Foreign banks can hold them, and don’t have to fold them.

That’s the takeaway from Federal Reserve guidance released last month on foreign-owned banks and CLOs: These institutions can acquire and retain ownership stakes in certain collateralized loan obligations that are off limits to their  U.S. counterparts as the result of the Volcker Rule.

In a Feb. 27 “FAQ”, the Fed clarified a SOTUS (“Solely Outside the United States”) exemption under Volcker permits non-U.S. banks to invest or trade in so-called “covered funds,” which since December 2013 have included collateralized loan obligation issues containing tranches of unsecured notes (or bond buckets).Banks, including foreign institutions, have been studiously selling off investments or amending existing CLO portfolios into “loan-only” structures to bring them into compliance with Volcker. But with the Fed’s new guidance, say market sources, foreign banks – particularly in Europe – will have more freedom to retain and invest in non-compliant CLOs in the U.S.

“While European banks may not have been big 2.0 investors, to the extent they had qualms about investing in European non-Volcker compliant CLOs, they probably feel safe to make such investments now,” stated the Loans Syndication and Trading Association, in a newsletter published last week.

“While the SOTUS exemption might be a positive, but not life altering, step in the U.S., it should be an unalloyed good in Europe,” the newsletter also stated.

European banks have been skittish on investing in U.S. CLOs issued prior to 2014 that hold buckets of bond investments, according to market sources. U.S. banks holding such assets themselves have until July 2017 to excise the bond holdings through negotiations with issuers or to divest them from their portfolios – likely at fire sale prices at that point.

 Before the guidance was issued, many legal advisors to non-U.S. banks had to weigh whether investing in non-compliant CLOs in the U.S. – even through non-affiliated, third-party sponsors – constituted a breach of Volcker.

Many in the market believed that the SOTUS exemption was only specified for banks marketing covered funds outside the U.S., but was silent on the matter of whether a bank could invest under the exemption through a covered fund built and managed by a third-party hedge/private equity fund or CLO manager.   

Partners at international firm Allen & Overy, for instance, had formerly cautioned non-U.S. banking entities about investing in covered funds “absent such a fund meeting a specific exemption. “The [new] FAQ clarifies that the restriction and the offering and sale to residents in the United States applies only to the marketing activities,” not to arm’s length arrangements through third parties, the firm stated in an alert following the guidance’s publication.

So long as the bank keeps its distance in the promotion of the funds, the prohibition does not apply. That means a foreign bank can’t service as a manager, advisor, commodity pool operator or commodity trading advisor to a covered fund, according to a client alert from law firm Morrison & Foerster.  

The new guidance “provides long-awaited and sought-for relief to foreign banking entities. Without this critical guidance, foreign banking entities had been concerned that the practical use of the SOTUS covered fund exemption would be severely limited,” the alert stated. “Many foreign banking entities are reported to have widely invested in third-party funds that would meet the SOTUS covered fund exemption but for the uncertainty surrounding the marketing restriction.”

So long as a foreign bank has a “majority of banking activity” outside the U.S. institutions can qualify for the SOTUS exemption for their CLO interests, according to David Preston, a senior analyst with Wells Fargo Securities, in a March 13 CLO Lagniappe report that looked at the new FAQ guidance.

Despite the relief granted through the guidance, it does not necessarily portend a major change forthcoming shift of older CLOs to European or other foreign-bank hands, according to the LSTA. U.S. banks will still seek out amendments for their non-compliance CLOs on the books – since those that aren’t amended by July 2017 would have to be divested, likely at discounts. It was estimated last year banks would need to divest of more than $70 billion in CLO senior notes.  

As more CLOs are re-negotiated, this leaves fewer and fewer non-compliant CLOs in the market available for trading. And there would be few CLO buyers to trade with the European banks other than in non-U.S. circles.   

“Many non-European foreign bank investors theoretically would not need to seek these amendments. However, market participants say such notes would become less liquid because the buyer base and market makers would be limited,” the LSTA stated in its newsletter. “Therefore, even though the non-European foreign banks might not need to seek amendments, they may still choose to do so.”

European banks are also still subject to retention rules in the European Central Bank zone, and “[o]n the market making side, due to prohibitive capital charges, U.S. banks still probably won’t make markets in non-Volcker compliant CLOs,” the LSTA also noted. “European banks might be able to step up and make markets, but it might have to be from overseas – and it’s not clear whether that’s viable.”

But even in “limited fashion,” the SOTUS exemption will relieve foreign banks from being “forced to divest” their holdings, the LSTA newsletter said. “If there’s going to be a fire sale, it’s definitely better to have a smaller fire sale.”


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