The problem springs from the finalized set of regulations implementing the Volcker Rule, part of the Dodd-Frank banking reform legislation passed in 2010, which bans "proprietary trading" by banks. The rule is named after former Federal Reserve chairman Paul Volcker, whose idea was to make sure banks don't "gamble" while enjoying the advantage of gathering deposits insured by the Federal Deposit Insurance Corp.
The idea of a Volcker Rule was first publicly uttered by President Obama in January 2010, with the final rule being unveiled nearly four years later, on Dec. 10.
One of the items that received some -- but apparently not enough -- clarification in the final set of Volcker regulations is the requirement for banks not to invest in "covered funds," which include many collateralized debt obligations (CDOs) backed by trust preferred securities.
Following a "preliminary assessment" of the final Volcker regulations, Zions Bancorporation (ZION - Get Report) of Salt Lake City on Dec. 16 said it had determined that "substantially all" of its investments in trust preferred collateralized debit oblations (CDOs) would be disallowed under Volcker. The company said it would record a fourth-quarter other-than-temporary impairment charge of $629 million on the transfer of disallowed held-to-maturity securities to held-for-sale. The bank also said it had until July 21, 2015 to sell the trust preferred CDOs, "unless, upon application, the Federal Reserve grants extensions to July 21, 2017."
KBW analyst Collyn Gilbert wrote in a note to clients on Dec. 16 that there were two community banks -- Sun Bancorp (SNBC) of Vineland, N.J., and First Commonwealth Financial (FCF - Get Report) of Indiana, Pa. --under her firm's coverage that could see relatively large losses from the sale of securities springing from the Volcker Rule.
The Federal Reserve, FDIC and the Office of the Comptroller of the Currency attempted to stifle an an uproar among community bankers last Thursday when on Dec 19 they released a FAQ Regarding Collateralized Debt Obligations Backed by Trust Preferred Securities under the Final Volcker Rule. In the FAQ, the regulators said banks could evaluate their CDOs backed by trust preferred securities to determine if they "could be restructured during the conformance period" to take advantage of "another exclusion or exemption under the Investment Company Act."
After publishing a letter expressing its "dismay" over the lack of clarity over the CDO/trust preferred exclusion, the American Bankers Association and several community banks late on Tuesday filed complaints against federal regulators in the U.S. Court of Appeals for the District of Columbia saying "community banks across the country face precipitous write-downs and further irreparable harm on December 31, 2013, if the relevant provision of the Volcker Rule is not immediately suspended."
In their FAQ, the regulators seemed to indicate Zions Bancorporation had taken an unnecessarily aggressive approach in immediately deciding to move the securities in question to "held-for-sale," while taking a significant fourth-quarter loss, even though the bank doesn't have to rid itself of the securities until July 2015.
However, the bank regulators may have forgotten something. Something rather important to bank accountants and bank investors.
"The banks have to reach a conclusion, to say what their financials are, as of Dec. 31. If there is a chance they will have to write the CDOs down they have to report them as available-for-sale" immediately," says Lawrence Kaplan, of counsel in the Corporate practice of Paul Hastings in and is based in the firm's Washington, D.C. office.
The ABA said in its complaint that the Volcker Rule's ban on the CDOs in question "will impact over 275 banks and cause an estimated $600 million in capital to vanish overnight"The ABA said at least 37 banks would be affected."
Even if the banks writing down the CDOs backed by trust preferred securities eventually determine the accounting losses can be reversed, "the banks have a capital hit right away," which means some banks may slip from being considered well-capitalized under regulatory guidelines to being undercapitalized, and "you could have a 90-day clock for regulators to seize the bank," Kaplan says.