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Volcker extension still challenging for new CLOs

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[April 10, 2014]  By Billy Cheung, Lynn Adler and Natalie Harrison

NEW YORK (Reuters) — A Federal Reserve announcement on Monday that would relax Volcker Rule conformance periods still leaves banks holding collateralized loan obligation (CLO) debt in a quandary.

The Federal Reserve intends to give banks until July 2017, a two-year extension, to divest or restructure their CLO debt falling under Volcker's "ownership interest" umbrella. Such debt typically back CLOs that own securities other than loans and contain contractual language enabling bondholders to remove CLO managers for cause.

Regulators, including the Federal Deposit Insurance Corporation, Securities Exchange Commission, Office of the Comptroller of the Currency, and Commodity Futures Trading Commission, agreed to grant a similar delay, according to Monday's Fed announcement.

But this regulatory decision fails to resolve some key issues that determine whether banks will eventually be forced to sell or legally modify CLO "ownership interest" debt under Volcker. Such concerns include whether replacing CLO managers would be treated as a senior creditor right outside of "ownership interest" rules. Regulators also did not address industry attempts to exempt from the rule CLOs issued before Volcker.

"There may be around $100 billion pre-Volcker CLOs outstanding at that point, and banks — U.S. and non-U.S. — will probably hold around $50 billion-plus, and that still needs to be resolved or be divested," said Meredith Coffey, Loan Syndications and Trading Association's (LSTA) executive vice president of research and analysis. "So the problem is improved — but it's decidedly not solved"

Domestic banks have historically been the biggest buyers of senior AAA CLO tranches and were facing very near term decisions on their CLO debt portfolio before Monday's Fed announcement.

The extended compliance time could help banks holding bonds issued by older CLOs, otherwise known as 1.0 CLOs, that are due to be repaid by July 2017. To the extent that those older bonds mature on schedule or the deals are retired early, banks could continue owning their debt without running afoul of Volcker. In a January research report, Royal Bank of Scotland estimated that $135 billion of 1.0 CLO debt remains outstanding but $50 billion will be repaid this year alone.

"It helps some people holding legacy 1.0 CLOs that have a legal final maturity before July 2017, but for legacy CLO 2.0s that have a legal final maturity after 2017, those will likely have to move to available to sale and be marked to market in addition to having to be divested by 2017," said Paul Forrester, a partner at Mayer Brown's structured finance practice.

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The 2.0 CLOs, which refer to deals issued after 2009, represent approximately $150 billion of deal volume, according to Thomson Reuters LPC data. Over 70 percent of 2.0 CLO debt tranches will likely still be outstanding when the revised Volcker requirements kick in, according to a Wells Fargo research note published Tuesday. Banks still need to figure out what to do about those deals.

"CLO participants will likely be disappointed with the lack of a broader exemption," wrote JP Morgan fixed income analyst Rishad Ahluwalia in a research note distributed to clients today. "However, given the lengthened conformance on the majority of existing CLO holdings, we do not think there will be much near-term reaction in spreads."

The additional time afforded to banks does allow holders more negotiating room to amend deals that potentially remove ownership interest language.

If CLO equity holders also decide to refinance debt tranches after typical two-year non-call periods, the additional conformance time would enable banks to avoid forced sales since they would benefit from an orderly repayment of their debt.

"The expectations are that the market will stabilize, and there should be some modest spread tightening at the AAA level over the course of the next couple of quarters," said John Fraser, managing partner of 3i Debt Management US. "The stability will make it easier for existing holders to trim exposure if they think they need to, or give them the luxury of more time to figure out how the market is going to develop."

(Editing by Michelle Sierra and Jon Methven)

[© 2014 Thomson Reuters. All rights reserved.]

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