Regulating Risk: Implementation Risk in New Regulation Phase-In Compliance of Volcker’S Treatment of Clos Will Help Avoid Fire Sales

Hamilton Place Strategies www.hamiltonplacestrategies.com 202-822-1205

January 2015

Regulating Risk: Implementation Risk In New Regulation Phase-In Compliance Of Volcker’s Treatment Of CLOs Will Help Avoid Fire Sales

Key Findings: n a column this weekend, “Kicking Dodd- IFrank in the Teeth,” the NYT’s Gretchen Morgensen argued that H.R. 37’s aim is a • Measures designed to avoid fire sales “further rollback of regulations put in place caused via phased-in compliance for leg- to keep markets and Main Street safe from acy CLOs has been supported by Mem- reckless Wall Street practices.” She specif- bers of both parties, the broader busi- ically 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. Morgensen’s 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 disproportionately impacted relative While Volcker Rule is a much broader regula- to their CLO investments and overall tion (well beyond CLOs), the minor provision capital base. in H.R. 37 keeps the Volcker Rule’s ban on proprietary trading and covered funds com- • CLOs have a cumulative 20-year default pletely intact. It simply affords a phased-in rate of 0.41 percent. compliance aimed at existing CLOs created • According to S&P, no AAA or AA-rated before the Volcker Rule was finalized. For CLO tranche has defaulted in the last CLOs issued after Jan. 31, 2014, this provision 20 years. changes nothing. While the change is small by financial regu- • The CLO fix in H.R. 37 cannot be latory standards, H.R. 37 will help ensure the described as a rollback of Dodd-Frank or Volcker Rule does not force banks of all sizes the Volcker Rule. into fire sales, potentially leading to billions • Proprietary trading is still banned. of dollar of losses that would threaten credit Taking an ownership stake in hedge access for American businesses. The CLO funds is still banned. Divesting market provides financing for thousands non-compliant CLOs is still required. of leading American companies such as The only change is that banks will American Airlines, JC Penney, Time Warner, have two additional years to divest General Motors, and Rite Aid. CLOs also fi- themselves of legacy CLOs. nance smaller, growing businesses that can’t access the bond market to grow and create Hamilton Place Strategies 1 jobs. According to testimony by Meredith businesses, as well as the U.S. Chamber of Coffey, Executive Vice President, Research Commerce concerned. In testimony, the and Analysis, Loan Syndications and Trading U.S. Chamber openly questioned, “Why Association (LSTA), recent figures show the would banks be forced to divest a safe debt CLO market currently provides $300 billion in instrument under a provision of law intend- capital to U.S. non-investment grade compa- ed to cover hedge funds?” They concluded nies. that the Volcker Rule’s putting banks on the sideline would “remove a major source of Background liquidity from the CLO market, and make it CLOs are investment funds that invest in harder for business that need the CLO mar- senior, fully collateralized bank loans to U.S. ket for loans to find the financing that they companies. Much like a mutual fund, an need to operate, grow, and create jobs.” (It investment manager purchases individual is worth reinforcing that H.R. 37, however, corporate loans and actively manages the does not change this underlying policy in resulting portfolio. In effect, CLOs are able to any way, despite such concerns, and that connect investors with patient capital look- more robust legislation – H.R. 4167, as dis- ing for a low risk investment with business- cussed below – to address new issuances es in need of financing. Banks, insurance passed the House last year by unanimous companies, and other voice vote.) cautious investors tend By driving down the value of What’s The Problem? to purchase AAA CLO CLOs in the marketplace, forced Fire Sales! notes. divestitures create undue tur- Forced divestitures can Why The Debate? The moil for the market and banks, result in fire sales, where Volcker Rule And “Own- impacting the ability of Ameri- buyers force prices down ership Interest” can businesses to obtain credit. causing sellers to take The Volcker Rule is losses. The Bipartisan designed to restrict Policy Center’s Aaron banks from speculative trading by banning Klein explained in a February 2014 op-ed proprietary trading or by owning interests that, “In normal economics, once prices fall in things like hedge funds or private eq- too low, sellers will stop selling and hold uity firms. At the same time, “the statute onto their assets, and prices will return to itself provides that it [the rule] is not to be normal. However, if someone is forced to construed to limit or restrict the ability of a sell - no matter what the price - then a fire banking entity to sell or securitize loans in a sale can spiral. This also damages those who manner otherwise permitted by law,” ac- don’t sell, by reducing the value of their as- cording to the Federal Reserve. sets far below market.” On face value, CLOs seem to fall outside the By driving down the value of CLOs in the scope of Volcker. However, certain stakes in marketplace, forced divestitures create un- CLOs inadvertently fell victim to the Fed’s due turmoil for the market and banks, im- broad definition of “ownership interests” in pacting the ability of American businesses “covered funds”. The Final Rules (in a break to obtain credit. This concern has driven with the customary legal status of CLO debt) both Republicans and Democrats to find decided to treat CLO’s senior debt as equity, solutions in the past year. qualifying it as an ownership interest by the Recent Legislative Activity Fed’s standard. Therefore, banks are required to divest themselves of most CLO’s by July In March 2014, Rep. Andy Barr (R-AL) and the 2017. Ranking Member of the House Financial Ser- vices Subcommittee on Capital Markets This provision understandably left many 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 pro- vided 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 – Rep. Carolyn Maloney (D-NY) – worked to While some global banks certainly hold pass H.R. 4167 with a 53-3 vote in commit- CLOs, they aren’t the only ones. Banks of tee. It was followed by a unanimous voice all sizes hold CLOs, which is why both the vote in the full House. After passage, Rank- American Bankers Association and the In- ing Member Maloney said, “This legislation dependent Community Bankers Association will provide a necessary clarification of the have supported the CLO language in H.R. 37. Volcker Rule while maintaining the original For example, Amalgamated Bank, which has legislative intent.” The bill also had the sup- $3.8 billion in assets, owns $132.9 million in port of HFSC Ranking Member Maxine Wa- CLOs. Nationwide Bank, which has $5.8 bil- ters (D-CA), who in a letter to the Fed with 16 lion in assets, owns $134.9 million. First Ni- other lawmakers expressed concerns about agara Bank, a regional bank with $38 billion the broader “ownership” definition in the in assets, holds more than $1 billion in CLOs. Final Rule. In fact, according to LSTA, the ten banks with the largest CLO exposure relative to This bill didn’t move forward in the Senate. their capital base averaged only $7.3 billion Subsequently, Rep. Mi- in total assets as of the chael Fitzpatrick intro- second quarter 2014. duced H.R. 5405, which In fact, according to LSTA, the is a substantially similar ten banks with the largest CLO Notably, ICBA President package to H.R. 37, but exposure relative to their cap- Cam Fine said, “This the CLO language in that ital base averaged only $7.3 legislation would make bill reflected H.R. 4167 billion in total assets as of the much-needed changes (not this year’s compro- second quarter 2014. to existing law to help mise) and would have community banks grow addressed the “owner- capital and support local ship interest” issue discussed above. H.R. economic development and job creation.” 5405, with the more robust CLO language, In particular, the ICBA said, the bill “would passed the House in September 320-102, prevent the Volcker Rule from unnecessar-

Hamilton Place Strategies 3 ily decreasing community bank capital and that was before the collapse in the price of harming local communities.” oil, which has undoubtedly pummeled some of these securities.” Myth #2 The provision would permit more risk on Wall Street Myth #4 This provision represents a Re- publican effort to rollback Dodd-Frank. CLOs may share an acronym close to “CDOs,” which has led some critics to conflate their H.R. 37 represents a package of widely bi- purpose in financial markets. From a cred- partisan and non-contentious bills aimed at it risk perspective, they could not be more helping businesses, particularly small and different. emerging companies, access capital, so it rightfully includes the very modest CLO An S&P study of 6,100 CLO tranches found improvement. Further, when specifically just 25 defaults between 1994 and 2013. looking at the CLO provision in H.R. 37, it That’s a cumulative 20-year default rate of actually seeks to prevent banks from absorb- 0.41 percent. And banks tend to buy the least ing unnecessary losses by preventing fire risky CLO tranches. Of those rated by S&P sales – a goal of Dodd-Frank and the Volck- as AAA or AA, none defaulted between 1994 er Rule – not start them. As stated above, and 2013. H.R. 37 is a compromise version of H.R. 4167, So while CLOs held by banks pose little cred- which passed the HFSC and the House with it risk, the OCC estimated that losses from bipartisan support. Proprietary trading is still forced divestitures could lead to $3.6 billion banned. Taking an ownership stake in hedge in losses. Any such losses will represent an funds or private equity firms is still banned. avoidable implementation risk created by H.R. 37 simply affords a phased-in compli- Volcker, not for credit reasons. ance to allow banks of all sizes (that made sound investments in well-performing and Myth #3 This is merely a stall tactic for fur- investment-grade assets) to divest CLOs the ther lobbying. CLOs can be adjusted so they proper way and to help avoid fire sales. conform to Volcker’s standards Conclusion Changing the creditor protection or ridding a CLO’s portfolio of securities is not as simple Dodd-Frank has changed the banking sector as it seems. According to reporting by Mayra forever. Banks have double the capital, triple Rodriguez Valladares, David Kriedler of S&P the liquidity, and are subject to more rules estimates that “roughly half of the approxi- and oversight. The largest of U.S. banks face mately $350 billion of CLOs outstanding will enhanced capital and liquidity rules, increas- 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 require active approval of any change, not Volcker Rule. The provision in H.R. 37 regard- a lack of dissent. “Where debt and/or equi- ing CLOs does not represent a rollback, but ty tranches are widely a common sense and held across the investor While CLOs held by banks pose additive improvement to community, the logistics little credit risk, the OCC esti- minimize disruption. of obtaining positive mates that losses from forced Hamilton Place Strate- consent 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. Meanwhile, Morgensen points out, that Our clients will be im- while the top three banks had unrealized pacted by the potential passage of H.R. 37. The views expressed here are strictly those gains in their CLO holdings, according to SNL data, “some banks were facing losses. And of HPS.

Hamilton Place Strategies 4