Full Circle: How the New Volcker Ruling Will Affect CLOs

The Volcker Rule, which went into effect on April 1, 2014, limited the way banking entities were permitted to have an “ownership interest” in what was broadly defined as Covered Funds. The rule was designed to limit risks taken by banking entities acting as an “investment company” under the Investment Company Act of 1940 that also receive deposit insurance by taxpayers and the federal government.

While well intended, the original rules created confusion without full clarity on specific definitions themselves. Lawmakers who wrote the bill did so without fully understanding the differences within the industry of securitization types and the diversified risks these investments inherently maintain.

In the original rule, securitizations such as Collateralized Debt Obligations (CDOs) were targeted as non-permissible investments because they held mortgage loans and the mortgage industry was a driving factor in the economic meltdown of 2007-08. Collateralized Loan Obligations (CLOs), which are similarly structured to CDOs but hold portfolios of more strictly underwritten credit, also got swept up in the legislation. CLOs have been historically safer and suffered no defaults during the crisis.

The ambiguity of the original Volcker Rules led to some confusion about whether banks were permitted to hold securitization notes. This confusion caused banks to back away from investing in tranches of CLOs, reducing the pool of investors for new issuance. Clarification will increase facilitation of credit to the wider economy as banks re-enter the transactions with a larger range of financial options.

New legislation that goes into effect on October 1, 2020 clarifies what constitutes a Covered Fund, while also clarifying that an ownership interest will no longer include the right to remove a manager for cause and will include a safe harbor for the ownership of debt interests within the portfolio. Up to five percent of securitization assets can be held as debt securities. In short, banks will be able to invest in securitization notes while managers will increase their ability to participate in restructurings and improve their flexibility in executing the portfolio strategy.

Tim Ruxton, Managing Director of Sales for Alter Domus, has worked with several large banks and managers in the past 20 years, managing teams that worked with CDOs and CLOs. Here, he offers his insight into what the new rules mean and how managers and banks can use them to expand their portfolios.

The Return of Liquidity

According to Ruxton, the fact that the new rule clarifies that managers can now trade in bonds again will help in several ways. “Because of the timing of trade settlements, managers are sometimes unable to invest in an opportunity as rapidly as they would like. The ability to sell a bond quickly to raise cash for a trade is an advantage that we’ve seen in European CLOs but not in the US since 2013. Also, when the industry recently went through a period of multiple loan restructurings, managers were often unable to participate when debt was offered. I believe this unfairly limited managers’ ability to execute their strategy and added risk to the market. I’m always in favor of more manager control and reduced risk.”

Get the Timing Right

Although the new ruling goes into effect on October 1st, fund managers don’t have to wait until then to set up new CLOs to take advantage of the five percent bonds feature. A “springing bond bucket” in any new issuance indenture language will allow the CLO to begin owning bonds on October 1st. This prevents the unnecessary expense of reissuing or amending the documents once the new rule goes into effect. Current indentures would have to go through an amendment process to allow for the regulatory relief to be effective on their current portfolios. It remains to be seen if many managers will take on this expense.

Ownership Ambiguity Cleared Up

After the Volcker Rule took effect, banking entities weren’t sure whether they were permitted to invest in AAA notes of the securitization tranches because the language was ambiguous, so most shied away from it. But the new ruling clarified the matter and ownership is now defined by the previous 1940 legislation.

With the Covered Funds clarity comes an expansion of the CLO investor pool as banks will no longer be restricted in owning CLO tranches. This means managers are likely to become very busy in the coming months with new clients looking to get back into a prized marketplace.

Ultimately, this should result in a larger issuance because the investment base is growing. “I think this new ruling could give managers a little more variety in how they can negotiate their terms or perfect their offering,” Ruxton said.

Issuance Equals the Need for an Expert Middle Office

The more issuance managers have, the more they need Alter Domus to control the expense of an expert middle office. One of the many benefits of working with Alter Domus is that the team has extensive experience working with CLOs before the 2014 Volcker Rule went into place. Alter Domus can:

• Facilitate the onboarding of new issuances at a fast pace. This comes from the experience of working with these types of structures in the past as well as a deep bench of CLO talent.
• Work nimbly and flexibly, expertly picking up the pace of issuance as needed. We understand the demands placed on mangers as many of our staff have worked in that side of the industry.
• Our Trade Settlement Team does both bonds and loans, which makes for seamless transactions as you work with the same consistent closing experts for all settlements.
• Leverage multiple decades of securitization transactions, which has created excellent working relationships with banks, agents, brokers, and other counterparties.

Ruxton says he remembers the early 2000s when things moved at a very fast clip before the slowdown, and says his team understands the demands investors place on managers. “We are able to sympathize with that, anticipate those needs and quickly provide the information they’re looking for.”

The Volcker Rule has come full circle, and managers must quickly ramp up to meet the needs of an expanding marketplace. Alter Domus can help make the transition easier with years of relevant and proven experience.