TruPS CDOs now exempt from the Volcker Rule

Yesterday, after some intense industry pressure, US regulators (OCC, FDIC, SEC, etc.) collectively announced that the bulk of the so-called TruPS CDO securities issued prior to May 19, 2010 will be exempt from the Volcker Rule. Let's take a quick look at the issues around this decision.

1. What are TruPS?

Trust Preferred Securities, issued mostly by banks, are longer-term fixed maturity securities that pay a fixed quarterly coupon. They are junior to any bonds but senior to common equity (similar to preferred stock). Securities issued by banks prior to May 19, 2010 qualify for tier-1 capital and were a good way for many smaller banks to raise capital.

2. What are TruPS CDOs?

TruPS issued by multiple banks were pooled for diversification and funded by issuing "tranched" CDO debt. The coupon payments from the TruPS pool are used to repay this debt, with the higher rated tranches having a priority claim on these payments over the lower rated CDO debt.

3. How does the media explain this exemption from the Volcker Rule?

Here is an example from the WSJ.

WSJ: - Banks had been seeking changes to a provision of the Volcker rule that would have forced firms to sell such debt investments by July 2015 to avoid violating the regulation.

The so-called Trups CDO provision had sparked heated opposition from community bankers, who said the rule would unfairly harm hundreds of small banks that bought the investments by forcing them to take immediate write-downs on their holdings.

4. Do community banks really invest in TruPS CDO?

While some smaller banks do have CDO holdings, it's not that common, and the explanation from the WSJ is simply wrong.

5. So how was the banking industry able to pressure the regulators into this exemption?

Community banks were allowed to raise tier-1 capital by issuing TruPS. But small banks could not access the broader capital markets to sell this paper. It would be the equivalent of a local community bank attempting a rated bond issuance or an IPO. That just doesn't work. So CDO managers would privately transact with small banks and pool their TruPS in a portfolio that could be financed in aggregate (as oppose to each bank having to find investors for its trust preferred securities).

The American Bankers Association and other industry groups argued that if you allow small banks to raise capital using TruPS that could only be efficiently financed via CDOs, you can't prohibit other banks from buying/holding these securities. This "inconsistency argument" worked and banking entities in the US are now allowed to invest in (pre-May 19, 2010) CDOs primarily consisting of TruPS collateral.

6. What's next?

The next on the chopping block are CLOs, where the industry is arguing that if corporate loans are good enough for banks, some of the debt issued against portfolios of corporate loans should be allowed as well. No comment from the regulators so far.

Reuters: - The Loan Syndications and Trading Association (LSTA) urged US regulators on Wednesday to modify the Volcker Rule concerning collateralized loan obligations (CLOs) to prevent upheaval in the industry and potentially big losses for US banks.

Elliot Ganz, the LSTA's executive vice president, told the House Financial Services Committee that the definition of "ownership interest" in the final Volcker Rule will have significant unintended consequences for the CLO market, including material losses for US banks and restrictions on the availability of credit for US businesses.

Five US bank regulatory agencies on Tuesday approved a tweak to the rule that would allow banks to keep interests in certain funds backed by trust-preferred securities, but they did not address CLOs.

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From our sponsor:

Goldman loses the Volcker Rule battle over credit funds

About a year ago we discussed the argument made by Goldman's lawyers that under the Volcker rule, banks should be allowed to invest in credit funds (see post). The rationale is that if banks can lend to companies directly, why can't they invest in funds who make the same types of loans? In particular, Goldman was defending its lucrative mezzanine fund business which provides junior capital to companies. Goldman and other banks compete with private equity firms such as Blackstone in managing credit portfolios for clients.

The final Volcker Rule regulation seems to indicate that Goldman has lost that argument. (See great summary on Volcker Rule pertaining to private funds from Simpson Thacher - below)

Simpson Thacher: - the Agencies were unpersuaded by industry comments that ... credit funds (which are generally formed as partnerships with third-party capital that invest in loans or make loans or otherwise extend the type of credit that banks are authorized to undertake on their own balance sheet) should also be excluded.

That means Goldman and other banks will be limited to the standard 3% investment in the mezzanine or other credit funds they manage. And clients generally expect banks to commit significantly more of banks' own capital to funds they manage in order to avoid potential conflicts (such as having banks stuff these funds with bad investment banking transactions).

This is a big win for private equity firms who will be able to grab market share of this business from banks. However it's not a great outcome for companies who rely on this type of financing, as lender competition declines.


STB Volcker Memo

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From our sponsor:

Steve Hanke criticizes Basel III for the wrong reasons

A recent post on the Cato Institute blog by Steve Hanke paints a grim picture of the impact from increasing bank capital ratio requirements on the US economy. He compares the current situation to the Basel I accord that supposedly lost George H. W. Bush his reelection by squeezing the money supply and causing a recession (in the early 90s). And the upcoming Basel III is going to do the same.

Cato Blog: - While the higher capital-asset ratios that are required by Basel III are intended to strengthen banks (and economies), these higher capital requirements destroy money. Under the Basel III regime, banks will have to increase their capital-asset ratios. They can do this by either boosting capital or shrinking assets. If banks shrink their assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.

So, paradoxically, the drive to deleverage banks and shrink their balance sheets, in the name of making banks safer, destroys money balances. This, in turn, dents company liquidity and asset prices. It also reduces spending relative to where it would have been without higher capital-asset ratios.

The other way to increase a bank’s capital-asset ratio is by raising new capital. This, too, destroys money. When an investor purchases newly-issued bank equity, the investor exchanges funds from a bank account for new shares. This reduces deposit liabilities in the banking system and wipes out money.

Theoretically that's correct. However, US banks have been well capitalized for some time now (see this post from almost a year ago). Therefore Basel III by itself is not going to force significant capital increases by US banks. This of course is not the case in Europe (see discussion) and elsewhere (for example in South Korea the impact will be significant).

The data in the US suggests that unlike in the early 90s, money supply continues to grow unabated. Most US banks are operating as though they are already under Basel III, even if the rules haven't been fully implemented. Therefore if there was an impact on broad money stock, we would have already seen it.

As discussed here numerous times, the issue with Basel III is the ridiculous complexity and numerous idiotic rules in which a small group of bureaucrats with little understanding of US credit markets decide what banks should and should not hold (see discussion here and here). This, combined with the somewhat arbitrary Volcker Rule will have unintended consequences (see discussion). Professor Hanke is therefore correct to criticize Basel III, but he is doing it for the wrong reasons. In the US it is not about bank capitalization these days as it is about terrible regulation.

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From our sponsor:

Dealer MBS positions hit record levels; Volcker Rule creates market distortions

Primary dealer holdings of mortgage-backed securities was at an all-time high last week, as the dealers take advantage of the Fed's MBS purchases. Because of the public's push for increased transparency from the Fed, it is generally not that difficult to determine which securities the Fed will be buying (see discussion). And that means easy pickings for the dealers who "front run" the central bank.

USD mil (Source: NY Fed)

So how is it that securities dealers can load up on MBS, given the impending Volcker Rule? The new regulations have a small exception to the prop trading activities restriction. US treasury and agency securities will be permitted. And MBS securities in the chart above are mostly those issued by Fannie and Freddie. It's another example of regulatory driven market distortion. Moreover, these distortions are only going to get worse, as nations such as Canada and Japan are looking to obtain Volcker Rule exceptions for their government debt. A shift into mortgage and sovereign paper and out of corporate paper is the (not so) unintended consequence of the new regulations. This ultimately hurts middle market companies, as US legislators seem to prefer to see the dealers front run the Fed on MBS rather than holding middle market corporate bonds.

Of course private equity firms are loving this. With banks getting out of corporate bonds, private equity firms expand their lending business (a form of "shadow banking"), charging much higher rates. Some readers have questioned that this is actually taking place. Well, here is a direct quote from GSO/Blackstone:

Reuters: - "We really want to thank Mr. Volcker. That rule is a little bit like the Employment Act for GSO and what we do. And it kind of took our competitor prop desk and kind of put them off to the side, so that helps as well," Bennett Goodman, GSO's co-founder and a senior managing director at Blackstone told the Bank of America Merrill Lynch banking and financial services conference on Tuesday.
...
"The business model being adopted by the banks is they want to be syndicators of risk. They don't want to extend their balance sheet to provide capital to a mid-market single-B rated company, which is usually our target audience. And as a consequence, we want to own that risk."

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From our sponsor:

Citi ends its decade-long ill-fated love affair with hedge funds

Guest post by TheDealer


Some years ago Citigroup built a massive internal hedge fund platform called Tribeca. It was managed by Tanya Beder who became famous in advising Orange County on its derivatives fiasco in the 90s. She tried to turn Tribeca into an $20bn institutional hedge fund supermarket. This was a massively expensive undertaking that lasted for about 3-4 years and met with limited success.

Citi later bought Old Lane (Pandit's fund - that wasn't too successful on its own in terms of performance) for $800mm. As is typical of these large banks, it decided to build up Old Lane and shut down/replace Tribeca. Out with the old and in with the new. Then in 2008, when Pandit got promoted, Old Lane triggered the so-called key-man clause. This allowed Old Lane investors to withdraw their money immediately - as they promptly did. Citi followed by shutting down Old Lane as well. The firm later tried to rebuild the business once again under the name of Citi Capital Advisors.

Now, years later, Citi has a $6bn hedge fund platform which consists of Tribeca, Old Lane, and other pieces (including people and technology) of hedge fund ventures and acquisitions the firm undertook (more money was spent along the way to keep the funds going). The bulk of the platform consists of fixed income funds including mortgages, credit, (part of the AUM are some CLO assets - a low margin business) etc. - all involving heavy infrastructure expenditures.

Citi has about $2.5bn-$3bn invested in these funds, which of course puts the bank at odds with the Volcker Rule. So the firm recently decided to simply give the hedge fund platform to the managers - effectively for free - and spin them out into a separate firm. Of course Citi will have to pull its money out before the Volcker Rule comes into effect in 2014, forcing the new fund to replace the assets via an institutional fund raise. That's a difficult undertaking in this environment - even for Citi.

The spin-out marks a sad ending to a decade-long effort in Citi's history, as it spent an enormous amount of money trying to build, buy, raise a large hedge fund platform. With the spin-out, the bank will have little to show for after a decade of efforts. It's a great example of value destruction in a business that Citi as well as a number of other large banks never fully mastered.


See this Institutional Investor write-up from 2009 for some Citi hedge fund nostalgia.

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From our sponsor:

Credit/mezz funds create a major hole in the Volcker Rule

There is a hole in the Volcker Rule that banks are trying exploit. But before jumping to conclusions, let's walk through the following logic. The Volcker Rule prohibits significant proprietary trading and limits banks' investments in hedge funds and private equity to 3% of Tier-1 capital. It also prohibits banks from holding more than 3% of any one fund's assets. The purpose of Volcker Rule is to focus the bulk of banks' capital on its primary business of lending. Seems clear-cut, right?

But what if a bank invests in a finance company whose primary business is lending to corporations. That should be permitted under the Volcker rule - at least based on the rationale behind the rule. But what if the finance company is a partnership that is structured like a private equity fund and its role is to lend to companies - as a bank would. Is that OK? And what if the fund makes risky corporate loans - possibly subordinated and unsecured high yielding loans. Is that "crossing the line"? The Volcker Rule does not prohibit a bank from making risky loans - in fact there is nothing in the Dodd-Frank legislation that prohibits banks from doing so. The US actually needs more risky business loans, not less, in order to get the economy moving. After all most small and midium-size business loans are risky by their nature. So why can't a bank jointly with investors own a company that makes such loans?

Such funds are actually quite common. Some are managed by private equity firms like KKR, while others are managed by banks like Goldman. In the case of Goldman (and other banks), the bank is also an investor in its own fund. From the investors' perspective that's a good practice to have the bank co-invest with them in order to eliminate potential conflicts - many investors in fact demand that banks invest alongside with them.

Some of these funds are called "mezzanine" ("mezz") funds because the loans they make tend to be in the part of the capital structure that is below the senior debt but above the equity. Goldman for example makes a great deal of money in this business as a GP (management/performance fees) and as an LP/investor (mostly income from these loans). The firm, together with other banks, has lobbied hard to allow it to stay in this business. Now the question before the regulators is whether such practices by banks should be prohibited.

WSJ: - Credit funds lend to companies that might not otherwise get financing, such as companies backed by private-equity firms, and tend to hold their investments to maturity while using a limited amount of leverage. Goldman has argued in meetings with regulators and in letters to them that these funds function like banks, just with a different structure, according to public records and the people familiar with the efforts.

The firm has argued that the funds help the economy by broadening the availability of credit and are less risky than other investments constrained by the Volcker rule. Regulators' response has been noncommittal, the people said.

As with any such regulation the answer is not clear-cut. To add to the puzzle, most non-bank investors in such funds are insurance firms and pension funds - corporate, municipal, state, teachers, police, and other types of pensions. So anyone who has a defined benefits pension in the US is most likely an indirect investor in credit funds.

With Romney as President, such activities would likely be permitted, as he pushes to change Dodd-Frank (per his campaign promises). Romney, being an ex-private-equity executive, understands credit funds and how they can potentially expand lending in the US to companies that would otherwise have a tough time obtaining credit. The current administration on other hand may push back on this lobbying effort by banks and move to prohibit investment in credit funds as being too risky. Whatever the case, one should always watch out for "unintended consequences" of new regulation.

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The shrinking corporate CDS market

The Dodd–Frank financial reform is killing the single name corporate CDS market. Liquidity in this market is drying up quickly. This is due mostly to dealers' inability to take positions when they make markets (Volcker Rule) and a cumbersome clearing process that will impose higher margin on corporate CDS for end-users (in some cases higher than the equivalent positions in corporate bonds via repo). In fact the business of basis trades - bonds vs. CDS - is no longer viable in many cases because of the margin requirements on both sides and no ability to offset.

The fact that dealers who clear CDS are not expecting this business to be profitable (see discussion) is not helping either. And single name CDS regulated by the SEC while indices such as CDX regulated by the CFTC adds to the uncertainty. At the same time margin and clearing rules differ materially among the clearinghouses (ICE, CME) and trades are not fungible between them (a trade cleared on the CME can not be offset with the opposite trade cleared via ICE). This uncertainty is adding to this decline in liquidity. The situation is so bad that an index of 100 CDS doesn't have enough liquid CDS for the index to be formed.

FT: - Indices that track the price of credit default swaps (CDS), contracts which act as insurance against a default on corporate bond payments, have become a popular way for banks and hedge funds to speculate on the creditworthiness of American companies and for bond fund managers to hedge risks in their portfolio.

But underlying CDS trading has shrivelled to such an extent that there are not enough actively traded names to make up a 100-company index.

This takes us back to the question of making the financial markets "safer". Not a single institution has ever failed due to a problem with corporate single name CDS. But banks and corporations do use this product to hedge all sorts of things - including receivables, counterparty exposure, reducing loan exposure to a single company, etc. It's not at all clear therefore how nearly eliminating this market through blunt regulation will be helpful for the financial system or the economy as a whole.

SoberLook.com

Large corporate bond issues dominating secondary market

Earlier this year we discussed how the Volcker rule combined with Basel III is already reducing corporate bond liquidity by diminishing dealers' ability to make markets. It's just one of those "unintended consequences". Dealer inventories, which are essential for market making, have shrunk to the lowest level in 10 years. Some, including people at the Fed, have suggested that non-bank entities will step in to take the dealers' place as market makers. That is unlikely to happen in the near future.

One question that people are asking is why haven't we seen more lobbying from the corporate sector against the Volcker rule. There are multiple reasons for this, including corporations' unwillingness to put their reputation on the line by lobbying against this populist anti-bank regulation. But one of the key reasons is that the biggest impact will be on the medium to smaller US firms who simply don't have the resources to battle this legislation. With limited inventories the dealers increasingly make markets only in the largest bond issues, particularly those traded by the large corporate bond ETFs (LQD, HYG, etc.).

Source: CS

As liquidity in the smaller bond issues declines further, investors will demand a premium to hold them. Small to medium sized US firms will be disadvantaged relative to their large competitors due to higher cost of funds.

SoberLook.com

The Volcker Rule is not going to bring your house back

Got a great deal of hate mail lately on the post entitled Regulate it all, ask questions later. Many want to see solid research that would point to potential pitfalls of the so-called Volcker Rule. Otherwise they will fully support this regulation. Much has been written on the subject, but a recent paper by Darrell Duffie of Stanford, provides support to that Sober Look post.

Duffie draws two conclusions from his work:

1. "Over the years during which the financial industry adjusts to the Volcker Rule, investors would experience higher market execution costs and delays. Prices would be more volatile in the face of supply and demand shocks. This loss of market liquidity would also entail a loss of price discovery and higher costs of financing for homeowners, municipalities, and businesses."

2. "The financial industry would eventually adjust through a signi cant migration of market making to the outside of the regulated bank sector. This would have unpredictable and potentially important adverse consequences for financial stability."

As an example of flaws in the proposed regulation (among many in the paper), take a look at the chart below that shows the average return for stocks over time after they have been been removed from the S&P500 index. Typically as index mutual funds, ETFs, and other index linked investment programs (the AUM of these is in the hundreds of billions) are forced to sell a stock, the market makers step in for large blocks of shares. The dealers involved in the stock will make a profit over time as the newly excluded stock recovers, but they need the ability to take risk by holding the stock over a period. If the dealers are no longer there to make markets in these shares, the stock would crater, ultimately disrupting the market. And no, none of the other players, including algo traders, hedge funds, etc. will generally be willing to step in for such large blocks of shares. Since they are not market makers, they are not obligated to show a bid. That disruption hurts the non-index investors and the company itself.

Average cumulative returns for deleted S&P 500 stocks (Source: Darrell Duffie - 2010a).

Ultimately the answer to the banking crisis is in the improved overall capitalization and strengthened bank liquidity positions. The Volcker Rule, particularly in its current form is not the answer, because it has never been about market making. So before writing another hate mail on how you lost your house and how the Volcker Rule would have prevented it, read the paper. A little bit of knowledge will go a long way.

Enjoy!

DuffieVolckerRule

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