Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name is Stewart Foley, I'll be your host. And today we're talking about the pending changes the NAIC is proposing for the capital treatment of CLOs. We're joined by two experts today from MetLife Investment Management - Angela Best, director of CLO Research, and Francisco Paez, head of structured products research at MetLife Investment Management. Thank you both for being on.
Francisco: Thank you for having us, Stewart.
Stewart: We're happy to have you. We start these off like we start them all. And I'll start with you Angela, what's your hometown, your first job, and a fun fact?
Angela: Okay, I'm going to start with my fun fact. I have flown an airplane and used to take flight lessons. That is when I was more of a risk taker. I've certainly settled down since then. My hometown is Cliffside Park, New Jersey.
Angela: My first job was at Merrill Lynch in credit research.
Stewart: Oh, nice. Francisco, how about you?
Francisco: So my hometown is Quito, Ecuador. My first job. Let's see, my first job when I was a teenager, I actually helped a company that was starting a fax calling list and I was trying to get the fax numbers from a whole bunch of different companies so that we could put together a directory. So it was a “fun” job. Now in terms of fun facts, let's see, I'm into grilling and barbecuing, absolutely love that. And I make a picanha in a rotisserie that will put your average theme Brazilian restaurant to shame. How about that?
Stewart: There you go. What a great fun fact. That's fantastic.
So, there's a lot of energy that's been spent and a lot of time talking about this topic. It's a very important topic for insurance companies. Insurance companies hold something north of $200 billion of CLOs, mostly in highly rated tranches. The NAIC is proposing moving away from ratings-based RBC framework for CLOs to a model-based one. Why are they doing this?
Francisco: I'll jump into that, Stewart. So I think there are a couple of things that are behind, I guess, the initiative here. The first one is the NAIC for many years has stated that it wanted to distance itself a little bit from relying as much on rating agencies overall, and certainly for RBC purposes, so this is very much in line with that. You would recall that right after the GFC, the NAIC stopped use using ratings for RBC determination for both CMBS and RMBS. So, this is fairly consistent with that and continuing with that theme. That's been a longstanding theme for the NAIC. And then I think that secondly there is a concern that structured products have a different economic behavior than some more traditional bond types. So there is some concern that ratings may not necessarily capture those dynamics as precisely as a modeling approach could potentially capture it.
Stewart: And it's interesting, and Angela, I’ll direct this to you, as a major investor in CLO tranches, are you doing anything differently as a result of this proposal, and what has the market's reaction been?
Angela: Sure. So there has really been no change to our approach and our investment thesis on the sector remains the same. When I think about the way we invest, we're investing based on fundamental merits of the security. The NAIC is trying to better align RBC with fundamentals. So we don't expect the proposal to have a material adverse impact on our strategy. What are we doing? We're certainly closely following the development of this proposal. At this stage, we've been examining the NAIC stress test exercises on insurers’ holdings of CLOs in addition to looking at the way that they model CMBS and RMBS for cash flow modeling. And we're trying to understand those frameworks to see what we can glean from those approaches and how best to extrapolate how this recommendation could look in practice for CLOs.
You asked about market participants. The market participants are certainly actively listening to the NAIC. They are, at this stage, just absorbing the limited amount of details of the proposal and they've been thoroughly active and vocal sharing comments and research directly with the NAIC given their comment period. The market wants to ensure that decision-makers are understanding the asset class, are aware of the historical performance so that the blended capital charges are, at the end of the day, commensurate with risk. We have found historically NAIC and also staff are fairly transparent. They've always been open to communication and I think their intention is to have a dialogue with market participants to understand the concerns and any observations we have along the way so that they can take that into consideration as they are designing rules, and also the framework. They want to continue to promote healthy competition, mitigate foreseen risk, and make sure that the market continues to function as it has.
Stewart: Yeah, I mean that's very helpful. And I guess one of the questions I have, Francisco, is just talking about CLOs being singled out. Is that the case? And I think one of the key things that the NAIC is trying to address is this concept of "no arbitrage." Can you unpack what no arbitrage means and is that principle only being used for the CLO asset class?
Francisco: Sure. So what the NAIC is trying to do is: it's trying to make sure that there is consistency in terms of RBC treatment for assets regardless of what form those assets take. What I mean by that is if you have a set of assets that have X% RBC treatment, if you just buy the assets outright, the NAIC is trying to make sure that that same X% or something close to that X% of RBC is consistent if you buy the same assets in the form of a securitization. That is something that's not always the case. There are instances where you could have as an insurance company investing in assets that have a high level of RBC, but if you put them into a securitization vehicle that issues different tranches and you buy the full capital structure from that securitization vehicle, you end up having a lower capital charge than you would if you had bought the assets outright.
And that is the case with CLOs. It's not the only case, but that is the case with CLOs. If an insurance company buys leveraged loans, it's going to get a capital treatment, that's roughly around 9% for the type of rating that you typically find in leveraged loans that go into CLOs. But if you take those loans and you put them in a securitization vehicle, called the CLO, and then you issue bonds and you buy all of the bonds out of that securitization vehicle, roughly the blended RBC for all of those tranches, if you bought them all, would be about a third of what you would have if you actually bought the loans outright. So, that's what the NAIC is trying to at least moderate, reduce, I don't know if it's necessarily possible to have the exact same number, but something that would be materially similar to if you bought the assets outright. So that's the concept of ‘no arbitrage’ that the NAIC is looking to achieve here.
Now, are CLOs being singled out? I don't think that CLOs are being singled out. First of all, the idea to model CLOs is just a logical progression from the NAIC, that started with CMBS and RMBS. If you think about the different structured sectors that are homogenous in nature or generally homogenous, I think that CLOs is a great candidate to just take that next step in terms of using modeling for RBC determination. So certainly not singled out given the precedent in RMBS and CMBS. Now in terms of the ‘no arbitrage’ principle, this is something that was recently introduced and it was introduced in the context of this effort with CLOs. But I don't think that this is something that the NAIC is looking to achieve exclusively for CLOs, but something that is looking to be more broadly achieved.
Now when I think about CMBS and RMBS why haven't we seen that same principle being discussed given that CMBS and RMBS are already modeled? I think that the reason is that if you take roughly the RBC that you would get in the assets for those securitizations and then you take the blended RBC of the bonds that are issued by an RMBS or CMBS trust, you're going to see that the absolute difference is not large at all. Both of those numbers are very close to each other. So I don't think that the NAIC for those asset classes had felt that there was a need to do something that's different. So I don't think that you see the same discrepancy that we have in CLOs. I think that CLOs will be the first step, but I would imagine that the NAIC wants to look at this concept a little bit more broadly.
Stewart: That's really helpful and I appreciate you kind of breaking that down for us, that concept generally. I mean it makes sense to me, right? It stands to reason. So Angela, when we talk about the proposal and the CLO market itself, do you anticipate dislocation in the CLO market? You'd mentioned that there's a lot of transparency among the NAIC staff and so forth. How do you see this playing out?
Angela: I think we'll have to see more details around the staff's recommendation to be able to conclusively determine what that impact is on market dynamics. Based on our educated guess on how the NAIC may model CLOs, we don't think that the final outcome would cause some form of a wholesale pullback on purchases of mezzanine tranches. I think we'd expect more of a marginal shift in the insurance buyer base for triple Bs, double Bs and equity just as a simple result of the higher expected capital charges. Since we think those tranches are going to really bear the brunt of the higher capital. CLOs will likely continue to offer a competitive return. I think insurers are going to continue to support their affiliated CLO management businesses through equity investments as needed, when needed, as they have in the past. If you look at the overall market, the market has grown significantly, it's reached over $1 trillion globally, and we certainly think that's meaningful evidence to signal a maturing asset class, and it continues to gain broader market participation. The investment space, when you look at it's primarily banks both domestic and international, followed by insurance companies, asset managers, funds, and BDCs.
So when you take a look at that composition, and we've actually had experiences, in the past, where you've had a large market participant such as Japan, or this past year, the US banks to bolster their balance sheets, who have pulled back with their investments and the market has continued to function. So when you actually start to drill down and look at ownership by rating, let's say particularly double Bs and equities, the base starts to thin and becomes more heavily concentrated towards asset managers including that of CLO managers and funds. Naturally, those buyers are more active, they also have higher yield targets.
So, I think those categories will continue to maintain a large market share and I think the market will continue to recalibrate and function. I think dislocation would be a harsh turn, but I think we still need to see more details to see the magnitude, but I think it will be somewhat marginal with regard to insurers depending on their profiles and their investment target.
Stewart: One of the things that's been discussed elsewhere, not on this podcast, but the growth of the asset class. I mean it's been a favorite among insurers. And, it seems as though that there's a lot of talk around this, but it's good that there is this dialogue, right? There seems to be plenty of time for the market to anticipate that.
So, Francisco, when we talk about investors trying to anticipate the potential impact of the NAIC on their portfolios, what should they be looking for? I mean obviously staying on top of these regulatory shifts is important. What would you tell a CLO investor to be looking out for today?
Francisco: I think as Angela mentioned, there are still a number of details that need to come out from the NAIC, so we need to reserve judgment until all of those come out. But in general, I think that investors need to understand what the NAIC is trying to accomplish here. And what the NAIC is trying to do is it's trying to say, okay, show me what happens to a CLO tranche over a number of different economic scenarios. So, an investor can come up with a set of different economic scenarios that can go from a very optimistic scenario to a very pessimistic scenario and then just model that CLO using some of the standard market tools available, and see what happens to that tranche. The NAIC has been incredibly transparent with its methodology around modeling RMBS and CMBS. We'll have to see whether or not the modeling of CLOs mimics exactly RMBS and CMBS modeling, but I think it's likely that it will follow some of the same themes. So one can actually look at that methodology, see how they come up with the projections for losses, how that then gets translated into an RBC mapping and try to apply that to a CLO.
So, an investor that can run all of those different scenarios and then try to map that CLO to an RBC and see how does that compare to what I have today. If I did it that way, is it worse, is it better than using ratings? We have done that exercise internally and try to just guesstimate, at this point, that's the best that we can do, and try to guesstimate what happens if the NAIC finalizes this proposal. And what we found was that, and Angela was alluding to this in general, senior tranches, meaning triple A down to single A, don't really see much of an impact from going from a ratings-based to a model-based approach for RBC.
Really you start to see the impact on the lower part of the capital structure, so triple B and lower, and it's progressive. If we look at the triple B impact, we don't think that it's going to be dramatic. We think that there is likely to be an impact there. I don't think it's going to be dramatic. I think that triple B tranches will continue to be attractive from an ROE standpoint, even with the modeling approach getting implemented. But then it gets increasingly more punitive as you go down the capital structure, and really the equity tranche is the tranche that is most likely to be affected.
So, that is what we did internally. We actually put out a paper over the summer discussing in detail how an investor can do that. But this is what I think that the CLO investors, particularly insurance companies, can and should be looking at, particularly as we see the NAIC come out with more details, I think that that's going to allow market participants to really dial in their expectations a little bit more.
Stewart: Yeah, and I should have mentioned this earlier, but MetLife Investment Management has just published a paper on our site as well on this topic But Angela, you've invested in CLOs for many years. You're an expert in the space, without a doubt. So we need more details, but do you see your CLO strategy changing? Or, how do you think these proposed changes may impact your strategy on CLOs going forward?
Angela: I think the potential impacts of individual insurance companies at this stage are still unclear and we need more details, but when we think about the way we manage portfolios, I don't expect the material impact to the way we manage portfolios or to our investment strategy. Insurance companies have multiple and varied objectives within their investment decision. We think about asset liability matching, where are we getting income generation, how do we continue to diversify our portfolio? And I think capital efficiency is a consideration, but not the sole driver. Because of these, I think, varied objectives, there's really no one hard-and-fast rule regarding which investments are going to meet insurance companies means and which ones don't.
I think our strategy overall really has remained consistent. We've generally focused on a diversified portfolio of higher-rated assets. We have been more opportunistic looking at mezzanine tranches, triple Bs and double Bs when the value is there and when the credit profile of the collateral is compelling. So I think overall we'll continue to track and monitor the progression of the proposal. I don't believe there's going to be a big change in the way we operate. And I think insurance companies are going to have to continue to evaluate the overall investment merit, and capital charges are going to be one component of that. The way we look at it from an investor perspective, not only us, but there's been a lot of long-time investors in this space with investments across the capital stack. So if you think about CLOs and we talked about the performance, the structural protections and the overall value, I think it would be hard to have some form of a wholesale pullback. I think there's going to be marginal changes, but I don't think anything is going to be material at this stage. But we'll certainly look for more details to come out from the NAIC and that proposal and see where that takes us.
Stewart: Thank you. And just as we wrap here, I want to take you back to where we started the podcast. Which is, Francisco, you mentioned you started life in Ecuador and I was a professor for a number of years and there's often folks who are earlier in their career listening to the podcast, so I started with Angela on my icebreaker, so I'll come to you at this one.
So, as you look out at a complicated landscape right now across the capital markets and look at the insurance industry in general, I'll take you back to when you were early in your career, what advice would you give your 21-year-old self today?
Francisco: That's a great question, Stewart. Let me see here. I think that the advice would be, look, you need to be certainly really good technically speaking on whatever it is that you do. So certainly take that to the highest level that you can, but don't forget sort of the softer side of things and of business. We're in the business of people, so from that perspective, certainly invest your time in developing those softer skills, be it communication, be it relationship skills, leadership skills, all of those are really important and as you progress in your career they're going to be increasingly so.
Stewart: And Angela, you've started in New Jersey, what would you tell your 21-year-old self?
Angela: I would say that networks matter and it's very important to continue to develop through networks not only internally, but externally. And not only within your respective asset class, but across many asset classes across different sectors. And then I'd also say credentials matter. Where you go to school, having an MBA, having a CFA if you're within the finance industry. I think you need the credentials, you need the network, and then it all comes together.
Stewart: Great advice, great education on the NAIC's proposed changes to treatments in CLO capital charges with Angela Best, director of CLO Research and Francisco Paez, the head of structured products research at MetLife Investment Management. Thank you very much for being on. We learned a lot today. Thank you.
Francisco: Thank you for having us, Stewart.
Angela: Thank you.
Stewart: It was my pleasure. Thanks for listening. If you have ideas for podcasts, please shoot me a note at podcast@insuranceAUM.com. My name's Stewart Foley and this is the insuranceAUM.com Podcast.
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