Last week’s House vote on H.R. 5461 included provisions that seek to address potential disruptions of the collateralized loan obligations (CLOs) market by giving financial institutions two additional years to divest securities that were purchased before the Volcker Rule was issued.
Some have argued these changes to Dodd-Frank create significant risk, but that is a far overreaching claim. Unfortunately, there continues to be some confusion about CLOs - misconceptions that we can only think come from a conflation with CDOs (debt obligations). But in this case, the letter “L” makes all the difference.
The evidence contradicts the view that CLOs are too risky. According study by Standard & Poor’s released in January 2014, the 20-year default rate for CLOs is a miniscule 0.41 percent - far below the default rate in almost any other asset class. Moreover, banks don’t buy “risky tranches” of CLOs - far from it. They invest almost exclusively in AAA tranches, and according to the S&P study, there has never been a default in the CLO AAA tranches.
Because CLOs have performed so well, including through the worst financial crisis since the Great Depression, banks have continued to buy AAA tranches in good faith over the past several years. But when the Volcker Rule was issued at the end of 2013, it became clear that because these AAA notes had some creditor protective rights, the Volcker Rule treated them like equity – and would force the banks to sell their investments in very short order. This was a major problem because selling CLO investments quickly would be - in effect - a fire sale.
Banks stood to lose billions of dollars - even though every single investment was structurally sound. And this is not simply industry speculation. A cost-benefit analysis released by the Office of the Comptroller of the Currency estimated banks could suffer a $3 billion loss through the forced sale. It was completely reasonable that banks that purchased these AAA notes in good faith wanted to avert this unfortunate – and completely avoidable – outcome. To do so, banks agreed with the regulators that they would only buy CLOs comprised solely of loans in the future. But they also asked to not be forced to sell the AAA notes of CLOs that were made up of at least 90 percent loans.
However, the regulators took another approach. Instead, the Federal Reserve suggested that the conformance period – the time in which banks had to sell the notes – be extended until July 2017 for CLO notes owned by banks as of the end of 2013. While this provided some relief, it does not go far enough and would still lead to significant, unnecessary losses.
First, there will be more than $100 billion of – perfectly performing but non-Volcker compliant – CLOs outstanding in July 2017. Second, because only CLO notes that were owned by banks at the end of 2013 are covered, the second a bank sells a CLO note – as it must to meet the rules – the extended conformance period disappears. This will dramatically reduce liquidity – and thus reduce the pool of potential buyers. In effect, the rule says, “you must sell your notes, but we have taken away the buyers”.
And this is where Congress appropriately stepped in. The provisions related to CLOs in H.R. 5461 - which were reported out of the Financial Services Committee by a vote of 53-3 with overwhelming bipartisan support - states that the conformance extension should be permitted for CLO notes issued (not owned) by January 2014. Banks still need to fix - or (more likely) sell - these notes by July 2017. This fix simply allows banks to so do without facing a completely illiquid market.
Smith is the executive director of the Loan Syndications & Trading Association (LSTA). Follow LSTA on Twitter @TheLSTA.