Collateralized Loan Obligations (CLOs) and the Volcker Rule

Collateralized Loan Obligations (CLOs) and the Volcker Rule

September 20, 2017
Collateralized Loan Obligations (CLOs) and the Volcker Rule
Recent rulemaking to implement Section 619 (the Volcker
because bonds (unlike loans) are designed to be marketable
Rule) of the Dodd-Frank Act focused attention on bank
securities. (Note: Robust secondary markets exist for some
participation in collateralized loan obligations (CLOs).
forms of loans, e.g., mortgages, and market liquidity varies
Loans can be pooled and funded via a CLO trust structure,
with market conditions.) Despite some idiosyncratic
which subsequently creates and issues securities. This In
differences, the CDO trust structure is applied to many
Focus provides background discussions on loan funding,
classes of securities, including such CLOs as asset-backed
distinguishing between types of functionally equivalent
securities (ABS), mortgage-backed securities (MBS),
transactions, and how the structure of bank CLOs is used to
student-loan asset-backed securities (SLABS), and
fund loans. On December 10, 2013, the federal financial
commercial mortgage-backed securities (CMBS). In some
regulations issued final rules for the Volcker Rule, but its
areas of finance, the term CLO is industry jargon for
effects on CLO markets may be inconclusive. H.R. 10, a
business loans (specifically, loans for highly leveraged
broad financial reform bill that passed the House, would
businesses) funded in this manner. A sponsor may form a
repeal the Volcker Rule.
CLO (i.e., trust) that subsequently issues securities to fund
(and are collateralized by) the pool of longer-term loans in
Funding Loans: Background Concepts
the CLO. Banks may decide to retain some of the securities;
Lenders generally fund their longer-term assets (e.g.,
additionally, mutual funds, hedge funds, insurance
consumer and business loans) via a continuous series of
companies, and other investors may purchase securities
shorter-term borrowings. Lenders profit from the spreads
issued by the CLOs. Hence, the CLO structure serves as
between the loan prices (interest rates), or the difference
another mechanism to obtain funding for loans originated
between the rates charged on longer-term loans, and the
by the banking system.
rates paid to savers (e.g., depositors, short-term creditors)
on successive sequences of shorter-term loans. Specifically,
CLOs have features similar to loan participations. For
depository institutions (i.e., banks and credit unions) may
example, repayment to CLO shareholders is typically stated
fund their loans via recurring deposits, which are short-term
upfront (e.g., specific dates, rates, and maturity) rather than
loan obligations to depositors. Depositors expect to be
expressed as a share of the revenues generated by the trust.
repaid their principal and receive interest at regular
CLOs and holders of loan participations receive a specified
intervals; each interval represents a short-term loan by
return, which is considered less risky relative to holding an
depositors to the institution holding their deposits.
equity position. (Investors with equity or ownership
interests, by contrast, may receive an unspecified return
Depositories are not limited to funding loans solely with
linked to the fluctuating value of the firm.)
deposits. For example, suppose a regional merchant,
wanting to expand to additional cities, goes to a local bank
CLO issuances may have features analogous to ownership
for a loan. If the small bank is unable to offer the loan,
interests in a hedge fund. For example, a hedge fund
rather than surrender the merchant to a larger bank, it may
manager manages the fund assets for the equity investors;
offer to coordinate with other local banks to jointly provide
banks that hold CLO issuances may have little or no direct
the loan using a loan participation structure. The local bank
familiarity (customer relationships) with the numerous
would originate the loan, thus acting as the sponsor or lead
borrowers who have loans in the trust. The performance of
bank of the participation arrangement. The sponsor
the trust arguably would depend upon the selected loans
typically retains the largest portion of the loan and sells
(entrepreneurial decisions) by a third party CLO manager
smaller portions (shares) of the loan to other institutions.
rather than the underwriting requirements (entrepreneurial
This structure allows the sponsor to maintain control of the
decisions) of the holders of CLO issuances. Furthermore,
customer relationship and overcome funding limitations.
shareholders may have voting rights and can subsequently
The other banks in the participation may use their shares to
select a CLO trust manager. Such features provide the basis
diversify geographical concentration risks in their lending
for interpreting CLO shareholders as having analogous
portfolios, meaning that this funding structure can also
equity ownership interests in a hedge fund instrument.
serve as a prudential financial risk management tool.
The Volcker Rule Applied to CLOs
CLO Structures and Distinctions
The Volcker Rule is designed to prohibit banking entities
A collateralized debt obligation (CDO) is another type of
from engaging in propriety trading, (i.e., making
funding structure. A CDO is a trust formed to hold debt,
investments for their own trading accounts) and having
which can be in the form of loans or bonds. CLOs are a
certain relationships with hedge and similar funds covered
subset of the more general category of CDOs; CLOs are for
under the rule, which arguably may increase banking
loans and collateralized bond obligations (CBOs) are for
entities’ exposures to downside loss risk. Financial
bonds. One difference between a CLO and a CBO is that
regulators issued a final regulation in December 2013 that
bonds are generally more easily transferrable than loans
included definitions for the prohibited business
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Collateralized Loan Obligations (CLOs) and the Volcker Rule
relationships and for the class of prohibited investment
recent decline reflects fewer loans, fewer impermissible
funds such as hedge funds. For more information, see CRS
financial instruments, or both. In addition, the federal
Report R43440, The Volcker Rule: A Legal Analysis, by
banking regulators finalized higher risk-retention
David H. Carpenter and M. Maureen Murphy.
requirements for CLO sponsors. Finally, the CLO market
depends upon the demand and supply for loans, which may
The treatment of CLOs under the Volcker Rule has been a
be linked to current macroeconomic conditions, thus
subject of debate. CLOs may be structured in a manner
generating what appears to be a cyclical trend in CLO
similar to loan participation shares, which generally are not
issuances.
considered covered funds under the Volcker Rule. CLOs,
however, may also be structured in a manner such that
Active Legislation
banks’ ownership interests appear similar to those
The Financial CHOICE Act of 2017 (FCA; H.R. 10) was
associated with hedge funds; the Volcker Rule prohibits
introduced on April 26, 2017, and the bill passed the House
banking entities from having ownership interests in hedge
on June 8, 2017. The FCA, which is a broad bill that would
funds.
make many changes to financial regulation, would repeal
the Volcker Rule requirements, thereby making it possible
A CLO is generally considered a covered fund, meaning
for banks to own CLO issuances that could include a wider
that a bank may not sponsor or have ownership interests;
assortment of financial instruments in addition to
however, the final rule establishes criteria that would be
extensions of credit.
met for a CLO to qualify for an exemption from the
Volcker Rule. For example, the permissible assets that may
Figure 1. U.S. CLO Issuances of Leveraged Loans
be included in CLO structures, which banks may sponsor or
Annual, Billions of Dollars
retain ownership interests, are defined as extensions of
credit (i.e., consumer loans, business loans, loan
participations, or certain other limited types of assets). In
addition, the final rule provides guidance on how banks
may construct CLO structures to avoid the retention of
impermissible ownership or equity interests that resemble
hedge funds. For example, a prohibited funding structure
would include voting rights similar to ownership rights for
shareholders.
The federal financial regulators did not grandfather existing
CLO structures that predated the final rule. CLOs may have
contained bonds or other assets that did not qualify for

exemption from the Volcker Rule. Banks were initially
Source: S&P Global Market Intelligence, powered by Leveraged
given until July 2015 to comply with the requirements of
Commentary and Data (LCD), at LeveragedLoan.com; the graph may
the final rule via restructuring noncompliant CLOs or
be found at http://www.leveragedloan.com/primer/#!clos.
selling their ownership interests; but the conformance
Note: The red bar represents the first half of 2017.
period was extended through July 2017. If noncompliant
CLO securities are unloaded in a hasty manner such that the

market consists of more sellers relative to buyers, the
For More Information
market value (price) of the slices could fall and translate
For more information, see CRS Report R43440, The
into accounting (capital) losses on bank balance sheets.
Volcker Rule: A Legal Analysis, by David H. Carpenter and
M. Maureen Murphy; David S. Krischer and Heath P.
Understanding the effects of the final Volcker Rule on the
Tarbert, “CLOs and the Volcker Rule,” The Review of
CLO market is challenging. Error! Reference source not
Banking & Financial Services, vol. 31, no. 8 (August
found. shows that U.S. bank CLO issuances (collateralized
2015), pp. 81-90; and Dennis Scholl and Ronald L. Weaver,
primarily by loans made to highly leveraged businesses)
“Loan Participations: Are They “Securities,” Florida State
dropped off during the recent recession, but had since
University Law Review, vol. 10, no. 2 (Spring 1982), pp.
rebounded and now appears to be declining after 2014. The
215-234.
CLO issuances since 2014 are likely to reflect the more
narrow definition of compliant CLOs, consisting solely of
Edward V. Murphy was the original author of this In Focus.
loans and excluding other financial instruments (e.g.,
bonds, derivatives unrelated to loans in the pool,
commodity forward contracts). Hence, the volume of CLO
Darryl E. Getter, Specialist in Financial Economics
issuances reflect changes in the composition of CLO trusts,
IF10736
meaning that it is difficult to disentangle how much of the

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Collateralized Loan Obligations (CLOs) and the Volcker Rule

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