It could have been a lot worse.
Final rules implementing the Volcker Rule remove many obstacles to securitization compared with the initial version, though they will likely make trading in many asset-backed securities less liquid. The rules are also likely to disadvantage private-label residential mortgage-backed securities (RMBS), even as the government seeks to attract more private financing to the housing market.
Enacted as part of the Dodd-Frank Act, the Volcker Rule prohibits banks from engaging in proprietary trading and from sponsoring or holding ownership interests, or lending money to hedge funds, private equity funds, and other funds that rely on an exemption to the Investment Company Act of 1940.
As originally proposed in 2011, asset-backed commercial paper (ABCP) conduits, collateralized loan obligations (CLOs), and certain lease and equipment securitizations that rely on such an exemption would have been classified as “covered funds.”
Most ABS Qualify for Exclusion
In the final rule, issuers of asset backed securities that hold only loans and qualifying ABCP conduits are not covered funds. The preamble to the rule states that the regulators believe this exclusion applies to a “significant majority” of the securitization market, including residential mortgages, commercial mortgages, student loans, credit card receivables, auto loans, auto leases and equipment leases.
In addition, many bank securitizations that may not qualify for these exclusions to covered funds could still qualify for a separate exclusion for wholly owned subsidiaries and joint ventures. This could provide relief for securitizations of some more esoteric asset classes, such as time-share loans, container leases and receiver advances.
Banks May Have to Shed CLOs
However, to qualify as a loan securitization, a trust may not own any equity, bonds or other securities. Trusts must also own the loans directly; a synthetic exposure to a loan, such as through holdings of derivatives like credit default swaps, will not satisfy the conditions for the exclusion. This is an issue for two types of securitizations that banks not only securitize, but hold in large quantities: CLOs and collateralized debt obligations backed by trust preferred securities (Trups CDOs).
Currently, most CLOs do hold significant investments in bonds or other securities. This is partly because 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.
Since the final rule does not grandfather existing assets, banks must dispose of their holdings in CLOs backed by equity or debt securities before it takes effect in 2015. The Loan Syndications and Trading Association (LSTA) has warned that this could disrupt both the market for CLOs and non-investment grade corporate loans, making it more expensive for companies to borrow. Banks own $60 billion to $70 billion of CLO notes, according to the LSTA.
Just what banks might have to sell was an open question as ASR went to press. Ownership rights are typically associated with the equity, or most subordinated tranche of securities issued by an entity. However, many CDOs and CLOs provide rights to a “controlling class” of senior debt security holders, allowing them to participate in the selection of the investment manager or investment adviser. This creates the potential for holders of these securities to be considered to have ownership interests as well. And bank holdings are concentrated in these senior CLO securities.
The LSTA, along with the Securities Industry and Financial Markets Association, the Structured Finance Industry Group and the Financial Services Roundtable, has asked joint federal regulatory agencies asking them to confirm that CLO debt securities that have the right to replace a manager for cause should not be considered “ownership interests” under the Volcker Rule.
Banks are also big holders of Trups CDOs, and the publishing of the final rule prompted several banks to unload their holdings of these securities at substantial losses. The American Bankers Association has challenged the Volcker Rule in court. (See accompanying article).
ABCP Conduits Also Spared
The final rule provides a specific exclusion for ABCP conduits, which often hold loans indirectly, in the form of variable funding notes or other ABS backed by loans. To qualify for the exclusion, however, conduits must hold only loans or ABS supported by loans, and they may only issue securities with a legal maturity of 397 days or less. Also, the sponsors of ABCP conduits must provide unconditional liquidity coverage. That means the bank must agree to step in and repay maturing commercial paper issued by the conduit in the event of losses in the underlying assets.
Currently, not all banks with ABCP programs provide full support, according to Fitch Ratings; some provide partial support’ contracts where they advance cash to commercial paper holders in the event of mismatch of the timing of interest payments on the collateral and payments on the commercial paper. But partial support contracts do not obligate banks to make good on defaulted assets.
However, Fitch expects that sponsors providing partial support will convert to full support over the next several months. “Many sponsors have already restructured to issue under different legal exemptions and developed the ability to issue liabilities in addition to traditional ABCP-like callable, putable and investor-option extendible notes for liquidity coverage management purposes,” it noted in a Dec. 12 report.
Market Making Redefined
Another key improvement in the final rules is the definition of a market maker. The original proposal required banks to provide two-sided quotes continuously, problematic for less liquid types of ABS. The new version requires them to be willing to buy and sell in a specific asset class. “The original definition was taken from the equity securities world and it didn’t work well in the fixed-income market, where there are hundreds of thousands of CUSIPS,” said Hardy Callcott, a partner at SidleyAustin LLP.
The new rule also permits underwriters to hold cash and “permissible” securities and derivatives in the securitization. Those securities, said Cindy Williams, a partner at Dechert LLP, include cash equivalents such as Treasuries as well as securities the securitization trust might obtain from a work out of defaulted assets or a remedy for distressed ones.
“And with respect to [over-the-counter] derivatives, a bank is permitted to hold interest-rate and currency hedges that are directly associated with the risks of the securitized assets,” Williams said.
A major bugaboo left in place leaves private-label RMBS at a distinct disadvantage to RMBS issued by government sponsored Fannie Mae and Freddie Mac.
The final rule significantly reduces the types of data banks will have to collect and maintain to show that their market making activities reflect customer demand and are not proprietary bets on the movement of security or derivative price. However, noted Callcott, banks will still require new compliance staff, must estimate customer demand to justify market making activity, and independent testing will be required, as will the CEO’s certification.
“It’s a very burdensome compliance regime to set up,” Callcott said, adding that government, agency and sovereign bonds are exempt from those requirements. “In the ABS world, this is a huge advantage for Fannie and Freddie. ABS issued by a private company counts as a corporate, so that’s a real, competitive disadvantage for private-label RMBS.”
The Volcker restrictions arrives at a time when officials in Congress and the executive branch have expressed support for shifting more mortgage financing to the private sector. Fannie and Freddie announced Dec. 16 that they will charge higher fees to guarantee loans to borrowers with lower credit scores or low down payments. The move, which increases interest rates on these loans, is designed to make them more attractive for private investors to securitize.
A former director of the SEC who worked on the Volcker Rule said that its requirements present a headwind for the private-label market. “On balance, I think it will be challenging at some level for non-government or non-agency securities, but it’s still too early to tell whether it will impact the market in a meaningful way,” this person said.
Underwriting Exception Unhelpful
The other major exception to trading restrictions besides market making is for underwriting transactions. However, the off-the-run nature of many structured finance deals could make it challenging to benefit from it.
The former SEC official said that, prior to Dodd-Frank, banks could underwrite transactions and essentially sell the securities when it was most advantageous or profitable. Under the Volcker Rule, they can’t underwrite more than they reasonably expect to sell to their customers, and that means they will have to develop a process to deal with securities that take longer to sell or, for whatever reason, become difficult to sell. For highly structured transactions, this person said, banks could ascertain demand from interested clients. But unlike investment-grade corporate bonds and equities, there may be few comparable products that a bank can use to bolster its case.
Wall Street, of course, has been prepping for the Volcker Rule almost since the get-go, shedding high-risk assets such as hedge funds and private equity funds and paring inventories of securities and derivatives. The big investment banks have also downsized their trading desks. Ron D’Vari, chief executive of New Oak Capital, said these desks are instrumental in moving large blocks and stepping in as the buyer of last resort when securities become undervalued.
Those trading desks were targeted by regulators because of the leverage they typically used and the risk they posed to the banks. However, they’ll likely be sorely missed when the private-label RMBS market picks up and the balance sheets of hedge funds and other specialty funds where those traders now reside are insufficiently large to take up the task.
“In a more normalized world, where the volume of non-agency mortgages becomes comparable to the past, then you will need bank participation to facilitate and move trades,” D’Vari said.
The Volcker Rule has already had a significant impact on the buy side. Dave Graetzer, head of the fixed-income trading desk at Advantus Capital Management, said that investment banks now use their own principal to facilitate fewer large trades and instead seek to match up buyers and sellers on an agency basis. In addition there’s significantly greater dispersion of bids, indicating some banks’ lack of interest in purchasing the securities, “so I’m unable to sell them at what I think is a competitive bid,” he said.
Graetzer added that waning liquidity, stemming in part from the Volcker Rule, and the threat of volatility that would exacerbate illiquidity prompted Advantus to shift the composition of its portfolios toward more liquid assets.