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.4. Do community banks really invest in TruPS CDO?
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.
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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