CLO market must pull together to meet Volcker challenge
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CLO market must pull together to meet Volcker challenge

The CLO market is ready for more supply and ripe for innovation, but that optimism is tempered by threats of a liquidity crunch in non-Volcker-compliant triple-A paper. The market is hoping for a deal on legacy CLOs to stop a trading freeze, but if that doesn't happen, it needs to wake up to two uncomfortable truths.

It transpired at IMN's well-attended CLO conference last week that the Federal Reserve’s two year extension for banks to make their CLO holdings comply with the Volcker rule only applies to CLOs held by banks now. If the paper trades, it will no longer benefit from the extension, and banks may not be able to keep hold of their CLOs.

Market participants are now rightly worried that this willimpair secondary market liquidity, a further worry for bank investors that were already concerned about having to sell their bonds into a declining market.

At the panel he chaired on Volcker at the conference, Elliot Ganz, executive vice president and general counsel at the Loan Standards and Trading Association, pointed out that the Fed’s extension does not officially take place until August, meaning there is potentially time to get a deal on grandfathering of legacy CLOs by then.

But Sairah Burki, director of Policy at the Structured Finance Industry Group, said she felt there was not much momentum for further changes either from regulators or on Capitol Hill. Despite Congressman Andy Barr’s Volcker relief bill heading to the full house, few expect it to make it into legislation.

The CLO market must surely now wake up to two uncomfortable truths: that relief on this issue is not forthcoming, and that this affects banks now.

Accounting woes

As hopes of a solution fade, banks holding non-compliant CLOs will come under pressure to recognise impairments on these assets and apply Other Than Temporary Impairment (OTTI) treatment, which will lead to irreversible write-downs on those instruments.

The only way to avoid this is for banks to be refinanced out of existing CLOs, or for CLO managers to amend documentation to make their deals Volcker-compliant. Some managers, like ING, have done this; others, like Octagon Credit Investors, have not.

At the conference, plenty of industry participants pointed out that Volcker compliance was a bank problem, not a manager problem, that it is up to banks to find a solution. But it affects all CLO buyers, and therefore all managers too.

It is not safe to assume that banks will use their allowance for investing in covered funds — set at 3% of tier one capital — to hold CLOs. And while the triple-A buyer base is deeper than it has been for some time, banks, with their low cost of funding, are the natural holders of AAA CLO paper. If they are forced to sell, yields will rise, and equity will suffer.

Compromise

Equity investors don’t want to lose their bond buckets to make deals Volcker-compliant. But between losing that extra collateral flexibility and owning an illiquid asset, most would surely choose the former. The other option to get compliant is for triple-A investors to waive their ownership rights, but it is not clear whether regulators will even accept that workaround yet.

This lack of clarity makes deal amendments even more pressing, because it progresses the search a form of standard language to give investors confidence that when CLOs are "Volckerised", they actually do become Volcker-compliant.

One bank investor who spoke to GlobalCapital recently received a legal opinion on a Volckerised deal which cast doubt upon whether it was indeed Volcker-compliant. While legal opinions on this issue should be taken with a spoonful of salt — as one lawyer said, they are “not deliverable” — the fact that this uncertainty exists is another sign that Volckerisation is not going to be an easy process.

The process needs to gain momentum, and quickly, otherwise the new issue market will suffer, and all the new investors that left last week’s conference with optimistic forecasts ringing in their ears will have nothing to buy.

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