On April 7th the Federal Reserve Board (the “Fed”) announced that it would provide banking entities with two additional one-year extensions to conform their ownership of CLOs covered by the Volcker Rule. The Fed stated that it would act on these extensions in August of 2014 and 2015. The Fed’s action would extend the conformity period from the current deadline of July 2015 to July 2017. The Fed’s approach to remediating the unintended consequences created by the Volcker Rule brings to mind a famous quote by famed publisher Malcolm S. Forbes, that “it’s so much easier to suggest solutions when you don’t know too much about the problem.” While the extension offers some relief for CLO 1.0 (i.e. pre-2008) deals, it fails to alleviate the effects of the Volcker Rule on the CLO market. Considering the overwhelming testimony regarding the potential impacts of the Volcker Rule, one must wonder if the regulators appreciate the Volcker Rule’s material impact on the CLO market.
As we have discussed previously here, here, here and here, the Volcker Rule prevents banking entities from holding ownership interests in “covered funds”. Many CLOs would be considered “covered funds” and the Volcker Rule did not “grandfather” CLOs issued prior to the publication of the final rule. As a result, banking entities would not be permitted to hold an “ownership interest” in many CLOs after the conformity period ends.
The extended conformity period would provide relief for CLO 1.0 deals. Though CLO 1.0 deals were not structured to be Volcker Rule compliant, many CLO 1.0 deals will be amortized by the end of the extended conformity period. By way of background, market commentators have noted that CLO 1.0 deals currently total $135 billion with a forecasted $50 billion paydown anticipated in 2014. Thus, the impact of the Volcker Rule on covered noteholders in CLO 1.0 deals will be ameliorated due to the extended conformity period.
However, the extended conformity period does not provide the same type of relief for CLO 2.0 deals. A large majority of CLO 2.0 deals will continue to be outstanding in July 2017. While many AAA buyers and managers have started the process of amending CLO 2.0 deals to include Volcker Rule compliant provisions, it is unlikely that every CLO 2.0 deal can be amended to be Volcker Rule compliant. Banks holding notes in vehicles that are considered “covered funds” that fail to become Volcker compliant will be required to divest of such CLO holdings. According to a recent OCC estimate, this divestment could cost banks up to $3.6 billion. As the LSTA recently noted, CLOs have performed extremely well and there have never been any credit losses on CLO AAA and AA notes, nonetheless, the application of the Volcker Rule to bank holdings of CLO AAA and AA rated notes would likely force banks to sell CLO notes into a declining market and, perversely, realize material losses on what historically has been a very safe investment.
While market participants have expressed appreciation regarding the regulatory attempts to alleviate the Volcker Rule’s unintended consequences, early responses to the release from market participants indicate a strong desire for a comprehensive solution. In addition to market participants, legislators have noted that the extended conformity period proposed by the Fed fell short. Congressman Scott Garrett, Chairman of the Financial Services Subcommittee on Capital Markets and Government-Sponsored Enterprises, admonished the Fed. He noted that Congress may be required to fix the problems if the regulators fail to do so. Perhaps a legislative solution would resemble the Barr Bill, which would grandfather pre-January 31, 2014 CLOs and make other changes to clarify when CLO holdings would constitute an “ownership interest”. While the market has one small bird in hand, it must continue to wait for the birds in the bush.