Loan Market Breathes Easier on Volcker Rule

It's official: The leveraged loan industry has avoided the worst of the Volcker Rule.

Early versions of the rule, which curbs risk-taking by banks by limiting what they can do with their own money, had put a scare in the loan market. Regulators had considered subjecting syndicated loans to the ban on proprietary trading, and the original draft prohibited banks from trading or lending to collateralized loan obligations.

But the final rule, released last week by banking and securities regulators, excludes syndicated loans from the ban on proprietary trading. This exclusion also applies to bridge-loan notes, or short-term financing meant to backstop borrowers until they can access the high-yield bond market or other, more permanent financing.

The final rule also exempts certain CLOs, which are big buyers of syndicated loans, from the definition of a "covered fund," meaning that these CLOs are not subject to the ownership or transactions limitations of the Volcker Rule. So banks can still provide warehouse financing for these transactions and make a market in their assets and liabilities.

"This concludes an almost three-and-a-half-year odyssey and appears at first glance to be a very positive result for the loan market and the LSTA (albeit with some important issues to be worked out)," Bram Smith, executive director of the Loan Syndications and Trading Association, an industry trade group, said in an email.

The LSTA will host a webinar on the rule for its members on Wednesday.

The nearly $300 billion CLO market accounts for about 45% of all institutional investments in corporate loans that are below investment grade, according to the LSTA.

However, the carve-out only applies to CLOs that meet the definition of "loan securitizations" and do not hold assets other than loans, short-term cash equivalents and related derivative.

That means CLOs with any investments in securities, including bonds and CLO notes, are considered "covered funds" and subject to the ownership and transaction prohibitions. (Loans are not securities.)

Currently, most CLOs hold significant investments in bonds or other securities. This is partly because competition for loans from mutual funds and other investors has been growing and CLO managers may find it difficult to source enough collateral for deals.

Corporate bonds can be an attractive substitute, particularly if they are issued by the same borrowers accessing the loan market. CLOs may also receive equity or other securities in exchange for loans they hold if the borrower undergoes a debt restructuring or bankruptcy.

Also, to be eligible for the "loan securitization" carve-out, a CLO must own the loan directly; a synthetic exposure to a loan, such as through holding a derivative like a credit default swap, will not satisfy the conditions for the exclusion.

The Volcker Rule takes effect on April 1, 2014, but the Fed announced it will delay the end of the compliance period until July 21, 2015. This means that banks would have until then to divest their holdings in CLOs that do not meet the requirements of a "loan securitization."

Even if it's breathing easy about the Volcker Rule, the loan industry is still facing regulatory obstacles. Issuance of CLOs may be hit by proposed risk-retention rules that require sponsors of these deals to hold on to a portion of the debt issued. The LSTA has asked regulators to take into account the kind of debt bundled by CLOs, the robust underwriting process and that fact that virtually all CLO managers are registered advisors subject to strict federal securities laws. The LSTA has warned that smaller CLO managers would be unable to issue new deals under the proposed rules, and that the resulting consolidation would make it more difficult for companies to obtain financing.

Some $75 billion of U.S. CLOs were issued through November of this year, making it the third-highest year on record, trailing only 2006 and 2007, according to Wells Fargo (WFC). Analysts at Wells expect issuance to moderate next year, to around $60 billion, partly as a result of risk-retention rules and other regulations making it less attractive to either manage or own these securities.

Other analysts think issuance could be higher as managers pull deals forward in advance of the regulation. Barclays expects 2014 issuance to be in the range of $75 billion to $80 billion. With $40 billion to $45 billion of CLOs expected to be redeemed or amortized in 2014, the market would still grow by about $20 billion.

This article originally appeared on LeveragedFinanceNews.com