May 15, 2015 / 5:57 PM / 3 years ago

US banks fend off threats to CLO holdings

NEW YORK, May 15 (IFR) - US banks are still struggling to make their collateralised loan obligations compliant with the Volcker Rule despite a move by the Federal Reserve late last year to give them more time to do so.

The Federal Reserve gave banks until July 2016 to “Volckerise” their CLO portfolios. The Fed also announced its intention to grant banks an additional one-year extension through to July 2017 to conform.

But that extra time may still not be enough for the banks who are still unclear about how to position CLOs that they would be required to divest in their balance sheets.

Simply put, there is some ambiguity within some banks about whether these CLOs belong in their portfolios of assets held to maturity or in baskets of assets held for sale.

A growing chorus of conservative accountants argue that CLOs that have not yet been made fully Volcker compliant should be treated as “assets held for sale” and marked-to-market.

The change would mean the price fluctuations in those CLOs, as they are marked-to-market would be captured in the bank’s earnings statements, argued one attorney.

Such fluctuations on older CLOs could be significant as the Fed begins to raise interest rates and lead to volatility in a bank’s statements.

This conservative view of accounting rules, due to its obvious side-effects on balance sheets, is not sitting well with many US banks. Most are in fact working on a plan to use the deadline extension to make the CLOs Volcker compliant, argued one manager.

If CLOs end up as disallowed investments, there could be unrealised losses associated with current accounting treatment, he said, but it’s not significant.

Volcker prohibits banks from having an ownership interest in CLOs backed by anything but loans and also prevents them from selecting their CLO managers.

Banks have so far been focused only on removing bond baskets from CLOs, and slower in addressing concerns about their rights to remove managers.

When banks buy CLOs they tend to buy Triple A rated tranches, which give them the right to replace the managers, for cause.

That right is understood to confer an ownership interest in CLOs, bolstering the argument that CLOs are more like private equity funds and hedge funds in which Volcker strictly limits bank ownership.

“Once you get rid of the bond basket you are no longer a covered fund,” said one manager.

Regulators have been slow to weigh in on whether or not the right to remove a manager categorises CLOs as a prohibited covered fund.

If regulators say it does then US banks, which hold the lion’s share of those senior Triple A rated CLO tranches, probably worth billions of dollars, could be forced to sell.

“We should get an exemption once we get the regulators’ attention,” said J Paul Forrester, a partner with Mayer Brown.

The regulator did not return request for comment on how it viewed management selection in the context of Volcker. But if traders are expecting a buying opportunity as banks are forced out of CLOs they may have to wait for a long while.

Some attorneys think banks could simply waive management selection rights and not be forced to sell the CLOs.

“It’s a silver bullet,” said another attorney also advising banks on Volcker compliance. “If banks give up that right, they will no longer have ownership interest and won’t have to divest anything,” he said.

“Our bank clients are relying on our advice and that view to keep from marking their portfolios currently.”

Another deadline

Traders meanwhile are prepping for a fire-sale of CLOs in June and July as banks face a July 21 deadline to prove that their trading desks’ market making exemptions from the proprietary trading restrictions are legitimate.

Some traders are expecting that if banks are not able to hit this mark, CLOs in the trading desks will need to be sold. If the volume is sufficient it could pressure pricing and that could create a windfall for buyers.

Banks have been preparing to meet requirements for market-making and should be able to show regulators that trading inventories are related to client demand, which is intended to serve as an impediment to prop trading, said one CLO manager.

A version of this story will appear in the May 16 edition of IFR Magazine, a Thomson Reuters publication (Reporting by Philip Scipio; editing by Shankar Ramakrishnan)

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