The Federal Reserve Board announced yesterday that it will give banking entities two additional one-year extensions to conform their ownership interests in and sponsorship of certain CLOs covered by the Volcker rule. The conformance period currently runs through July 2015, and the extensions would give banks until July 21, 2017 to either work with CLO managers to amend non-compliant CLOs, or divest of such investments. The extension applies only to CLOs issued prior to Dec. 31, 2013.
For a copy of the Federal Reserve Board’s statement, click here:
Under the Volcker Rule, CLOs that own bonds and are issued under Rule 3c-7 are ‘covered funds,’ and banks cannot have an ownership interest in a covered fund. Under Volcker, ownership includes ‘the right to participate in the selection or removal of an investment manager’ of the covered fund, outside of an EOD.
The extension is helpful in that it would reduce the impact of Volcker for the vast majority of CLO 1.0s. RBS CLO strategist Ken Kroszner, in a research note issued in response to yesterday’s announcement, says “nearly all legacy CLOs will have amortized by July 2017, so this amendment will likely remove some regulatory risk related to holding these positions for banks. The current 1.0 universe totals $135 billion and we have forecasted a $50 billion run-off in 2014 alone.”
However, the extension does not address the impact of Volcker on CLO 2.0s that will remain outstanding after July 2017. U.S. CLO 2.0s issued during 2014 have generally been structured as Volcker compliant, but the extension would leave uncertainty around the CLO 2.0s issued before 2014 – many of which are likely to be outstanding in July 2017.
“We expect that a vast majority of 2013 vintage CLOs ($80 billion issued in 2013) and most 2012 vintage deals ($55 billion issued in 2012) will still be outstanding at that time given most of these deals were issued with 4-year reinvestment periods. The success of refinancing CLOs with ‘Volcker compliant language’ may help mitigate some of this risk down the road as nearly all of these deals will end their non-call periods before 2016 thereby leaving more than a 1.5 year buffer for most CLOs,” said Kroszner.
As such, although it provides holders of non-compliant CLO debt with additional time to either amend or dispose of this paper, the proposal would fall short of the solution proposed by the Barr Bill, which was approved by the House Financial Services Committee (FSC) last month. That legislation would provide for the grandfathering of all CLO debt issued before Jan. 31, 2014, where the only indication of ownership interest is the ability to participate in ‘for cause’ manager removal.
In response to yesterday’s announcement, the Loan Syndications and Trading Association (LSTA) says the extension will not solve the problem, and that issuing a comprehensive rule that would completely grandfather CLO notes issued prior to the publication of the final rule is needed in order to divert impairment of the CLO market.
“While the LSTA appreciates the Federal Reserve’s efforts to mitigate the damage that the final rule implementing the Volcker Rule would cause to banks holdings of CLO AAA and AA rated notes, a two-year extension of the conformance period does not solve the problem,” said Elliot Ganz, general counsel and executive vice president for the LSTA.
“In its recent cost-benefit analysis, the OCC estimated that the forced divestiture of CLO notes by banks required under the Volcker Rule could cost U.S. banks up to $3.6 billion,” said Meredith Coffey, executive vice president of research & analysis for the LSTA. “In contrast, the expected credit losses on banks’ holdings of CLO notes are less than $2 million. It is ironic that the Volcker Rule, which is designed to limit banks’ investments in risky assets, would force banks to realize billions of dollars of losses in a very safe investment, due to a fire sale.”
Meanwhile, Congressman Scott Garrett, Chairman of the Financial Services Subcommittee on Capital Markets and Government-Sponsored Enterprises, issued a statement yesterday instructing the U.S. financial regulators to go back to the drawing board on their impending “fix,” or risk having it done for them.
“Since the banking regulatory community is unwilling to correct their mistakes, Congress must do it for them. To be frank, this might also have to include Congress looking to make changes to the law such as subjecting these agencies to the appropriations process and further consolidation,” he said. – Sarah Husband