Hamilton Place Strategies

www.hamiltonplacestrategies.com
202-822-1205
January 2015

Regulating Risk: Implementation Risk In New Regulation

Phase-In Compliance Of Volckers Treatment Of CLOs Will Help Avoid Fire Sales
Key Findings:

The CLO fix in H.R. 37 cannot be

described as a rollback of Dodd-Frank or
the Volcker Rule.
Proprietary trading is still banned.
Taking an ownership stake in hedge
funds is still banned. Divesting
non-compliant CLOs is still required.
The only change is that banks will
have two additional years to divest
themselves of legacy CLOs.

While the change is small by financial regulatory standards, H.R. 37 will help ensure the
Volcker Rule does not force banks of all sizes
into fire sales, potentially leading to billions
of dollar of losses that would threaten credit
access for American businesses. The CLO
market provides financing for thousands
of leading American companies such as
American Airlines, JC Penny, Time Warner,
General Motors, and Rite Aid. CLOs also finance smaller, growing businesses that cant
access the bond market to grow and create

n a column this weekend, Kicking DoddFrank in the Teeth, the NYTs Gretchen
Morgensen
argued that H.R. 37s aim is a
Measures designed to avoid fire sales
caused via phased-in compliance for leg- further rollback of regulations put in place
to keep markets and Main Street safe from
acy CLOs has been supported by Memreckless Wall Street practices. She specifbers of both parties, the broader busiically referenced one provision that would
ness community, and banks of all sizes.
allow institutions holding collateralized loan
In fact, H.R. 4167, which goes beyond
obligations (CLOs) securitized prior to the
H.R. 37 to provide relief for even new
final Volcker Rule to sell them by July 2019
CLO issuances, passed HFSC last year
rather than July 2017. Morgensens argument
by a vote of 53 to 3 and then the full
is part of a larger narrative that any reform
House by unanimous voice vote.
to Dodd-Frank an 848 page bill with thousands of pages of rules represents a win
While some global banks hold CLOs, they for Wall Street and a loss for Main Street.
are not the only ones.
However, the facts suggest otherwise.
Smaller bank holding companies are
While Volcker Rule is a much broader reguladisproportionately impacted relative
tion (well beyond CLOs), the minor provision
to their CLO investments and overall
in H.R. 37 keeps the Volcker Rules ban on
capital base.
proprietary trading and covered funds com CLOs have a cumulative 20-year default pletely intact. It simply affords a phased-in
compliance aimed at existing CLOs created
rate of 0.41 percent.
before the Volcker Rule was finalized. For
According to S&P, no AAA or AA-rated
CLOs issued after Jan. 31, 2014, this provision
CLO tranche has defaulted in the last
changes nothing.
20 years.

Hamilton Place Strategies 1

jobs. According to testimony by Meredith

Coffey, Executive Vice President, Research
and Analysis, Loan Syndications and Trading
Association (LSTA), recent figures show the
CLO market currently provides $300 billion in
capital to U.S. non-investment grade companies.
Background

businesses, as well as the U.S. Chamber of

Commerce concerned. In testimony, the
U.S. Chamber openly questioned, Why
would banks be forced to divest a safe debt
instrument under a provision of law intended to cover hedge funds? They concluded
that the Volcker Rules putting banks on the
sideline would remove a major source of
liquidity from the CLO market, and make it
harder for business that need the CLO market for loans to find the financing that they
need to operate, grow, and create jobs. (It
is worth reinforcing that H.R. 37, however,
does not change this underlying policy in
any way, despite such concerns, and that
more robust legislation H.R. 4167, as discussed below to address new issuances
passed the House last year by unanimous
voice vote.)

CLOs are investment funds that invest in

senior, fully collateralized bank loans to U.S.
companies. Much like a mutual fund, an
investment manager purchases individual
corporate loans and actively manages the
resulting portfolio. In effect, CLOs are able to
connect investors with patient capital looking for a low risk investment with businesses in need of financing. Banks, insurance
companies, and other
cautious investors tend By driving down the value of
to purchase AAA CLO
CLOs in the marketplace, forced
notes.

Whats The Problem?

Fire Sales!

divestitures create undue turWhy The Debate? The

moil for the market and banks,
Volcker Rule And Own- impacting the ability of Ameriership Interest
can businesses to obtain credit.
The Volcker Rule is
designed to restrict
banks from speculative trading by banning
proprietary trading or by owning interests
in things like hedge funds or private equity firms. At the same time, the statute
itself provides that it [the rule] is not to be
construed to limit or restrict the ability of a
banking entity to sell or securitize loans in a
manner otherwise permitted by law, according to the Federal Reserve.
On face value, CLOs seem to fall outside the
scope of Volcker. However, certain stakes in
CLOs inadvertently fell victim to the Feds
broad definition of ownership interests in
covered funds. The Final Rules (in a break
with the customary legal status of CLO debt)
decided to treat CLOs senior debt as equity,
qualifying it as an ownership interest by the
Feds standard. Therefore, banks are required
to divest themselves of most CLOs by July
2017.
This provision understandably left many

Forced divestitures can

result in fire sales, where
buyers force prices down
causing sellers to take
losses. The Bipartisan
Policy Centers Aaron
Klein explained in a February 2014 op-ed
that, In normal economics, once prices fall
too low, sellers will stop selling and hold
onto their assets, and prices will return to
normal. However, if someone is forced to
sell - no matter what the price - then a fire
sale can spiral. This also damages those who
dont sell, by reducing the value of their assets far below market.
By driving down the value of CLOs in the
marketplace, forced divestitures create undue turmoil for the market and banks, impacting the ability of American businesses
to obtain credit. This concern has driven
both Republicans and Democrats to find
solutions in the past year.
Recent Legislative Activity
In March 2014, Rep. Andy Barr (R-AL) and the
Ranking Member of the House Financial Services Subcommittee on Capital Markets
Hamilton Place Strategies 2

with 95 Democrats supporting.

This bill was re-introduced as H.R. 37 last

week. However, this version has dropped
the provision regarding the definition of
ownership. As a result, while H.R. 5405 provided relief for both new and legacy CLOs,
H.R. 37 only provides phased-in compliance
for CLO notes issued before Jan. 31, 2014.
Banks still must divest all non-conforming
CLOs. However, for just legacy CLOs specifically, those notes issued prior to the final
rule banks have two more years in which
CLOs could be sold or paid down according
to their terms.
While H.R. 37 failed to pass the House last
week, it is likely to see the House floor again
this week. Unfortunately, a number of myths
have clouded discussion of this issue.
Myth #1 This is a handout to Wall Street
banks

While some global banks certainly hold

CLOs, they arent the only ones. Banks of
all sizes hold CLOs, which is why both the
American Bankers Association and the Independent Community Bankers Association
have supported the CLO language in H.R. 37.
For example, Amalgamated Bank, which has
$3.8 billion in assets, owns $132.9 million in
CLOs. Nationwide Bank, which has $5.8 billion in assets, owns $134.9 million. First Niagara Bank, a regional bank with $38 billion
in assets, holds more than $1 billion in CLOs.
In fact, according to LSTA, the ten banks
with the largest CLO exposure relative to
This bill didnt move forward in the Senate.
their capital base averaged only $7.3 billion
Subsequently, Rep. Miin total assets as of the
chael Fitzpatrick introsecond quarter 2014.
In fact, according to LSTA, the
duced H.R. 5405, which
Notably, ICBA President
is a substantially similar ten banks with the largest CLO
exposure
relative
to
their
capCam Fine said, This
package to H.R. 37, but
legislation would make
the CLO language in that ital base averaged only $7.3
much-needed changes
bill reflected H.R. 4167
billion in total assets as of the
to existing law to help
(not this years compro- second quarter 2014.
community banks grow
mise) and would have
capital and support local
addressed the ownereconomic
development
and job creation.
ship interest issue discussed above. H.R.
In particular, the ICBA said, the bill would
5405, with the more robust CLO language,
prevent the Volcker Rule from unnecessarpassed the House in September 320-102,
Rep. Carolyn Maloney (D-NY) worked to
pass H.R. 4167 with a 53-3 vote in committee. It was followed by a unanimous voice
vote in the full House. After passage, Ranking Member Maloney said, This legislation
will provide a necessary clarification of the
Volcker Rule while maintaining the original
legislative intent. The bill also had the support of HFSC Ranking Member Maxine Waters (D-CA), who in a letter to the Fed with 16
other lawmakers expressed concerns about
the broader ownership definition in the
Final Rule.

Hamilton Place Strategies 3

ily decreasing community bank capital and

harming local communities.
Myth #2 The provision would permit more
risk on Wall Street
CLOs may share an acronym close to CDOs,
which has led some critics to conflate their
purpose in financial markets. From a credit risk perspective, they could not be more
different.
An S&P study of 6,100 CLO tranches found
just 25 defaults between 1994 and 2013.
Thats a cumulative 20-year default rate of
0.41 percent. And banks tend to buy the least
risky CLO tranches. Of those rated by S&P
as AAA or AA, none defaulted between 1994
and 2013.
So while CLOs held by banks pose little credit risk, the OCC estimated that losses from
forced divestitures could lead to $3.6 billion
in losses. Any such losses will represent an
avoidable implementation risk created by
Volcker, not for credit reasons.
Myth #3 This is merely a stall tactic for further lobbying. CLOs can be adjusted so they
conform to Volckers standards

that was before the collapse in the price of

oil, which has undoubtedly pummeled some
of these securities.
Myth #4 This provision represents a Republican effort to rollback Dodd-Frank.
H.R. 37 represents a package of widely bipartisan and non-contentious bills aimed at
helping businesses, particularly small and
emerging companies, access capital, so it
rightfully includes the very modest CLO
improvement. Further, when specifically
looking at the CLO provision in H.R. 37, it
actually seeks to prevent banks from absorbing unnecessary losses by preventing fire
sales a goal of Dodd-Frank and the Volcker Rule not start them. As stated above,
H.R. 37 is a compromise version of H.R. 4167,
which passed the HFSC and the House with
bipartisan support. Proprietary trading is still
banned. Taking an ownership stake in hedge
funds or private equity firms is still banned.
H.R. 37 simply affords a phased-in compliance to allow banks of all sizes (that made
sound investments in well-performing and
investment-grade assets) to divest CLOs the
proper way and to help avoid fire sales.
Conclusion

Changing the creditor protection or ridding a

Dodd-Frank has changed the banking sector
CLOs portfolio of securities is not as simple
as it seems. According to reporting by Mayra forever. Banks have double the capital, triple
the liquidity, and are subject to more rules
Rodriguez Valladares, David Kriedler of S&P
and oversight. The largest of U.S. banks face
estimates that roughly half of the approxienhanced capital and liquidity rules, increasmately $350 billion of CLOs outstanding will
ing the cost of size. With H.R. 37, the core of
need to amend structures. Further, Kevin
Kendra of Fitch Ratings says most structures Dodd-Frank is going nowhere, neither is the
Volcker Rule. The provision in H.R. 37 regardrequire active approval of any change, not
ing CLOs does not represent a rollback, but
a lack of dissent. Where debt and/or equia common sense and
ty tranches are widely
additive improvement to
held across the investor While CLOs held by banks pose
minimize disruption.
community, the logistics little credit risk, the OCC estiof obtaining positive
mates that losses from forced
Hamilton Place Strateconsent from a majority divestitures could lead to $3.6
gies (HPS) consults with
may become more of a billion in losses.
financial institutions and
challenge.
their trade associations.
Our clients will be imMeanwhile, Morgensen points out, that
pacted
by
the
potential
passage of H.R. 37.
while the top three banks had unrealized
gains in their CLO holdings, according to SNL The views expressed here are strictly those
of HPS.
data, some banks were facing losses. And
Hamilton Place Strategies 4