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1 [1] (September 20, 2017)

handle is hein.crs/govcgvq0001 and id is 1 raw text is: FF. ' riE -S-' $. h ,i , September 20, 2017 Collateralized Loan Obligations (CLOs) and the Volcker Rule Recent rulemaking to implement Section 619 (the Volcker Rule) of the Dodd-Frank Act focused attention on bank participation in collateralized loan obligations (CLOs). Loans can be pooled and funded via a CLO trust structure, which subsequently creates and issues securities. This In Focus provides background discussions on loan funding, distinguishing between types of functionally equivalent transactions, and how the structure of bank CLOs is used to fund loans. On December 10, 2013, the federal financial regulations issued final rules for the Volcker Rule, but its effects on CLO markets may be inconclusive. H.R. 10, a broad financial reform bill that passed the House, would repeal the Volcker Rule. Lenders generally fund their longer-term assets (e.g., consumer and business loans) via a continuous series of shorter-term borrowings. Lenders profit from the spreads between the loan prices (interest rates), or the difference between the rates charged on longer-term loans, and the rates paid to savers (e.g., depositors, short-term creditors) on successive sequences of shorter-term loans. Specifically, depository institutions (i.e., banks and credit unions) may fund their loans via recurring deposits, which are short-term loan obligations to depositors. Depositors expect to be repaid their principal and receive interest at regular intervals; each interval represents a short-term loan by depositors to the institution holding their deposits. Depositories are not limited to funding loans solely with deposits. For example, suppose a regional merchant, wanting to expand to additional cities, goes to a local bank for a loan. If the small bank is unable to offer the loan, rather than surrender the merchant to a larger bank, it may offer to coordinate with other local banks to jointly provide the loan using a loan participation structure. The local bank would originate the loan, thus acting as the sponsor or lead bank of the participation arrangement. The sponsor typically retains the largest portion of the loan and sells smaller portions (shares) of the loan to other institutions. This structure allows the sponsor to maintain control of the customer relationship and overcome funding limitations. The other banks in the participation may use their shares to diversify geographical concentration risks in their lending portfolios, meaning that this funding structure can also serve as a prudential financial risk management tool. A collateralized debt obligation (CDO) is another type of funding structure. A CDO is a trust formed to hold debt, which can be in the form of loans or bonds. CLOs are a subset of the more general category of CDOs; CLOs are for loans and collateralized bond obligations (CBOs) are for bonds. One difference between a CLO and a CBO is that bonds are generally more easily transferrable than loans because bonds (unlike loans) are designed to be marketable securities. (Note: Robust secondary markets exist for some forms of loans, e.g., mortgages, and market liquidity varies with market conditions.) Despite some idiosyncratic differences, the CDO trust structure is applied to many classes of securities, including such CLOs as asset-backed securities (ABS), mortgage-backed securities (MBS), student-loan asset-backed securities (SLABS), and commercial mortgage-backed securities (CMBS). In some areas of finance, the term CLO is industry jargon for business loans (specifically, loans for highly leveraged businesses) funded in this manner. A sponsor may form a CLO (i.e., trust) that subsequently issues securities to fund (and are collateralized by) the pool of longer-term loans in the CLO. Banks may decide to retain some of the securities; additionally, mutual funds, hedge funds, insurance companies, and other investors may purchase securities issued by the CLOs. Hence, the CLO structure serves as another mechanism to obtain funding for loans originated by the banking system. CLOs have features similar to loan participations. For example, repayment to CLO shareholders is typically stated upfront (e.g., specific dates, rates, and maturity) rather than expressed as a share of the revenues generated by the trust. CLOs and holders of loan participations receive a specified return, which is considered less risky relative to holding an equity position. (Investors with equity or ownership interests, by contrast, may receive an unspecified return linked to the fluctuating value of the firm.) CLO issuances may have features analogous to ownership interests in a hedge fund. For example, a hedge fund manager manages the fund assets for the equity investors; banks that hold CLO issuances may have little or no direct familiarity (customer relationships) with the numerous borrowers who have loans in the trust. The performance of the trust arguably would depend upon the selected loans (entrepreneurial decisions) by a third party CLO manager rather than the underwriting requirements (entrepreneurial decisions) of the holders of CLO issuances. Furthermore, shareholders may have voting rights and can subsequently select a CLO trust manager. Such features provide the basis for interpreting CLO shareholders as having analogous equity ownership interests in a hedge fund instrument. The V dkeRul., e Applie to x , . The Volcker Rule is designed to prohibit banking entities from engaging in propriety trading, (i.e., making investments for their own trading accounts) and having certain relationships with hedge and similar funds covered under the rule, which arguably may increase banking entities' exposures to downside loss risk. Financial regulators issued a final regulation in December 2013 that included definitions for the prohibited business .O 'T p\w -- , gn'a', goo mppm qq\ M , q 'M I 11LULANJILiM,