Following the financial crisis in 2008, various types of legislation were put in place to stop certain financial transactions having potentially ruinous effects on the banking system, the Volcker Rule being one of them.
The current rules bar US banks from having an ‘ownership interest’ in a covered fund, such as hedge funds and private equity funds. This interest is broadly defined in the Volcker Rule, including not just subordinated debt of a transaction but even the most senior tranche, ie triple A, as this class of notes typically holds a right to remove the manager for cause.
However, one criticism of the legislation is that it excluded instruments such as collateralised loan obligations (CLOs) which are related to collateralised debt obligations (CDO), the former is a type of the latter. The main difference being that CLOs are made up of bank loans, not assets such as mortgages which certain other types of CDOs may contain. These structured finance products arguably were one of the prime causes of the crash given certain sub-prime mortgage CDOs contained toxic assets. CLOs under their current classification under Volcker could comprise of only loans and short term cash equivalents, not bonds.
However, if proposed changes are adopted, and they are expected to be, loan securitisation will be expanded to permit the acquisition and holding of up to 5 percent of non-loan assets such as bonds. Furthermore senior debt tranches that bear certain hallmarks which are set out in the proposal will be able to take advantage of a 'safe harbour' from the definition of "ownership interest", even if such notes carry the right to remove the manager for cause. Triple A CLO notes typically bear such hallmarks.
If, as expected, the proposals are put through, existing CLO agreements have a ‘bond bucket’ concept already included in the deal documentation. Those that don’t will have obtain consents to amend their CLO deals although will also be free to take advantage of this loosening of the regulatory framework.
While Federal Reserve chair Jerome Powell is in favour in the proposals, there are some concerns by some at US regulator, the Securities and Exchange Allison Herren Lee, a commissioner at the SEC said in a statement: "As with the rule last fall, this proposal replaces clear, common sense restrictions with just the hope that banks will self-police and remain diligent in identifying and mitigating their own risks — an expectation that flies in the face of experience."
