How Dodd-Frank Might Kill the CLO Market

WASHINGTON — Regulators are facing mounting pressure from lawmakers and the financial industry to address ongoing concerns about the treatment of collateralized loan obligations under the Dodd-Frank Act, which critics warn could effectively destroy the market.

The most public fight has centered on such assets' inclusion under the Volcker Rule, which could force banks to sell off billions of dollars worth of CLOs before the rule goes into effect in July 2015. But a separate battle is also brewing over the impact of banking agencies' pending risk retention rule.

The fight has already won the attention of Congress, which industry supporters say is a sign that the tide may be turning in the public debate over securitization.

"Securitization got a pretty bad name during the crisis and was pretty consistently demonized for a long time," said Chris Killian, a managing director and head of securitization at the Securities Industry and Financial Markets Association. "But I think people are realizing it's a valuable way to fund credit."

Republicans and Democrats have been urging regulators to take another look at the Volcker Rule provision involving CLOs, particularly in the House, where the Financial Services Committee has already held several hearings on the problem.

At issue is the Volcker Rule's definition of a "covered fund." Under the rule, which is designed to restrict banks' investment in hedge and equity funds, institutions are considered to have an ownership interest if they have a say in removing its management. Because senior debt securities issued by CLOs include the right to fire the investment manager for cause, many argue that banks can no longer hold such assets once the Volcker Rule takes effect.

As a result, critics fear the provision will have a chilling effect on the market for CLOs, as big banks, which hold an estimated $70 billion worth, look for ways to sell off those assets before next summer. Some foreign banks with U.S. operations may also be affected.

"Whatever amount is disposed of, it will be disposed into a market that's not all that liquid," said Killian. "People have significant concerns about whether the market can take on that supply over the course of a year."

Stakeholders have suggested several possible solutions to regulators on the CLO issue, from writing a broad carve-out for CLOs under the rule to establishing a special class of "qualified" CLOs to writing a narrower clarification or interpretive guidance about what constitutes an ownership interest.

The move comes after the banking agencies tweaked the rule last month to resolve concerns over legacy collateralized debt obligations backed by trust-preferred securities — a win for community banks that would have been required to write down millions of dollars in CDOs. That fight has likely kicked off what is expected to be a lengthy lobbying battle over different aspects of the rule.

"I view the Volcker Rule as combining two things, huge complexity and structural change all around the market — and those two things are going to lead to the need for course correction," said Margaret Tahyar, a partner at Davis Polk & Wardwell. "Glitches are a part of what should be expected."

The handling of the Trups-backed CDOs issue has been largely lauded by industry, lawmakers and even some consumer advocates. Dennis Kelleher, president and chief executive of Better Markets, an advocacy group, called the fix a "perfect model for how to address legitimate concerns in a responsible, reasonable and narrow fashion."

But Kelleher, who said he was supportive of the idea that a narrow, for-cause removal clause in a CLO shouldn't be considered an ownership interest under the Volcker Rule, also warned that regulators must remain vigilant in their efforts to make necessary changes without introducing loopholes into the provisions.

"With almost any rule, once it gets passed and meets the real world, you have to make adjustments sometimes. The fact you need to make adjustments isn't a bad thing and doesn't mean it's a bad rule," said Kelleher. "But you have to prevent Wall Street from exploiting small, correctable problems to advantage them and gut the rule — it's their pattern."

Exactly how regulators will respond is unclear, but several top policymakers have indicated they are examining the concern closely.

"The issue is already at the top of the list," Daniel Tarullo, a Federal Reserve Board governor, told the House Financial Services Committee earlier this month.

Janet Yellen, chairman of the Fed, also told the panel a week later that the industry could expect an answer "reasonably soon."

The Financial Services Committee has another hearing on the issue scheduled for Wednesday, where lawmakers could also discuss potential legislative fixes, according to a committee press release.

But the Volcker Rule is only part of the problem facing CLOs. Industry representatives also point to the risk retention rule, which was re-proposed in August. Under the plan, investment managers would be required to retain 5% of the value of a CLO, which critics argue is infeasible and could significantly shrink the market. Unlike the Volcker Rule, which largely affects legacy CLOs held by banks, the risk retention rule would most directly affect new CLO issuances, meaning it has the potential to be even more damaging.

"The problem for CLOs from risk retention is almost exactly the opposite — the deals in existence are effectively grandfathered, but new deals, once it becomes effective, would have to have to retain 5%, which could effectively kill the market," said Elliot Gantz, executive vice president and general counsel for the Loan Syndications and Trading Association.

Because CLO managers are not capitalized like banks, industry supporters said that all but the largest players would be unable to comply with the proposal. Moreover, they argue that an alternative proposed by regulators, in which the arranging bank for a term loan, not the CLO manager, has to hold 5% risk retention for that CLO tranche, is also unworkable because it would require banks to keep the holding on their balance sheets and make them unable to hedge the risk.

"It just doesn't make sense with the way banks manage their risk," said Killian.

The issue has yet to bubble up in Congress to the same degree as Volcker Rule concerns, but a group of five Republican lawmakers from the Senate Banking Committee, including Sen. Mike Crapo, R-Idaho, the ranking member, wrote a letter to regulators in December raising concerns over the problem. House Republicans have signaled their concern as well.

Observers said that it is likely to come to the fore if the provisions remain when the risk retention rule is finalized, teed up by the attention focused on the market as a result of the Volcker Rule. Regulators took comment on the risk retention proposal through Oct. 30.

"The initial focus has been on Volcker, because the final rule came out, but the same principles apply to risk retention," said Ganz. "If you do something to reduce issuance of CLOs, I think members of Congress now understand that's not a good idea."