Fed Grants Banks Two-year Volcker CLO Extension, Banking Groups React Negatively | Practical Law

Fed Grants Banks Two-year Volcker CLO Extension, Banking Groups React Negatively | Practical Law

The Federal Reserve Board has granted a two-year extension, until July 21, 2017, for banking institutions to divest their non-conforming collateralized loan obligation (CLO) interests. Market reaction has been negative, as the financial industry sought permanent relief from the rule for CLOs.

Fed Grants Banks Two-year Volcker CLO Extension, Banking Groups React Negatively

Practical Law Legal Update 2-564-2246 (Approx. 4 pages)

Fed Grants Banks Two-year Volcker CLO Extension, Banking Groups React Negatively

by Practical Law Finance
Published on 09 Apr 2014 • USA (National/Federal)
The Federal Reserve Board has granted a two-year extension, until July 21, 2017, for banking institutions to divest their non-conforming collateralized loan obligation (CLO) interests. Market reaction has been negative, as the financial industry sought permanent relief from the rule for CLOs.
On April 7, 2014, the Federal Reserve Board (FRB) announced that it will provide FDIC-insured entities two additional one-year extensions, until July 21, 2017, to divest non-conforming collateralized loan obligation (CLO) interests prohibited under the Volcker Rule that were in place by December 31, 2013. Because Section 619 of the Dodd-Frank Act authorizes only one-year extensions for the Volcker Rule (for no more than three years total), the deadline was extended until July 21, 2016 and then further extended to July 21, 2017.
Under the Volcker Rule, insured depository institutions (IDIs) and their affiliates are generally prohibited from engaging in proprietary trading activities and from acquiring or retaining ownership interests in, sponsoring or having certain relationships with hedge funds or private equity funds (covered funds).
CLOs, as currently structured, include two characteristics cause them to be captured by the rule's prohibition:
  • First, asset pools that consist entirely of loans qualify for an exception to the rule's definition of "covered fund". However, most CLOs (like many other securitizations) include in the securitized collateral pool a de minimis amount of bonds and other securities. This causes the CLO issuer to be a covered fund under the rule.
  • Second, any entity that has a vote in removing management of another entity is considered to have an "ownership interest" in that entity. Because senior CLO tranches typically include the right to remove the investment manager of the CLO for cause, it is believed that FDIC-insured entities that own senior CLO tranches have an ownership interest in the CLO issuer.
Under this extension, FDIC-insured entities are provided two additional one-year extensions, until July 21, 2017, to divest non-conforming CLO interests that do not qualify for the exclusion in the final rule for loan securitizations and which were in place by December 31, 2013.
Banking industry reaction to the FRB announcement has been strongly negative, as the market had hoped for a permanent exemption for CLOs from application of the Volcker Rule. The LSTA released a response criticizing the FRB for merely seeking to avoid a "fire sale" of existing CLO holdings. The LSTA has suggested that the Fed should issue a comprehensive exemption grandfathering all CLO notes that were issued prior to the publication of the final rule.
The LSTA has noted that, unlike many other asset-backed securities (ABS) such as RMBS, CLOs performed well during the financial crisis and have always maintained a level of transparency and asset quality that differentiates CLOs from other types of ABS issued in securitization transactions. The LSTA has asserted that the failure of regulators to distinguish between these types of ABS is an unintended consequence of the rule that will hinder the commercial credit markets.
The LSTA quoted an estimate by the Office of the Comptroller of the Currency (OCC) regarding forced divestiture of CLO notes under the Volcker Rule which it says could cost US banks up to $3.6 billion since banks hold about $70 billion of the most senior CLO notes and a forced sale in a declining market will create material losses on these holdings (see Legal Update, Volcker Rule Could Cost Banks up to $4.3 Billion). The FRB has noted that at least half of CLOs owned by banks will mature on their own before July 21, 2017, which will cause significantly less disruption to the market.
Volcker-compliant CLOs have already emerged in the market, and this announcement will likely continue to encourage CLO issuers to structure new CLOs that omit:
  • The rights of senior tranche holders to remove the collateral manager.
  • Bonds or any non-loan assets from the CLO's securitized collateral pool.
It is believed that CLOs structured in this manner will not be captured by the Volcker Rule prohibition.
Update: According to the LSTA, the FRB has confirmed that CLO notes that are exempt from Volcker Rule compliance until July 2017 are rendered noncompliant upon the sale of the notes, nullifying the two-year extension for any such securities. This threatens to create liquidity challenges for banks looking to divest warehoused CLO securities.