The reaction to the final version of the Volcker Rule has generally been positive, especially given the obvious attempt by the federal agencies involved to exempt the CLO market from the new regulations. However, there is still concern about possible disruptions to the market in the event that CLO managers are forced to offload securities from their collateral pool, or if banks engage in forced selling of non-exempt transactions.
Elliot Ganz of the LSTA summed up the state of affairs nicely: “While this was a major win, not everything is rosy.”
First, the good news…
Prior to the final rules, there was much concern that CLOs might be categorized as covered funds (hedge funds or private equity funds), as the Volcker Rule prohibits U.S. banks from ‘owning’ covered funds. Banks would have not only been no longer able to invest in CLOs, but also may not have been able to make markets or warehouse CLOs. However, the final rules have gone a long way to exempt loan securitizations (CLOs) under certain conditions – specifically if they do not include bonds or securities.
…And then the not-so-good news
This specific requirement that exempt CLOs must not own securities creates a large issue, however, given the majority of 1.0 and 2.0 CLOs have bond baskets. Furthermore, because there is no “grandfathering” provision in the final rules, any CLOs still owning bonds on July 15, 2015 will not be exempt from the new regulations. As a result, for non-exempt funds CLOs, U.S. banks could not hold an ‘ownership’ interest after July 2015.
A lot remains unclear at this point, including to what extent the Volcker Rule might affect the European CLO market when it comes to U.S. banks investing, warehousing, or trading in European CLOs. Initial reactions from market players here suggest that while Volcker will affect European CLO managers, the impact is likely to be much less severe than for the U.S. market. Nonetheless, any thinning out of the potential triple-A investor base should U.S. banks be unable to invest in the senior debt of non-exempt CLOs is not good news for the development of the market, sources say.
Questions also remain around what constitutes ‘ownership’ of a covered fund, and whether a bank owning debt tranches of a non-exempt CLO equates to ‘ownership’ of a covered fund. The Volcker Rule defines ownership as “any equity, partnership, or other similar interest.” says Wells Fargo CLO analyst David Preston in his Dec. 16 report, CLO Salmagundi: A Deeper Look at the Volcker Rule. Under this definition, owning debt tranches of a non-exempt CLO is not considered ‘ownership’.
However, the “other similar interests” aspect to the definition includes the “right to participate in the removal of… an investment advisor… of the covered fund, (excluding the rights of a creditor to exercise remedies upon the occurence of an event of default or an acceleration event)”, and most CLOs allow triple-A investors certain rights regarding manager replacement, continues Preston.
There is much debate around this particular ownership issue, and in most cases triple-A investors’ ability to remove a manager would fall under the “the rights of a creditor to exercise remedies upon the occurence of an event of default” exclusion, and so would not constitute ownership. However, there is a question about whether the removal rights associated with the ‘for cause’ events often included in the Collateral Manager Agreement fall inside or outside of a perceived event of default, says Preston.
Further debate concerns the key man event and whether or not this could be used as an example of ownership under Volcker.
On a different note, it would appear initial concerns that U.S. banks may be restricted from trading non-exempt CLOs may prove unfounded, as Volcker contains a market-making exemption for banks to act as market makers of covered funds – subject to certain limitations that may impact market liquidity, Preston says.
The result could be widespread market disruption, says the LSTA’s Ganz. Under a scenario where banks could not own CLO tranches, either CLO managers would look to exclude these bonds from portfolios ahead of July 2015, or banks will have to sell out of non-exempt CLOs, putting price pressure on triple-A tranches and leading to potential losses for those banks.
A final course of action, Preston suggests, is to amend CLO documents to list all manager removal clauses specifically as events of default to remove any ambiguity, and to ensure that a close technical reading would not imply that controlling class investors are “owners.”
With regard to the first point, the issue may not ultimately be too big: managers effectively would have until mid-2015 to sell bonds, and 2.0 CLOs generally have smaller bond holdings than 1.0s. In addition, many in the 1.0 group are likely to have amortized or been called by the deadline, according to Preston.
However, while banks, as investors in CLO tranches, will likely push hard for CLO managers to offload their securities and to amend deals to prohibit them from owning securities going forward, some managers simply may not want to sell, or may not be able to sell or amend deals due to resistance from their equity investors.
This could all lead to a differentiation in both value and liquidity between compliant and non-compliant CLOs, as well as the likely emergence of a new CLO 3.0 structure that includes no allowance for bond buckets.
As a result, the LSTA may return to the regulatory agencies to seek relief with respect to the ownership interest. According to Ganz, this would concern “…in particular whether CLOs that have ‘for cause’ manager replacement triggers in triple-A notes are considered ownership interests.” There is also the possibility of asking the agencies to defer the effective date for the divestment of ownership interests.
It may also be possible for triple-A noteholders to contractually give up their replacement rights, thereby negating the indicator of ownership and making it permissible to hold the security, although this option is far from clear, Ganz says.
Ultimately, if there is no regulatory relief forthcoming and existing CLOs do not sell their securities by July 2015, banks would no longer be eligible to hold those triple-A securities.
Further clarity on the rules and their impact should emerge in the coming weeks. Some issues will be thrashed out – if not fully resolved – on the LSTA’s Volcker Rule Webcast, which is being held at 3:00 p.m. EST on Wednesday, Dec. 18. – Sarah Husband