Volcker extension still challenging for new CLOs

Wed Apr 9, 2014 1:48pm EDT
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By Billy Cheung, Lynn Adler and Natalie Harrison

NEW YORK (Reuters) - A Federal Reserve announcement on Monday that would relax Volcker Rule conformance periods still leaves banks holding collateralized loan obligation (CLO) debt in a quandary.

The Federal Reserve intends to give banks until July 2017, a two-year extension, to divest or restructure their CLO debt falling under Volcker's "ownership interest" umbrella. Such debt typically back CLOs that own securities other than loans and contain contractual language enabling bondholders to remove CLO managers for cause.

Regulators, including the Federal Deposit Insurance Corporation, Securities Exchange Commission, Office of the Comptroller of the Currency, and Commodity Futures Trading Commission, agreed to grant a similar delay, according to Monday's Fed announcement.

But this regulatory decision fails to resolve some key issues that determine whether banks will eventually be forced to sell or legally modify CLO "ownership interest" debt under Volcker. Such concerns include whether replacing CLO managers would be treated as a senior creditor right outside of "ownership interest" rules. Regulators also did not address industry attempts to exempt from the rule CLOs issued before Volcker.

"There may be around $100 billion pre-Volcker CLOs outstanding at that point, and banks - U.S. and non-U.S. - will probably hold around $50 billion-plus, and that still needs to be resolved or be divested," said Meredith Coffey, Loan Syndications and Trading Association's (LSTA) executive vice president of research and analysis. "So the problem is improved - but it's decidedly not solved"

Domestic banks have historically been the biggest buyers of senior AAA CLO tranches and were facing very near term decisions on their CLO debt portfolio before Monday's Fed announcement.

The extended compliance time could help banks holding bonds issued by older CLOs, otherwise known as 1.0 CLOs, that are due to be repaid by July 2017. To the extent that those older bonds mature on schedule or the deals are retired early, banks could continue owning their debt without running afoul of Volcker. In a January research report, Royal Bank of Scotland estimated that $135 billion of 1.0 CLO debt remains outstanding but $50 billion will be repaid this year alone.

"It helps some people holding legacy 1.0 CLOs that have a legal final maturity before July 2017, but for legacy CLO 2.0s that have a legal final maturity after 2017, those will likely have to move to available to sale and be marked to market in addition to having to be divested by 2017," said Paul Forrester, a partner at Mayer Brown's structured finance practice.   Continued...

An eagle tops the U.S. Federal Reserve building's facade in Washington, July 31, 2013. REUTERS/Jonathan Ernst