The outlook for new collateralized loan obligation issuance just got a boost.

The Federal Reserve recently put out a report on asset-backed securities that outlines an argument that could provide securitizers more comfort with the still-moribund CLO asset class. That is, if the Fed's recommendations are followed by the Securities and Exchange Commission and the Federal Deposit Insurance Corp.

The Fed issued its risk retention study Oct. 19. This was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which ordered the bank regulator to analyze the potential effects of new rules that will force securitizers to hold more risk in their structures.

The worry by those interested in seeing a return of CLO issuance: that the SEC and the FDIC will interpret the rules so rigidly that they will stifle any revival of CLOs.

CLOs are structured investment vehicles that invest in pools of leveraged loans. At the height of the 2005-2007 credit boom, they represented some 66% of buyers in the asset class that fueled the buyout boom. While easy credit has created a rebound in the junk bond market, new leveraged loan issuance remains low, mainly because nothing has been able to replace the demand that CLOs represented.

Some of this is because many investors in CLOs conflated the structures with toxic entities such as the collateralized debt obligations that invested in subprime mortgages. Investors therefore still refuse to put new money into the CLOs. There's also regulatory uncertainty, as many lenders, underwriters and managers of CLOs have been unsure how accounting rules, capital requirements and risk-retention policies will combine to affect those who take part in the structures.

The Fed's report makes a case for treating various classes of asset-backed securities differently. "This study concludes that simple credit risk retention rules, applied uniformly across assets of all types, are unlikely to achieve the stated objective of the Act -- namely, to improve the asset-backed securitization process and protect investors from losses associated with poorly underwritten loans," the study says.

As Dodd-Frank is written, issuers of asset-backed securities need to hold at least 5% of the risk in the structures. But what that means exactly is open to regulators' interpretation. On one hand, there's the danger that the FDIC and the SEC may ignore the Fed's call for differentiation and instead institute a one-size-fits-all rule. Such a strict reading of the law would force managers and underwriters to hold 5% of each tranche in the CLO -- in other words, pieces of the senior debt, subordinated debt and equity. Such an imposition might make the investments too onerous for managers or equity investors. There's also the problem of capital rules, which would force banks holding positions in CLOs to take big capital hits.

But that would effectively neuter investment in vehicles that have performed much better through the crisis than many of their ABS brethren.

The Fed acknowledges as much by pointing out that there were "very few" actual defaults by CLOs. In fact, many have seen recent ratings upgrades, in contrast with subprime CDOs, which continue to deteriorate. As the Fed puts it, CLOs have done so well because of the way they were structured. "The relative transparency of the asset pool and the relative simplicity of the structures may have also played a role [in limiting CLO defaults]."

CLOs performed well through the crisis because they were structured specifically to reduce risk. Managers of CLOs often held equity in the structures themselves, albeit at a level lower than the 5% being mandated by Dodd-Frank. Moreover, the fee structures for those managers are arranged in such a way as to ensure that they don't get the bulk of their money until all investors in the vehicles get paid back first.

This inherent alignment of interests suggests (although the Fed doesn't say so specifically) that any risk-retention regime imposed by regulators can take a light approach toward CLOs, asking managers, for example, to hold at least 5% of the equity in new vehicles, a slight increase from the norm, but bearable. That's an encouraging sign. As Wells Fargo & Co. analyst Dave Preston says in a recent report: "The Fed's recommendation that regulators attempt to develop different requirements 'tailored' to different types of ABS may help to remove a potential roadblock to new CLO issuance." Only, that is, if all the regulators decide to sing from the same song book.

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