Regulators extended, by two years, the deadline for banks to conform their holdings of collateralized loan obligation holdings to the Volcker Rule, but the extension comes with a big catch: not only is it temporary, but it is not available to everyone.

A fight has been brewing over a provision in the Volcker Rule that could force banks to sell off billions of dollars in CLO holdings before it goes into effect in July 2015.

The rule, which is designed to restrict banks’ investment in hedge and equity funds, determines that institutions have an “ownership interest” in such funds they have a vote in removing management.

Because senior debt securities issued by CLOs include the right to fire the investment manager for cause, some have argued that banks can no longer hold those assets once the Volcker Rule goes into effect.

In an April 7 press release, the regulators said they would give banks until July 21, 2017 to “conform their ownership interests in and sponsorship of CLOs to the statute.”

This was not the work-around that many were looking for.

Rep. Scott Garrett, R-N.J. issued a statement objecting to the compromise before it was even public. He noted that banks would still be forced to sell off their holdings, they would just have more time to do so. This ‘fix’ is no fix at all,” said Garrett, the chairman of the House subcommittee on capital markets. “The underlying facts remain the same. Whether it is today or two years from now, this rule will force small and large banks to needlessly write down or hold a fire sale of these performing assets — potentially creating huge bank losses and making our financial system less safe and less sound.”

The House Financial Services Committee has held several hearings on the issue, and the panel passed a bill last month with near unanimous support that would grandfather many CLOs issued before February and clarify the types of commercial loan pools subject to the rule going forward.
Garrett pointed to that legislation, arguing that lawmakers have already signaled how they would like to see the problem solved.

Then, on April 23, Elliot Ganz, an executive vice president and general counsel of the Loan Syndications and Trading Association, told participants at an industry conference of an even more troubling limitation. Ganz said that the Federal Reserve had confirmed that the two-year extension only applies to the original owners of the CLO notes, and would be revoked upon the sale or trade of the securities.

That means new owners will still have to ensure that their holding are Volcker-ready by the original July 2015 deadline—a policy that will only further complicate banks’ effort to divest the securities.
Ganz, who was speaking at a conference sponsored by Information Management Network, said the edict will also make it prohibitively expensive for banks to take these securities into inventory in order to provide liquidity to sellers of CLOs. 

“The problem is the dealer will not take it into inventory because it’s going to cost him 100% capital. Maybe even, believe it not, more than 100% capital,” he said. “So they’re just not going to willy-nilly take that into inventory. The market’s going to be slowed down much more” without the portability of the extension.

Ganz said the LSTA and other industry groups learned only this week of the Fed’s stance on applying the exemption to issuance, not ownership, It comes just as the CLO industry is undergoing heated rhetoric from critics at regulatory agencies and the media, as well as dealing with new challenges the Volcker Rule application is having on the treatment of CLO securities on banks’ books. 

The two-year extension was designed to allow banks more time to divest or their restructure forbidden CLOs, and also avoid flooding the CLO market with distressed-price securities from among the more than $70 billion of CLO holdings on banks’ books.

Calling the realization “incredibly disturbing,” he told attendees that the LSTA still hopes to change the Federal Reserve’s interpretation, since the formal extension of that policy won’t take place until August. “So hopefully we get another bite at the apple and try to persuade them this is a very bad idea.”

If that happens, it might be a rare success that the LSTA, the Financial Services Roundtable and other industry groups have had in gaining banks some quarter from the Volcker Rule pressure on CLOs. Sairah Burki, director of asset-backed securities policy with the Structured Finance Industry Group, described some of the lobbying efforts that she and other securities and finance groups made to persuade the Fed to exempt CLO holdings from the Volcker Rule—much like the Fed did with trust-preferred securities.

Burki said that regulators discussed the bonds issue with SFIG and LSTA at a meeting over the holidays, even suggesting ways to allow CLOs that had at least 90% loans and small bond buckets. But the ultimate decision was to exclude bonds. “We think regulators are pretty much done, pens down on this issue,” she said.

Whether the feds make any concessions on CLO composition, a more immediate issue for banks may be the accounting hurdles that the Volcker Rule creates. Ganz and Deborah Rappaport-Bigman, a partner with PricewaterhouseCoopers, both said at the conference that there is a growing industry consensus that impairments may need to be applied for any CLO security maturing after the Volcker Rule conformance date. That’s because these securities would eventually have to be sold, presumably at fire-sale prices. And the concern for banks is that the Volcker Rule may impose larger losses that anticipated.

“Prior to Volcker,” said Rappaport-Bigman, “you only had to recognize impairment related to credit loss through your [profit and loss], and any other difference in fair value would go to the balance sheet.”

But by being forced to reclassify the securities as “available for sale” instead of being held to maturity, “the OTTI [other than temporary impairment] amount [would be] the entire cost of the amortized cost and fair value.”

The issue is not theoretical. Several community banks opted not to wait for clarification on the Volker Rule and unload their CLO holdings. Webster Bank, a $20-billion asset institution based in Waterbury, Conn., recorded a $7.3 billion hit to its fourth quarter 2013 earnings in response to the Volcker Rule.

An alternative to offloading CLOs for banks is to push managers of these deals to bring them into compliance with Volcker, either by removing bonds from pools of collateral or by removing the rights of senior note holders to fire managers.

To the extent that banks can take advantage of the new deadline however, it may be more difficult to amend existing CLOs in order to bring them into compliance with Volcker, according to research published by Wells Fargo. That’s because holders of the junior-most CLO securities, known as “equity investors,” and the managers of these deals may view the problem as much farther in the future and less of a current priority. “More breathing room may translate to less focus,” analysts stated in the April 8 report.

They said that banks are most likely to be concerned about the approximately $140 billion in outstanding U.S. CLOs issued after 2009, which may be still be outstanding in July 2017. Most CLOs have a four-year reinvestment period, after which the deals’ managers start to use cash freed up from loans that mature or are refinanced to pay off CLO note holders. This amortization period continues until equity holders exercise their right to call a deal. 

As of the end of the second quarter of 2016, only 26% of CLOs issued since the financial crisis will be out of reinvestment, according to Wells Fargo. Therefore, by July 2017, it is unlikely that most of these deals will have amortized to the point that the equity holders will look to call the deals.

It is possible that some CLOs could be called early, giving managers the ability to refinance the collateral in a way that allows banks to reinvest or simply exit their holdings without a forced sale. The downside, however, is that the CLO market would need to find a new investor base as large as the current bank investor base to purchase refinanced notes, according to Wells.

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