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May 5, 2014
Collateralized Loan Obligations (CLOs), Structure, Use, and
Implementation of the Volcker Rule
Overview
A collateralized loan obligation (CLO) is one way to fund
Types of CLOs of Immediate Concern
debt through a trust that issues securities. Recent
rulemaking to implement Section 619 (the Volcker Rule) of
Although the term CLO is a broad term that includes many
the Dodd-Frank Act focused attention on bank participation
kinds of asset-backed securities, the current policy
in CLOs. This article provides a general overview of the
discussion is focused on a narrower class. Banking
CLO structure; with a particular focus on CLOs that have
regulation in the United States had historically limited the
been used by banks to fund commercial debt, and discusses
geographic reach of depository banks, and thus the trust
regulatory policies of CLOs in relation to the Volcker Rule.
structure has been a common structure to coordinate
Some policymakers are concerned that the December 2013
commercial lending in a growing economy and to facilitate
final regulation for the Volcker Rule may create unintended
the use of securities markets to supplement depository
hardship for banks that own interests in CLOs originated
lending. The next two sections will illustrate these two (of
prior to the issuance of the rule. There is proposed
many) uses of collateralized lending.
legislation (H.R. 4167) designed to address these concerns.
First, the use of the trust structure as a bank coordinating
General Definition and Structure of a CLO
mechanism can be illustrated with a hypothetical example.
A regional business, such as a food truck, might have a line
CLOs are a subset of the more general category of
of credit and other relationships with a regional bank. As
collateralized debt obligations (CDOs). In a CDO, a trust is
the business grows, it may desire to expand to additional
formed to hold debt. The debt might be loans or bonds, and
cities not served by its current lender. A regional bank
thus there are CLOs for loans and CBOs for bonds. The
might offer to coordinate with other regional banks, rather
difference between a CLO and a CBO is that bonds are
than surrender the food truck company to a larger bank.
generally more easily transferrable than loans because
One convenient coordinating device for such a loan
bonds are designed to be marketable securities whereas
package is a trust, in which the loans from various banks
most loans are not. However, there can be robust secondary
are pooled, yet the banks themselves retain much of the
markets for some forms of loans, such as mortgages,
interest in the loan pool by retaining most of the securities
although the liquidity of such secondary markets is
issued by the trust. Technically, such securities would be
sensitive to market conditions. A second potential
obligations of the trust collateralized by the loans held by
difference between CLOs and CBOs is that several banks
the trust (CLO). The food truck example is a caricature, but
may use the CLO structure to coordinate combined lending
it is a useful reminder that the trust structure is neither
to a single borrower (such as loan participations or loan
particularly innovative, nor the exclusive territory of the
syndicates), which can complicate the transfer of loans to
largest banks.
the trust or the decoupling of the loan from the lender.
Because of this potential coordinating role, CLOs are often
Second, the CLO structure can be used to allow securities
associated with commercial lending.
markets to supplement bank lending (so-called leveraged
loans). A lead bank can form a trust to pool loans. The
CDOs can be funded by issuing obligations (securities) that
trust can issue debt and equity securities (obligations) to
are collateralized by the debts (loans or bonds) held in the
fund the loans, which are collateralized by the loans in the
trust. This is the basic structure of many classes of
pool (CLO). In some areas of finance, the term CLO is
securities, including such CLOs as asset-backed securities
industry jargon for business loans funded in this fashion.
(ABS), mortgage-backed securities (MBS), student loan
Banks might retain some of the interest in the loans, but
asset-backed securities (SLABS), and commercial
mutual funds, hedge funds, insurance companies, and other
mortgage-backed securities (CMBS). For more
investors may also participate. Figure 1 shows recent
information, see CRS Report R43345, Shadow Banking:
trends in the share of CLOs as investors in commercial
Background and Policy Issues, by Edward V. Murphy.
loans.1 Other investor groups include mutual funds, hedge
Although lenders might use the trust structure to fund loans
funds, insurance companies, and other investors.
by selling securities to third parties through securities
markets, the structure can also be used to coordinate loans
1
among several lenders that then buy back some or all of the
See page 6 of “Risk Retention for CLOs,” November 2013, by Oliver
securities from the transaction.
Wyman, available at
http://www.fdic.gov/regulations/laws/federal/2013/2013-
credit_risk_retention-c_149.pdf.
www.crs.gov | 7-5700
Collateralized Loan Obligations (CLOs), Structure, Use, and Implementation of the Volcker Rule
Banks retain interest in the CLO arrangement in both the
Figure 1: Share of CLOs as Investors in Leveraged
food truck example and in the leveraged lending example.
Commercial Loans
However, if the trusts that are used as coordinating devices
for CLOs are considered risky investment funds, then banks
may have to divest themselves of such assets because of the
Volcker Rule.
The Volcker Rule and CLOs
In addition to prohibiting proprietary trading by banking
organizations, the Volcker Rule also prohibits certain
relationships between banks and risky investment firms.
Financial regulators issued a final regulation in December
2013 that included definitions for the prohibited business
relationships and for the class of prohibited investment
funds. For more information, see CRS Report R43440, The
Volcker Rule: A Legal Analysis, by David H. Carpenter and
M. Maureen Murphy.
The final Volcker Rule prohibits bank ownership of many
kinds of CLO securities because the trusts in the CLO
Source: “Risk Retention for CLOs,” November 2013,
structure are defined as prohibited investment funds. The
by Oliver Wyman, available at
December 13 rule prohibits bank ownership of obligations
http://www.fdic.gov/regulations/laws/federal/2013/2013-
from CLOs if the security includes rights similar to
credit_risk_retention-c_149.pdf.
ownership rights (elements of equity rather than pure debt).
Intended or not, the rule generally requires banks to divest
themselves of CLOs that they used to coordinate
commercial lending with other banks, not just CLOs that
are used to finance third-party lending.
The final Volcker Rule affects current and future CLO
structures. Going forward, banks may be able to construct
CLO structures to comply with the Volcker Rule by not
retaining the kinds of equity interests prohibited by the
December rule. However, the regulation also requires
banks to divest themselves of CLO interests that they
already possess by the conformance date. Banks that have
used the CLO structure as a coordinating device have
argued that they should be exempt from the general CLO
rule, or have their current interests grandfathered, or the
time they have to conform extended.
Active CLO Legislation
There is current legislation, H.R. 4167, to exempt from the
Volcker Rule bank ownership of certain debt interests in
CLOs originated before January 31, 2014. The bill defines
a CLO as an asset-backed security secured primarily by
commercial loans. The bill states that participation in
removal of the trustee for cause cannot be the lone indicator
of ownership interest to designate a security as an
ownership interest rather than debt. The bill effectively
More Information
would extend the conformance period of many existing
.
CLO structures. H.R. 4167 passed the House but has not
been acted upon by the Senate.
For more information, see CRS Report R43440, The
Volcker Rule: A Legal Analysis, by David H. Carpenter and
M. Maureen Murphy , CRS Report R43345, Shadow
Banking: Background and Policy Issues, by Edward V.
Murphy.
Edward V. Murphy, tmurphy@crs.loc.gov, 7-6201
IF00022
www.crs.gov | 7-5700
Document Outline