While collateralized loan obligation vehicles (CLOs) may ultimately have to be divested by “banking entities” subject to the Volcker Rule, the Federal Reserve Board (the Board) recently extended the compliance period for these particular investments by an additional two years to July 21, 2017, provided the investments were in place as of December 31, 2013. Many banks were concerned that they might have to divest their CLO-related investments as early as this coming July and, as a consequence, suffer losses resulting from having to take significant write-downs in the value of these assets.
The Volcker Rule outlaws, among other things, ownership or sponsorship by a banking entity of certain hedge funds and private equity funds defined as “covered funds.” CLOs are securitization vehicles backed predominantly by commercial loans and may also hold, or have the right to acquire, a certain amount of nonconforming non-loan assets such as debt securities. Under the Volcker Rule, loan securitizations solely comprising loans and related servicing assets, together with entities that are similar to loan securitizations (such as qualifying asset-backed commercial paper conduits and qualifying covered bonds) are excluded from the definition of “covered fund.” That exclusion will become inapplicable, however, for securitizations (including CLOs) that hold certain nonconforming non-loan assets.
This means that, if a CLO holds certain non-loan assets, as many do, then it is not eligible for the exclusion from the definition of “covered fund.” Absent the two-year extension, banking entities would arguably have to divest their CLO-related investments by July 21, 2015, most likely at “fire sale” prices.
The Board’s intention to grant two one-year extensions (until July 21, 2017) will, in the words of its own statement, “allow banking entities additional time to conform to the statute ownership interests in and sponsorship of CLOs in place as of December 31, 2013, that do not qualify for the exclusion in the final rule for loan securitizations.” The statement does not indicate that any applications will be required for a banking entity to avail itself of these two extensions of time, and the impression is that the Board will automatically implement them.
During that extended conformance period, banking entities will not have to include ownership interests in CLOs in their compliance with the Volcker Rule’s 3 percent per covered fund and 3 percent of Tier 1 capital aggregate fund limitations. Nor will banking entities be required during that period to deduct investments in CLOs from Tier 1 capital. The statement is silent, however, on the applicability of either the prudential limitations on investments in covered funds contained in certain sections of the final rule or the “Super 23A” proscriptions on affiliate transactions.
Notwithstanding the Board’s statement and the additional two years of relief from divestiture requirements, it is clear that those divestitures will eventually have to be made. What is murky is whether proper accounting treatment under GAAP will still require write-downs of investments by banking entities’ CLO-related interests, including debt securities of CLOs. Similar concerns animated the controversy over collateralized debt obligations backed by trust-preferred securities, as described in an earlier alert.