Could CLOs follow the path of TruPS CDOs?

By Nathan Stovall, SNL Financial

There is growing support for regulators to reconsider the prohibition of many collateralized loan obligations under the Volcker rule.

The Volcker rule effectively prohibits banks from owning most collateralized loan obligations, or CLOs, because the structures usually have more than loans and contain higher-yielding bonds to increase returns offered to investors. The bank lobby, advisers, and others have argued that banks should be able to maintain their holdings in the structures since they are debt positions and the case for CLOs has built steam in recent weeks, with House Democrats pushing for change and Federal Reserve officials saying that more clarity on the issue could come soon.

Federal Reserve Chair Janet Yellen on Feb. 11 offered some hope that the treatment of CLOs under Volcker could change, saying that the regulator would clarify whether some of the instruments would exempt "reasonably soon." The next day, 17 House Democrats, including Maxine Waters (D-Calif.) of the House Financial Services Committee, asked regulators to clarify that debt interests in CLOs would not be considered equity interest and would avoid classification as one of the covered funds prohibited under the Volcker rule.

The recent push comes after Volcker's treatment of CLOs seems to have already impacted the market for the securities. Uncertainty created by the Volcker rule appears to have weighed on CLO issuance volume, which fell in January to the lowest level since July 2012, according to a recent Bloomberg report. CLO issuance activity rebounded considerably in February, though, and has already exceeded the total volume that came to market in January. Newly issued CLOs might not contain bonds or contain covenants that could give managers the power to restructure the vehicles to bring them into compliance with the Volcker rule.

Concerns over the Volcker rule's treatment of CLOs have played out in the background to the fierce opposition mounted by the bank lobby and industry toward the prohibition against owning most collateralized debt obligations, or CDOs, backed by trust preferred securities. The bank lobby fought hard to keep banks, and in particular community banks, from having to sell TruPS CDOs held in their investment portfolios—an effort that was eventually successful. The bank lobby urged regulators in late December 2013 to rethink the treatment of CLOs under the Volcker rule, though concerns never seemed to reach the same fever pitch as the backlash over the initial treatment of TruPS CDOs.

Attorneys said in mid-January on an SNL webinar that they received a number of complaints from bank clients about the treatment of CLOs under Volcker and eventually expected the issue to receive more attention.

"I think it's going to be an issue that rises to the top once it quits being trumped by TruPS CDOs," Michael Krimminger, partner at Cleary Gottlieb Steen & Hamilton and former general counsel and deputy to the chairman at the FDIC, said on the webinar.

Most banks did not dispose of CLOs in the fourth quarter, although institutions only had a few weeks after the release of the Volcker rule to take action. Banks' holdings of CLOs actually rose to $72.18 billion at the end of the fourth quarter, up 4.4% from the end of the third quarter, according to SNL data.

Market watchers did not necessarily expect banks to dispose of their CLO positions quickly. Some advisers encouraged banks to wait for the dust to settle before disposing of CLOs. There was also some belief that CLO managers might be able to alter the structure of existing CLOs during the conformance period for the Volcker rule—which ends on July 21, 2015—to bring them into compliance with the provision by repositioning the structures so they will only hold loans.

A rumor even floated around the market in the last few months that one large bank had the potential to restructure existing CLOs and might even have the market power to do it. Some market watchers who spoke to SNL suggested it was JPMorgan Chase & Co. JPMorgan held $28.13 billion in CLOs at the end of the fourth quarter, or close to 39% of all banks' CLO holdings. A JPMorgan spokesman declined to comment on the rumor.

Regulatory attorneys have said that the Volcker rule would allow for restructuring during the conformance period, but they have also noted that most banks only own pieces of CLOs, not the entire controlling interest of the vehicle. Any attempted restructuring of a CLO could face challenges since the equity owners of the vehicle likely would not want to see their returns decrease as managers sought to remove higher-yielding bonds from the structures.

Banks just might not have to take action, though, as calls for another reprieve on the Volcker rule have gained steam. The more recent arguments are very similar to the ones the bank lobby made against the treatment of TruPS CDOs under Volcker and perhaps the concerns won't fall on deaf ears. If that happens, it seems likely that regulators would follow the same path they took with TruPS CDOs and grandfather existing CLOs and require new issuances to adhere to the current letter of the Volcker rule.