CLO Market: The Volcker Rule and Risk Retention

more+
less-

Financial Services Header

[co-author: Ethan Post*]

Collateralized Loan Obligations (CLOs) are a type of Collateralized Debt Obligation (CDO) created by pooling large commercial loans and debt instruments. This pool is divided into various tranches with different risk–return characteristics and interests in each tranche are then sold, mostly to institutional investors.

Historically, CLOs have been popular with investors because of their greater diversity and potential to outperform standard market benchmarks. Although CLO issuances tumbled during the recession amidst fears of leverage and securitized loans, pre–existing CLOs were safe during the recession, with only two of an estimated 630+ CLOs defaulting on cash payments to investors. This steadiness through the recession is likely due to the fact that CLO pools are generally made up of higher–quality debt instruments, not junk bonds or sub–prime mortgages.

Since the height of the recession, CLO issuances have soared – 2013's $82 billion in new issuances is the third largest year on record for CLO issuances and over $40 billion has already been issued in 2014. This surge is all the more impressive given the looming specter of Dodd–Frank's Volcker Rule and risk retention requirements.

Dodd-Frank's risk retention mandate represents the largest single challenge to the CLO market. By requiring managers of CLOs to retain a five percent interest in the CLO, the risk retention rules may tend to prevent small to mid–size managers from entering or remaining in the market, thereby reducing competition and decreasing the supply of CLO financing. On the bright side, regulators have already proposed an alternative method of satisfying this requirement that may be more beneficial to CLOs and have discretion to exempt certain classes of high–grade CLOs entirely – as they have already done for certain classes of residential mortgages.

Also part of Dodd–Frank, the Volcker Rule seeks to prevent banks from trading in proprietary funds for their own accounts and to restrict banks' ability to own interests in private equity and hedge funds. An unintended consequence of this rule would also prevent banks from holding interests in CLOs which include certain kinds of bonds in their securitization pool. CLO managers have already begun adapting to meet this challenge, structuring new CLOs so as to hold only loans, with the option to include bonds if the regulations change in the future. In addition, the U.S. House of Representatives has recently passed a bill that would allow banks to continue to hold pre–Volcker Rule CLO interests containing bonds. The CLO market thus seems capable of prevailing in the face of the Volcker Rule headwind.

While the CLO market is certainly facing its share of regulatory challenges, the industry has demonstrated an ability to adjust to regulatory changes while simultaneously maintaining the fundamental soundness of the CLO as an investment asset and should continue to thrive in the post-recession world.

*Law student not yet admitted to the Bar

Topics:  Banking Sector, Collateralized Debt Obligations, Collateralized Loan Obligations, Dodd-Frank, Investors, Tranche, Volcker Rule

Published In: General Business Updates, Finance & Banking Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Jackson Walker | Attorney Advertising

Don't miss a thing! Build a custom news brief:

Read fresh new writing on compliance, cybersecurity, Dodd-Frank, whistleblowers, social media, hiring & firing, patent reform, the NLRB, Obamacare, the SEC…

…or whatever matters the most to you. Follow authors, firms, and topics on JD Supra.

Create your news brief now - it's free and easy »