A two-year extension to the deadline for banks to comply with prohibitions against holding certain collateralized loan obligations does nothing to clear up uncertainty in this market, according to research published today by Wells Fargo. Moreover, it could slow the complicated process of making existing CLOs compliant with the Volcker Rule.
The Volcker Rule prohibits banks from having an “ownership interest” in securitizations of any assets other than loans. The problem is two-fold: most existing CLOs are backed by bonds as well as loans, and senior CLO securities typically give holders the right to fire the investment manager for cause, which could be construed as an ownership interest. This has prompted concerns that banks could be forced to sell of billions of dollars in CLO holdings.
On Monday, federal regulators said that they would give banks until July 21, 2017 to "conform their ownership interests in and sponsorship of CLOs to the statute." Previously the deadline was 2015.
In its report, Wells Fargo said that this extension may not clear up the confusion for existing holders, or for those who are waiting to see what existing bank holders will do. “Market participants still fear that banks will move to sell to avoid Volcker non-compliance,” the report stated. “This statement reduces the likelihood of such an event, but does not completely eliminate it, as other forms of regulatory relief may have.”
Moreover, the extension may actually work against the banks trying to amend existing deals in order to bring them into compliance with Volcker, either by jettisoning bond holdings or removing the right of senior note holders to fire the manager. 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,” Wells Fargo analysts stated in the 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.