Spreads on collateralized loan obligations have tightened a bit in recent weeks, and the pace of issuance is picking back up, as participants gain some confidence that rules restricting bank investments in these securities will be eased.
Ironically, this improved pricing could spur smaller banks to divest their CLO holdings now, to avoid incurring losses if they have to sell at a later date, according to Fitch Ratings.
In a report published today, the rating agency said that smaller banks would be more affected if the Volcker Rules’ prohibition on owning CLOs is not diluted. That’s because CLOs constitute an outsized portion of some banks' securities portfolios. So their capital and profits would be more affected by forced sales.
Smaller banks more exposed to CLOs include Florida Community Bank with 36% of its securities portfolio in CLOs at end-2013 according to data from Highline Financial, NexBank (35%), Bank of Orchard (25%), Stifel Bank (23%) and Sun National (17%). The impact would depend on the extent to which the CLO portfolio is compliant with the Volcker rule.
Small banks may prefer to sell sooner rather than risk a potential CLO fire sale by all banks near the rule's final implementation date if it is not relaxed, the report states. Florida-based BankUnited, for example, sold its entire $431m CLO portfolio in December 2013, taking a new loss of $1.4m.
Even if an exemption is made so banks can hold CLOs, or if some legacy holdings are temporarily grandfathered as in the Barr Bill approved by the House Financial Services Committee on March 14, small banks may still sell their positions given that secondary market pricing for CLOs has improved.
CLO exposures at the largest banks appear less concentrated. JP Morgan and Wells Fargo, which held over 70% of the $67bn of bank-held CLOs at end-2013, had CLO portfolios between 8% and 9% of total securities. Large banks have greater financial flexibility to adapt once the rule is clarified. But higher regulatory capital charges under Basel III proposals for certain CLO exposures may cause large banks to further re-think the composition and size of their overall CLO portfolios.
The issue is that most CLOs include bonds, usually to boost yields, and this means that they are treated as “covered funds” under the Volcker rule, finalized in December 2013. Since banks will be prohibited from holding such funds, this could have the unintended consequence of damaging the corporate loan market as CLOs provide nearly a quarter of outstanding loans to US companies, according to the Loan Syndication and Trading Association.
U.S. regulators are clarifying and potentially easing prohibitions surrounding CLOs. A key point of consideration in this process is whether a CLO bondholder's right to remove or replace a manager for cause constitutes an ownership interest.