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 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)
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