Despite considerable pressure from Capitol Hill, it does not appear that regulators charged with implementing the Volcker Rule plan to make it easy for new collateralized loan obligations (CLOs) to hold bonds.
The Volcker Rule rule prohibits U.S. banks, which are important buyers of CLOs, from having an ownership interest in a securitization backed by anything other than loans. CLOs have typically allocated a small portion of their assets to bonds, in part to help juice up returns. And because of the way that “ownership interest” is defined in the rule, banks are unable to hold the senior tranches of debt issued by CLOs, which give holders the right to fire manager for cause.
The industry’s lobbying efforts have worked at the legislative level, resulting in the Barr bill, which was introduced by Rep. Andy Barr, R-KY., and passed the House Financial Services Committee on March 13, with remarkably strong bipartisan support, by a vote of 53 to 3.
The proposed legislation would do two things: First, it would partially grandfather older CLOs because banks would not need to divest CLO debt securities issued before February of this year until July 21, 2017, even if they constitute “ownership interests.”
Second, the legislation clarifies that an “ownership interest” does not exist in cases where CLO managers can be fired for a material breach of contract
Even this might not provide the relief that CLOs are looking for, however.
“The agencies have taken a position, which they’ve expressed to a number of banks, that they think there are other issues with CLO notes, including excess spread,” said Elliot Ganz, general counsel for the Loan Syndications and Trading Association, who has been meeting regularly with the regulators. “So if you get the relief that the bill gives you, but the agencies take the view that it doesn’t matter, there are still ownership interests because of B, C, D, and F, you’ve got to divest anyway.”
So the Barr bill—which still needs to be passed by the full House of Representatives and Senate and signed by the president—is that the grandfathering provision would solve the market’s most dire problem: the looming sell off by banks of as much as $70 billion of CLO senior notes. But it wouldn’t really change anything for new CLOs; they still wouldn’t be able to hold bonds.
Under the first provision, all CLO 1.0s (those assets created before the 2008 financial crisis) would be grandfathered since they are all projected to be repaid or refinanced by 2017 anyway. Banks would not have to divest CLO 2.0s (those deals created from 2010 through February) until 2017. And while some of those deals would not be fully protected since they are expected to be around until at least 2020, the 2.0s are structured more conservatively, with 10% bond baskets that very few of them are actually using, Ganz said.
After slowing in late December and January following the release of Volcker, the CLO market began to pick up significantly in February, with most deals issued with “springing bond buckets,” or the ability to invest in bonds if there is clarification of the ownership language. Since it does not appear that regulators will be offering CLOs that “out,” new CLOs are likely to avoid bonds altogether. Despite new entrants such as asset managers and insurance companies who’ve been lured by the relative value of CLO triple-A spreads, the market still depends on banks to take down large portions of the triple-A tranches.
“Every time you hear that a big player is out [of the market for a while], spreads go up,” one CLO manager said. “When that big player is back in, spreads come down. The market isn’t deep enough to afford the loss of one of those guys without it impacting spreads and volume.”
The good news for now is that, at this point in the cycle, forgoing bonds may not be such a big deal, portfolio managers say, because they can find plenty of yield pick up with second-lien loans. Second liens have actually been outperforming high yield bonds for the last couple of years, which likely explains in part why CLO 2.0s haven’t been filling the bond bucket. And while second liens have seen some spread tightening [see accompany chart], they still offer quite attractive yields.
Over the last couple of years, “I don’t think so much of the bond basket has been used, so during this part of the cycle it’s been less important to have that ability,” said Lauren Basmadjian, a portfolio manager with Octagon Credit Investors who manages both CLOs and separate accounts. “But I think it’s short sighted to believe that it won’t eventually be a very important capability for CLOs to have. Right now, buying second liens makes more sense, but two years from now, there could be a lot of value created for equity and debt investors alike being able to use that bond basket.”
Meanwhile, the ball now moves back into the regulatory court. And Ganz said he expects lawmakers to give the interagency group—which includes representatives from the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Commodities Futures Trading Commission and the Securities and Exchange Commission—a certain period of time to come up with a regulatory solution to the CLO issue before taking up the Barr bill again.
“The real value is that the bill was passed 53 to 3 by the House Financial Services Committee,” Ganz said. “In this day and age, there’s not a lot in Congress that gets such strong bipartisan support. In our view, this two-year extension says to the agencies, We don’t want this market disrupted. We all agree there’s a problem; go fix it’.”