank capital requirements less onerous. These are new and unique, and tell us that [CLO managers] are having to reach a little bit more for demand from sources other than Japan,” says Caprio.

Switch to Europe

At the moment, the European CLO market makes up only around a tenth of total global issuance, but greater regulatory scrutiny, as well as cheaper hedging costs, mean Japanese investors could switch allegiance.

“I think the trend to focus a little bit more on European assets will continue simply because hedging costs are much cheaper [in Europe than in the US],” says the Japanese head of a European asset manager. US interest rates – a key factor in the cost of cross-currency swaps – currently stand at 2.25%, while the European Central Bank’s main refinancing rate is 0% and the Bank of England’s is 0.75%.

The asset manager adds: “Europe is also attractive from a risk-return perspective. Returns may be less but you need to look at the underlying assets, the leverage regulations and so on. The European market is in general much more conservative, depending on the asset class.”

As Japanese banks start to switch some of their allocation over to Europe, the challenge will be to make sure they build good relations with CLO managers there as the Japanese regulator ratchets up its scrutiny on CLO investments. Sources say Japanese investors may need to push European CLO managers to be more specific about the criteria for replenishing the portfolio, or for what loans can be included at inception.

“Japanese investors like to play with the top-three or top-five ranked managers in whatever asset class. They don’t want to speak to the small ones,” says the Japanese asset management head. “But they are going to have to diversify away from their historical reliance on US loan managers to European loan managers, who they will now have to get comfortable with.”

Even in Europe, Japanese banks may face challenges obtaining the information they need from CLO managers. One source points to French banking law, which protects the privacy of corporate borrowers. As a result, CLO managers have historically disclosed only the sector and maturity breakdown of the portfolio as a whole, rather than details on individual loans.

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