Today, Elliot Ganz, executive vice president and general counsel of the Loan Syndications and Trading Association (LSTA), testified before the House Financial Services Committee that the definition of “ownership interest” in the final Volcker Rule will have significant unintended consequences on the CLO market, result in material and arbitrary losses to American banks, and negatively impact credit availability for U.S. businesses.
During the hearing, “The Impact of the Volcker Rule on Job Creators, Part I,” Ganz explained that the final Volcker Rule effectively “converts” CLO debt securities into the equivalent of equity securities, thereby making them ineligible to be held by banks. Due to the safety and historically low impairment rate offered by CLOs, U.S. banks currently hold approximately $70 billion in these securities. Without clarification on the first “indicia of ownership,” banks would be forced to divest or restructure these notes over the next year and a half, possibly at a significant loss.
Ganz went on to explain that if banks are simultaneously forced to sell, the impact of this rule would be felt almost immediately: The act of selling would put downward pressure on CLO prices and could trigger more selling pressure, potentially causing a downward spiral of falling prices and further sales – all despite no fundamental changes in the projected cash flows of the underlying CLO debt securities. Such a scenario would unnecessarily and arbitrarily reduce bank capital levels.
“If the price of CLO debt securities were to drop by only 10%, banks holding CLO debt securities would face potential cumulative losses of up to $7 billion, which losses would be driven solely by imposition of the Final Rule,” said Ganz. “The Final Rule as written would cause banks to recognize significant losses on otherwise safe, high quality assets, which furthers no regulatory objective.”
Under the rule, banks – especially smaller banks with limited capital – would be under immense pressure to divest, and would most likely do so at a significant loss. As a result of this regulatory over-reach, banks would have less capital and the impact on the real economy would be far reaching. Community banks would have less money to lend to local economies, and mid-size banks would not be able to lend to medium-sized businesses responsible for creating jobs and growing the economy. Additionally, the disruption to the CLO market would make it more difficult for the many recognizable U.S. companies that rely on CLOs – including SeaWorld, Allison Transmission, and Pinnacle Foods – to access safe, affordable funding.
“Should the Final Rule be implemented as is, it will likely increase the cost of financing for American businesses and force companies to curtail expansion plans, forego new hiring and cut dividends – all of which are avoidable and will hurt ordinary Americans who are still recovering from financial crisis,” said Ganz.
To mitigate the significant harm the Volcker Rule could cause banks, businesses, and communities, the LSTA has requested regulators provide confirmation in an FAQ or other guidance that under the Volcker Rule, CLO debt securities that have a contingent right to remove a manager for cause or to vote for a replacement do not constitute an “ownership interest.” In addition, the LSTA supports introduced legislation that would grandfather existing CLO loans issued before Dec. 10, 2013, and allow banks to continue to hold those debt securities.
“We are disappointed that the agencies have addressed the issue of CDOs of TruPs while not yet addressing the important concerns relating to CLO notes,” said Ganz. “We are hopeful that the agencies will quickly take up our request that they confirm in guidance that the ability of holder of highly rated AAA and AA rated debt securities to remove or replace a manager ‘for cause’ does not constitute an ownership interest. Without that guidance, the CLO market could be disrupted because banks could be forced to divest these securities within the next 18 months.”
“The unintended consequences of the Volcker Rule will have serious, negative consequences not only for banks, but also for the many American businesses that rely on the CLO market for corporate funding to operate, expand, and create jobs,” said Bram Smith, executive director of the LSTA. “It is imperative that regulators provide clarity on this issue to prevent disruption to the market and safeguard an important source of funding for U.S. companies.” – Staff reports
To read the full testimony, please click here.