A few steps forward and a giant leap back. This familiar phrase might be the perfect summary of the CLO market’s Volcker Rule roller coaster since December 2013. A few weeks ago we wrote about the Federal Reserve Board’s (the “Fed”) less than satisfying “fix” to address what the market has perceived as one of the Volcker Rule’s unintended consequences. The Fed, in what had seemed to be an honest (although insufficient) attempt to prevent the need for banks to divest of holdings in CLO 1.0 transactions, agreed to provide two 1-year Volcker Rule conformance extension periods. As extended, the conformance periods will expire in mid-2017.
The 1-year extensions would apply to allow banking entities additional time to conform to the Volcker Rule “ownership interests in and sponsorship of CLOs in place as of December 31, 2013”. While the market’s reaction to the Fed’s plan was tepid at best – the market had hoped for a complete grandfathering of CLOs issued prior to the date of the final rule, the market at least appreciated that the regulators were beginning to understand the magnitude of the ramifications of the Volcker Rule. At the time of the Fed announcement, the market interpreted the language to mean that “ownership interests in and sponsorship of CLOs in place as of December 31, 2013” referred to CLOs in place as of December 31, 2013. However, upon requests for clarification from industry groups, the Fed recently announced that the phrase “ownership interests in and sponsorship of CLOs in place as of December 31, 2013” was intended to mean that the extended conformance period would apply only to interests owned as of December 31, 2013. In other words, market participants are only entitled to the conformance period extensions for holdings for which such entity possessed ownership as of the end of 2013.
The market has yet to feel the full impact of the Fed’s interpretation, however the effect on the liquidity of affected CLO notes being sold in the secondary market has not been positive. In an instance of purely poetic coincidence, the Fed’s interpretational statement will lead to higher costs and less liquidity in the secondary trading market for the very CLO securities that the Volcker Rule has required banks to divest. Banks are therefore left with the Hobson’s choice of retaining ownership of CLO notes that they know they will be required to divest at some point in the near future or sell now into a market frozen by the Fed’s announcement. The man with one eye truly is the king in the land of the blind.
The political response with respect to the Fed’s latest announcement remains to be seen. Perhaps Congress will step in and stop the regulatory roller coaster. Perhaps the regulators will reconsider their position. However, with each passing pronouncement by the regulators it becomes increasingly clear that the fun is just beginning.