How Volcker Will Stir Up the CLO Market

This is the seventh article in an eight-part series.

The market for collateralized loan obligations hit an all-time high in 2014 — but the onset of a number of regulatory requirements, including the Volcker Rule, mean the good times may not last long.

Collateralized loan obligations are securities backed by pools of loans to midsize and large businesses. If banks conduct good due diligence on the loans that they approve, and if investors understand the financial risks of CLOs, these instruments can inject significant liquidity into the market, enabling banks of all sizes to boost lending.

In the first nine months of 2014, CLO issuance reached$97.1 billion, according to S&P Capital IQ's Leveraged Commentary and Data. This is slightly higher than the previous 2006 record, when CLO issuance reached $97 billion.

But this pace is unlikely to continue because of a confluence of Dodd-Frank rules, including the risk retention rule and the Volcker Rule, which begin in earnest during the period between 2015 and 2018. In addition, a number of Basel III requirements will make banks think twice about buying CLOs.

No regulation worries CLO market participants as much as the Volcker Rule. Simply navigating the different elements of the rule relevant to CLOs is not a straightforward endeavor.

First of all, the Volcker Rule prohibits banks from having an ownership interest in CLOs that invest in bonds. While most of a CLO will be made up of loans such as leveraged loans and loans to small and midsize companies, it can also contain bonds. What creates confusion in the market is that the Dodd-Frank Act does not define the term "ownership interest," as Allen & Overy partner Heath Tarbert explained to me. However, the regulators " have defined it in the regulations implementing the Volcker Rule to mean any equity, partnership, or 'other similar interest' in a covered fund, whether voting or nonvoting, as well as any derivative of such an interest," he said.

This interpretation requires many banks to restructure their outstanding CLOs. Bank lobbyists were successful in obtaining a two-year extension, until July 21, 2017, to meet this requirement. "This relief is helpful to some issuers and investors," Tarbert writes, "but it is neither a 'grandfathering' of older CLOs nor relief of any kind with respect to CLOs issued or acquired after Dec. 31, 2013."

In order to become compliant with Volcker, "roughly half of the approximately $350 billion of CLOs outstanding will need to amend structures," according to David Kreidler at Standard & Poor's. Making matters more difficult is that CLO managers need the approval of the majority of both the equity and senior debt holders to amend existing CLO structures.

This is not as easy as it may seem. For one thing, "the most onerous structures require positive consent (active approval), as opposed to lack of dissention," as Kevin Kendra, managing director at Fitch Ratings, explains. "Where debt and/or equity tranches are widely held across the investor community, the logistics of obtaining positive consent from a majority may become more of a challenge."

Fitch believes that it is important the market is clear that the amendments incorporate investor consent. In addition to an amendment, Allen & Overy's Tarbert states that "CLO holders may wish to consider restricting their ability to exercise voting rights in a binding fashion that would convince the regulators that the CLO holders do not have the ability to influence the actions of management officials." In this way, it would be clear that banks investing in CLOs would not end up being equity owners in a CLO, thereby violating the Volcker Rule's ownership rule.

Another major issue is that banks trading Volcker-compliant portions of the CLO, known as tranches, must still show that the reason that they are trading them is because this is a normal part of their trading on behalf of customers — that is, for a market-making purpose. Banks have never before had to prove whether they are trading securities for proprietary or market-making purposes, so having the IT architecture and processes to collect data at such a granular level is a new work in progress.

Banks' ability to meet regulatory capital requirements will also be influenced by their CLO holdings. Under Basel III capital standards, banks must risk-weight all of their on- and off-balance-sheet instruments. The risk of a CLO tranche must therefore be calculated as banks determine Tier 1 capital. Banks tend to buy the least risky CLO tranches, but there is still potential for trouble. According to Kreidler, two-thirds of leveraged loans — loans made to companies that often have lower credit ratings — end up in CLOs. Banks need to closely watch developments in the credit quality of this kind of debt.

It is also important to note that in the coming years, banks' CLO holdings will be impacted by additional countercyclical capital requirements as well as loss-absorbency requirements for larger institutions. Moreover, CLOs do not count toward a bank's liquidity coverage ratio, the main purpose of which is to ensure that banks have enough high-quality liquid assets to survive a 30-day period of stress. Therefore banks contemplating buying CLO tranches should be conducting careful analysis to determine whether their yield is a sufficient reward to cover not only the securities' credit, market, operational, and liquidity risks, but also the Dodd-Frank compliance costs and Basel capital charges.

Next in the series: The Volcker Rule and financial regulators.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. Follow her on Twitter at @MRVAssociates.