8102019 Regulating Risk - CLO Primer

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Regulating Risk Implementation Risk In New Regulation

Phase-In Compliance Of Volckerrsquos Treatment Of CLOs Will Help Avoid Fire Sales

Hamilton Place Strategieswwwhamiltonplacestrategiescom

202-822-1205

In a column this weekend ldquoKicking Dodd-Frank in the Teethrdquo the NYTrsquos Gretchen

Morgensen argued that HR 37rsquos aim is aldquofurther rollback of regulations put in placeto keep markets and Main Street safe fromreckless Wall Street practicesrdquo She specif-

ically referenced one provision that wouldallow institutions holding collateralized loanobligations (CLOs) securitized prior to thefinal Volcker Rule to sell them by July 2019rather than July 2017 Morgensenrsquos argumentis part of a larger narrative that any reformto Dodd-Frank ndash an 848 page bill with thou-sands of pages of rules ndash represents a winfor Wall Street and a loss for Main StreetHowever the facts suggest otherwise

While Volcker Rule is a much broader regula-tion (well beyond CLOs) the minor provisionin HR 37 keeps the Volcker Rulersquos ban onproprietary trading and covered funds com-pletely intact It simply affords a phased-incompliance aimed at existing CLOs createdbefore the Volcker Rule was finalized ForCLOs issued after Jan 31 2014 this provisionchanges nothing

While the change is small by financial regu-

latory standards HR 37 will help ensure theVolcker Rule does not force banks of all sizesinto fire sales potentially leading to billionsof dollar of losses that would threaten creditaccess for American businesses The CLOmarket provides financing for thousandsof leading American companies such asAmerican Airlines JC Penny Time WarnerGeneral Motors and Rite Aid CLOs also fi-nance smaller growing businesses that canrsquotaccess the bond market to grow and create

Key Findings

bull Measures designed to avoid 983142ire salescaused via phased-in compliance 983142or leg-acy CLOs has been supported by Mem-

bers o983142 both parties the broader busi-ness community and banks o983142 all sizesbull In fact HR 4167 which goes beyond

HR 37 to provide relief for even newCLO issuances passed HFSC last yearby a vote of 53 to 3 and then the fullHouse by unanimous voice vote

bull While some global banks hold CLOs theyare not the only onesbull Smaller bank holding companies are

disproportionately impacted relativeto their CLO investments and overallcapital base

bull CLOs have a cumulative 20-year de983142aultrate o983142 041 percentbull According to SampP no AAA or AA-rated

CLO tranche has defaulted in the last20 years

bull The CLO 983142ix in HR 37 cannot bedescribed as a rollback o983142 Dodd-Frank orthe Volcker Rulebull Proprietary trading is still banned

Taking an ownership stake in hedgefunds is still banned Divestingnon-compliant CLOs is still requiredThe only change is that banks willhave two additional years to divestthemselves of legacy CLOs

Hamilton Place Strategies

January 2015

8102019 Regulating Risk - CLO Primer

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2Hamilton Place Strategies

jobs According to testimony by MeredithCoffey Executive Vice President Researchand Analysis Loan Syndications and TradingAssociation (LSTA) recent figures show theCLO market currently provides $300 billion incapital to US non-investment grade compa-nies

BackgroundCLOs are investment funds that invest insenior fully collateralized bank loans to UScompanies Much like a mutual fund aninvestment manager purchases individualcorporate loans and actively manages theresulting portfolio In effect CLOs are able toconnect investors with patient capital look-ing for a low risk investment with business-es in need of financing Banks insurancecompanies and othercautious investors tendto purchase AAA CLOnotes

Why The Debate The Volcker Rule And ldquoOwn-ership Interestrdquo

The Volcker Rule isdesigned to restrictbanks from speculative trading by banning

proprietary trading or by owning interestsin things like hedge funds or private eq-uity firms At the same time ldquothe statuteitself provides that it [the rule] is not to beconstrued to limit or restrict the ability of abanking entity to sell or securitize loans in amanner otherwise permitted by lawrdquo ac-cording to the Federal Reserve

On face value CLOs seem to fall outside thescope of Volcker However certain stakes in

CLOs inadvertently fell victim to the Fedrsquosbroad definition of ldquoownership interestsrdquo inldquocovered fundsrdquo The Final Rules (in a breakwith the customary legal status of CLO debt)decided to treat CLOrsquos senior debt as equityqualifying it as an ownership interest by theFedrsquos standard Therefore banks are requiredto divest themselves of most CLOrsquos by July2017

This provision understandably left many

businesses as well as the US Chamber ofCommerce concerned In testimony theUS Chamber openly questioned ldquoWhywould banks be forced to divest a safe debtinstrument under a provision of law intend-ed to cover hedge fundsrdquo They concludedthat the Volcker Rulersquos putting banks on thesideline would ldquoremove a major source of

liquidity from the CLO market and make itharder for business that need the CLO mar-ket for loans to find the financing that theyneed to operate grow and create jobsrdquo (Itis worth reinforcing that HR 37 howeverdoes not change this underlying policy inany way despite such concerns and thatmore robust legislation ndash HR 4167 as dis-cussed below ndash to address new issuancespassed the House last year by unanimous

voice vote)

Whatrsquos The ProblemFire Sales

Forced divestitures canresult in fire sales wherebuyers force prices downcausing sellers to takelosses The BipartisanPolicy Centerrsquos Aaron

Klein explained in a February 2014 op-ed

that ldquoIn normal economics once prices falltoo low sellers will stop selling and holdonto their assets and prices will return tonormal However if someone is forced tosell - no matter what the price - then a firesale can spiral This also damages those whodonrsquot sell by reducing the value of their as-sets far below marketrdquo

By driving down the value of CLOs in themarketplace forced divestitures create un-due turmoil for the market and banks im-pacting the ability of American businessesto obtain credit This concern has drivenboth Republicans and Democrats to findsolutions in the past year

Recent Legislative Activity

In March 2014 Rep Andy Barr (R-AL) and theRanking Member of the House Financial Ser-vices Subcommittee on Capital Markets

By driving down the value o983142CLOs in the marketplace 983142orceddivestitures create undue tur-moil 983142or the market and banksimpacting the ability o983142 Ameri-can businesses to obtain credit

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3Hamilton Place Strategies

with 95 Democrats supporting

This bill was re-introduced as HR 37 lastweek However this version has droppedthe provision regarding the definition ofownership As a result while HR 5405 pro-vided relief for both new and legacy CLOsHR 37 only provides phased-in compliance

for CLO notes issued before Jan 31 2014Banks still must divest all non-conformingCLOs However for just legacy CLOs ndash spe-cifically those notes issued prior to the finalrule ndash banks have two more years in whichCLOs could be sold or paid down accordingto their terms

While HR 37 failed to pass the House lastweek it is likely to see the House floor againthis week Unfortunately a number of mythshave clouded discussion of this issue

Myth 1 This is a handout to Wall Streetbanks

While some global banks certainly holdCLOs they arenrsquot the only ones Banks ofall sizes hold CLOs which is why both theAmerican Bankers Association and the In-dependent Community Bankers Associationhave supported the CLO language in HR 37For example Amalgamated Bank which has

$38 billion in assets owns $1329 million inCLOs Nationwide Bank which has $58 bil-lion in assets owns $1349 million First Ni-agara Bank a regional bank with $38 billionin assets holds more than $1 billion in CLOsIn fact according to LSTA the ten bankswith the largest CLO exposure relative totheir capital base averaged only $73 billion

in total assets as of thesecond quarter 2014

Notably ICBA PresidentCam Fine said ldquoThislegislation would makemuch-needed changesto existing law to helpcommunity banks growcapital and support local

economic development and job creationrdquoIn particular the ICBA said the bill ldquowouldprevent the Volcker Rule from unnecessar-

ndash Rep Carolyn Maloney (D-NY) ndash worked topass HR 4167 with a 53-3 vote in commit-tee It was followed by a unanimous voicevote in the full House After passage Rank-ing Member Maloney said ldquoThis legislationwill provide a necessary clarification of theVolcker Rule while maintaining the original

legislative intentrdquo The bill also had the sup-port of HFSC Ranking Member Maxine Wa-ters (D-CA) who in a letter to the Fed with 16other lawmakers expressed concerns aboutthe broader ldquoownershiprdquo definition in theFinal Rule

This bill didnrsquot move forward in the SenateSubsequently Rep Mi-chael Fitzpatrick intro-duced HR 5405 which

is a substantially similarpackage to HR 37 butthe CLO language in thatbill reflected HR 4167(not this yearrsquos compro-mise) and would haveaddressed the ldquoowner-ship interestrdquo issue discussed above HR5405 with the more robust CLO languagepassed the House in September 320-102

bull

bull

In 983142act according to LSTA the

ten banks with the largest CLOexposure relative to their cap-ital base averaged only $73billion in total assets as o983142 thesecond quarter 2014

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4Hamilton Place Strategies

ily decreasing community bank capital andharming local communitiesrdquo

Myth 2 The provision would permit morerisk on Wall Street

CLOs may share an acronym close to ldquoCDOsrdquowhich has led some critics to conflate theirpurpose in financial markets From a cred-it risk perspective they could not be moredifferent

An SampP study of 6100 CLO tranches foundjust 25 defaults between 1994 and 2013Thatrsquos a cumulative 20-year default rate of041 percent And banks tend to buy the leastrisky CLO tranches Of those rated by SampPas AAA or AA none defaulted between 1994and 2013

So while CLOs held by banks pose little cred-it risk the OCC estimated that losses fromforced divestitures could lead to $36 billionin losses Any such losses will represent anavoidable implementation risk created byVolcker not for credit reasons

Myth 3 This is merely a stall tactic 983142or 983142ur-ther lobbying CLOs can be adjusted so theycon983142orm to Volckerrsquos standards

Changing the creditor protection or ridding aCLOrsquos portfolio of securities is not as simpleas it seems According to reporting by MayraRodriguez Valladares David Kriedler of SampPestimates that ldquoroughly half of the approxi-mately $350 billion of CLOs outstanding willneed to amend structuresrdquo Further KevinKendra of Fitch Ratings says most structuresrequire active approval of any change nota lack of dissent ldquoWhere debt andor equi-ty tranches are widely

held across the investorcommunity the logisticsof obtaining positiveconsent from a majoritymay become more of achallengerdquo

Meanwhile Morgensen points out thatwhile the top three banks had unrealizedgains in their CLO holdings according to SNLdata ldquosome banks were facing losses And

that was before the collapse in the price ofoil which has undoubtedly pummeled someof these securitiesrdquo

Myth 4 This provision represents a Re-publican effort to rollback Dodd-Frank

HR 37 represents a package of widely bi-partisan and non-contentious bills aimed athelping businesses particularly small andemerging companies access capital so itrightfully includes the very modest CLOimprovement Further when specificallylooking at the CLO provision in HR 37 itactually seeks to prevent banks from absorb-ing unnecessary losses by preventing firesales ndash a goal of Dodd-Frank and the Volck-er Rule ndash not start them As stated aboveHR 37 is a compromise version of HR 4167which passed the HFSC and the House withbipartisan support Proprietary trading is stillbanned Taking an ownership stake in hedgefunds or private equity firms is still bannedHR 37 simply affords a phased-in compli-ance to allow banks of all sizes (that madesound investments in well-performing andinvestment-grade assets) to divest CLOs theproper way and to help avoid fire sales

Conclusion

Dodd-Frank has changed the banking sectorforever Banks have double the capital triplethe liquidity and are subject to more rulesand oversight The largest of US banks faceenhanced capital and liquidity rules increas-ing the cost of size With HR 37 the core ofDodd-Frank is going nowhere neither is theVolcker Rule The provision in HR 37 regard-ing CLOs does not represent a rollback but

a common sense andadditive improvement to

minimize disruption

Hamilton Place Strate- gies (HPS) consults withfinancial institutions andtheir trade associationsOur clients will be im-

pacted by the potential passage of HR 37The views expressed here are strictly thoseof HPS

While CLOs held by banks poselittle credit risk the OCC esti-mates that losses 983142rom 983142orceddivestitures could lead to $36billion in losses