The top stories of 2018

The collateralized loan obligation industry fought risk retention tooth and nail, claiming it was unjustly applied to those who purchase, rather than underwrite, collateral for asset-backeds, overly burdensome to asset managers with little balance sheet of their own, and would raise borrowing costs for below-investment-grade companies.

Nevertheless, the CLO industry adapted.

Since late 2014, when the rules were issued, smaller managers have teamed up with larger players and collectively raised billions of dollars from third-party investors to help finance their skin in the game. Issuance of CLOs reached a near-record $124 billion in 2017, feeding a frenzy for floating-rate debt that has allowed junk-rated companies to borrow large sums on increasingly favorable terms.

That doesn’t make legal victory any less sweet.

In March, the Court of Appeals for the D.C. Circuit sided with the Loan Syndications and Trading Association, an industry trade group; it held that Dodd-Frank does not authorize federal agencies to subject CLO managers who acquire collateral for deals on the open market to risk retention regulation, because those managers are not “securitizers.”

Residential PACE got off the ground much faster than commercial PACE, but in 2018, the tables started to turn.

Resi PACE originations, which had largely been confined to California, fell sharply as providers grappled with new consumer protection regulations in that state. The regulations include income verification and ability-to-pay rules that extended the time and effort required to obtain financing for energy and water efficiency improvements from now more than 30 to 45 minutes to multiple days.

Renovate America and Renew Financial, two of the largest providers of programs that finance energy-saving home upgrades, also faced more legal action from consumers.

Unlike earlier lawsuits, this one does not allege that the providers of Property Assessed Clean Energy Financing violated consumer protection laws. A U.S. District Court dismissed those claims last year, ruling that PACE liens are not subject to the federal Truth in Lending Act or Home Ownership and Equity Protection Act because they are not consumer credit. Instead, the new lawsuit alleges that Renovate America and Renew Financial breached a contract with Los Angeles County to implement basic consumer protections and ensure “best in class protections” for the benefit of homeowners who participated in the PACE program, including protection from “predatory lending, unscrupulous contractors and poor quality assessment servicing,” the complaint states.

Meanwhile, C-PACE providers continued to boost production, with CleanFund debuting in the securitization market with the sector’s first AAA rating, from DBRS.

Going forward, DBRS as well as Morningstar Credit Ratings expect PACE production to get a boost from the expansion of improvements eligible to be financed via tax assessments. However, the expansion will primarily benefit providers of PACE for commercial property, as residential PACE providers are struggling under the headwinds of new consumer finance protections in California, by far the biggest PACE market.

Fannie Mae has a mandate from its regulator to offload the bulk of credit risk on residential mortgages it insures to capital markets investors. Yet participation in the company's benchmark risk transfer program, Connecticut Avenue Securities, by an important class of investors has been limited. Real estate investment trusts are considered to be a natural buyer because of their appetite for this kind of risk: They must invest at least 75% of their assets in real estate. CAS, as they were originally designed, did not qualify, however. Though the performance of the bonds was linked to a reference pool of mortgages insured by Fannie Mae, they were technically general obligations of the company.

The latest CAS, which priced in October, is structured instead as a bankruptcy remote trust. Proceeds from the bonds are deposited in various investment accounts; they do not sit on Fannie Mae’s balance sheet. They are only available to the GSE should losses on the reference pool of loans reach a predetermined level.

“This has been a huge goal for us, practically since the beginning of the program,” said Laurel Davis, Fannie Mae’s vice president, credit risk transfer. “It’s a big innovation that has been a long time coming.”

Over the past couple of years, subprime auto lenders have been able to offload more and more of the risk in their loans to investors desperate for higher yields.

Despite the high rate of default among borrowers with poor credit, investors are snapping up billions of dollars of auto loan-backed securities with below investment grade ratings – in some cases as low as single-B. They are willing to do so in large part because lenders are putting up additional loans as collateral for the bonds, and because credit rating agencies believe that this overcollateralization will insulate investors from expected losses.

Problems at Honor Finance, an Evanston, Ill., lender backed by CIVC Partners, show that this form of credit enhancement can’t cure all ills. In July, both S&P Global Ratings and Kroll Bond Rating Agency downgraded the most subordinate securities issued in a 2016 transaction after Honor lost much of its senior management, stopped originating loans, and resigned as servicer. Losses on collateral for the deal are so high that both rating agencies believe investors are at substantial risk of not being repaid.

Honor isn’t alone in using this practice however; analysis by S&P Global Ratings indicates that extension rates at a number of other subprime auto lenders are creeping higher.

Though none are nearly as high as those of Honor, it’s a trend that bears watching, particularly for holders of the riskiest securities issued in subprime auto securitizations.

The Federal Housing Finance Agency ended single-family rental pilot programs that were aimed at testing the need for greater involvement from Fannie Mae and Freddie Mac in the market.

"What we learned as a result of the pilots is that the larger single-family rental investor market continues to perform successfully without the liquidity provided by the Enterprises," FHFA Director Mel Watt said.

As short-lived as it was, the program still had a positive effect, if only because of the buzz that they generated, according to Beth O'Brien, CEO of Corevest

Former Federal Reserve Board of Governors chairman Janet Yellen sounded alarm bells on the $1.3 trillion leveraged-loan market in October.

The ex-capital banker expressed dismay over deteriorating credit quality and maintenance covenants on the business loans extended by Wall Street to junk-rated companies, the speculative-grade segment of U.S. corporate borrowers that have more than $1.3 trillion in outstanding bank loans held by investors, including buyers in collateralized loan obligations.

“There are a lot of weaknesses in the system,” she told the Financial Times’s FT.com site, “and instead of looking to remedy those weaknesses I feel things have turned in a very deregulatory direction.”

She was not alone. The head of risk surveillance and data at the Fed, Todd Vermilyea, used the venue of a New York industry conference to express the Fed’s rising concerns over the rising debt levels of non-investment-grade firms. He also said the board would take a “closer look” at business debt levels that a subsequent Fed financial stability report in November would note had grown to “near-record levels” relative to gross domestic product.

The same report noted that 35% of outstanding corporate bonds were issued from the lowest end of the investment-grade scale, meaning a trove of downgrades could push much of that $2.25 trillion in loans and bonds in junk status.

Much of the rise in loan debt was fueled by investor tolerance for risk because of the high yields available in the class. But the risk appetite sharply dissipated by year’s end.

The year-long warnings took their toll on the market at year’s end, with no high-yield bond offerings issued in November and December, and investors pulling nearly $9.9 billion from actively and exchange-traded loan funds in the final five weeks of the year.

Middle-market CLOs became a favored vehicle for financing non-investment grade rated companies, driven by a push into direct lending by private equity firms.

GSO/Blackstone, Bain Capital and Guggenheim Securities were among a rush of large private-equity firms that launched first-time middle-market collateralized loan obligations, after lengthy experience with issuing and managing open-market broadly syndicated CLOs.

“For businesses that have robust CLO franchises, and have a robust direct lending franchise, it’s kind of natural to pursue something in middle market CLOs,” said Michael Herzig, a managing director with THL Credit, another firm that provides direct lending to lower middle market firms.

The opportunity arose for these firms as banks have retreated from originating SME loans (usually under $100 million), leaving the business to a clubby field of private lenders such as Ares Management, The Carlyle Group, Golub Capital Partners and Churchill Asset Management who originate the loans and collateralize them in middle-market CLOs.

Private equity firms are lining up major capital commitments for middle-market lending. Blackstone, for instance intends to raise $10 billion for direct lending operations through 2019. Direct lending already makes up the bulk of Ares' $87 billion in assets under management for its credit unit.

More private funds were formed in the last year to pursue direct-lending opportunities worlwide: according to Prequin, nearly $80 billion globally (about half of all capital being sought in private funds) were targeted for direct-lending purposes.

Through the end of the third quarter, middle-market CLO issuance had been on pace for a record volume of nearly $15 billion in 2018.