U.S. banks have been given more time to divest their holdings of collateralized loan obligations (CLOs) under the Volcker Rule, but they may still face large losses on those securities, says Fitch Ratings.
Last week, the U.S. Federal Reserve extended the deadline for banks to divest their CLO holdings, as required by the Volcker Rule, to July 21, 2017. Fitch says that the extra time could provide banks with more time to shop their investment portfolios, and that this may reduce the losses that could result from the forced sale of their CLO holdings. It also provides more opportunities for the banks to restructure some of their holdings to ensure compliance with the Volcker Rule, it says.
“Small banks could benefit from the extension more as they have higher portions of their securities allocated than larger banks,” it says. “While the largest banks, JP Morgan and Wells Fargo, have smaller percentages, they could incur large losses.”
The rating agency says that CLOs created before the financial crisis are likely to be called or otherwise paid out before they would be forced to be sold, and those created this year will be compliant with the rule.
“However, the majority of CLOs structured between the beginning of 2010 and the end of 2013 will not be converted into Volcker compliant structures, as it is neither practical nor feasible to gain approval from all the parties,” it says.
As a result, Fitch expects opportunistic investors to buy many of these securities for less than par. “We expect this to have a negative impact on banks that made the initial investment in these CLOs as forced sales prices will likely be significantly lower than the expected credit losses on the notes. We also expect a potential disruption in the CLO secondary market to affect the CLO primary market as evidenced by the current spread widening amid a benign credit environment,” it says.