It’s official: The leveraged loan industry has avoided the worst of the Volcker Rule.
Regulators were originaly considering subjecting loans to a ban on proprietary trading by banks. And the original draft prohibited banks from trading or lending to collateralized loan obligations.
But the final rule released Dec. 10 by the Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp. and Commodity Futures Trading Association excludes syndicated loans from a ban on proprietary trading. This exclusion also applies to bridge loan notes, short-term financing meant to backstop borrowers until they can access the high yield bond market or other, more permanent financing.
The final rule also exempts certain CLOs from the definition of a “covered fund,” meaning that these CLOs are not subject to the ownership or transactions limitations of the Volcker Rule. So banks can still provide warehouse financing for these transactions and make a market in their assets and liabilities.
“This concludes an almost threeand a half year odyssey and appears at first glance to be a very positive result for the loan market and the LSTA (albeit with some important issues to be worked out),” Bram Smith, executive director of the Loan Syndication and Trading Association, an industry trade group, said in an emailed statement.
The LSTA will host a webinar on the rule for its members on Dec. 18.
CLOs are important buyers; the nearly $300 billion market accounts for around 45% of all institutional investments in below investment-grade corporate loans, according to the LSTA.
However, the carve-out only applies to CLOs that meet the definition of “loan securitizations” and do not hold assets other than loans, short-term cash equivalents and related derivative.
That means CLOs with any investments in securities, including bonds and CLO notes, are considered “covered funds” and subject to the ownership and transaction prohibitions. (Loans are not securities.)
Currently, most CLOs do hold significant investments in bonds or other securities. This is partly because competition for loans from mutual funds and other investors has been growing and CLO managers may find it difficult to source enough collateral for deals.
Corporate bonds can be an attractive substitute, particularly if they are issued by the same borrowers accessing the loan market. CLOs may also receive equity or other securities in exchange for loans they hold if the borrower undergoes a debt restructuring or bankruptcy.
Also, to be eligible for the “loan securitization” carve-out, a CLO must own the loan directly; a synthetic exposure to a loan, such as through holding a derivative like a credit default swap, will not satisfy the conditions for the exclusion.
The Volcker Rule is effective on April 1, 2014, but the Fed announced it will delay the end of the conformance period by one year, until July 21, 2015. The LSTA said this means that banks would have until July 21, 2015 to divest their holdings in CLOs that do not meet the requirements of a “loan securitization.”
Just banks might have to sell is an open question. In a report published Dec. 13, analysts at Barclays said it is clear that banks will not be able to hold equity tranches of non-exempt CLOs in any material size, since that would constitute an ownership interest. However, they said it is less clear whether banks would have to shed their senior tranche exposure in non-exempt CLOs.
The rule spells out seven conditions deemed to represent ownership interest, according to Barclays. The first pertains to the right to select or remove CLO management. “While senior tranche owners do have this right, it is almost never an unconditional right and typically requires a cause such as default or gross negligence conditions that may be covered by an exclusion in that first ownership interest condition,” the report stated. “Thus, under a favorable read of the ownership interest definitions, banks could continue to hold senior tranches of both exempt and non-exempt CLOs.”
Under a less favorable reading, Barclays thinks that banks there would be at least two options for banks to hold AAAs of non-exempt CLOs. “First, CLOs holding high yield and other securities could swap that collateral for loans, making the structure exempt,” the report stated. “Naturally, the drawback of this approach is that effecting this type of swap would lead to lower collateral spreads, negatively affecting equity tranche returns. While the effect is not very large a back-of-the-envelope calculation with 10x leverage, 200bp lower spread, and 2.5% weighted-average high yield bucket size implies a 50bp hit to equity it comes at a time when equity returns are already being squeezed.”
A potential second option would be for banks to waive their rights to affect the management of the CLOs in which they hold senior tranches. “In some cases, as for banks holding AAAs as part of a basis package, they may have already transferred their rights to a third party; for others, irrevocably waiving such rights with the CLO trustee could also be a potential remedy.”
New CLOs might try to avoid the issue altogether by eschewing high yield bond and compensating with larger allocations to second-lien loans, according to Barclays.
Even if it’s breathing easier about the Volcker Rule, the loan industry is still facing other regulatory headwinds. Issuance of CLOs may be hit by proposed risk-retention rules that require sponsors of these deals to onto a portion of the debt issued. The LSTA has asked regulators to take into account the kind of debt bundled by CLOs, the robust underwriting process and that fact that virtually all CLO managers are registered advisors subject to strict federal securities laws. The LSTA has warned that smaller CLO managers would be unable to issue new deals under the proposed rules, and that the resulting consolidation would make it more difficult for companies to obtain financing.
Some $75 billion of U.S. CLOs were issued through November of this year, making it the third-highest year on record, trailing only 2006 and 2007, according to Wells Fargo. Analysts at Wells expect issuance to moderate next year, to around $60 billion, partly as a result of risk-retention rules and other regulations making it less attractive to either manage or own these securities.
Other analyst think issuance could be higher as managers pull deals forward in advance of the regulation. Barclays expects 2014 issuance to be in the range of $75 billion to $80 billion. With some $40 billion—$45 billion of CLOs expected to be redeemed or amortize in 2014, the market would still grow by about $20 billion, however