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The Deal: Regulators Urged to Tweak Volcker Rule CLO Provision

NEW YORK (The Deal) -- One day after federal regulators changed a provision in the Volcker Rule responding to concerns by community banks, a bipartisan group of lawmakers on Wednesday urged U.S. government agencies to make another change to the more than 900 page measure that was approved by five agencies in December.

At a House Financial Services Committee hearing, top Democrats and Republicans urged regulators to revise a provision that hurts the ability of banks - big and small - to issue so-called Collateralized Loan Obligations, a form of loan that is made to businesses that are not considered investment grade. A number of high profile companies access the CLO market, including Sears Roebuck, SuperValu (SVU - Get Report), J.C. Penney (JCP - Get Report) and Rite Aid (RAD - Get Report).

Under the Volcker Rule, CLO debt securities are treated as if they are equity securities, thereby making them ineligible to be held by banks. As a result, without any exemptions, over the next 18 months banks will have to divest or restructure up to 
$70 billion of CLO notes. Community bank executives have been telling regulators and lawmakers that CLOs are not systemically risky investments.

While most CLOs are held by the largest financial institutions, small banks have somewhere between $300 million and 
$1 billion in CLOs and, according to Elliot Ganz, the general counsel of the Loan Syndications and Trading Association, they will have to take a $30 million hit or more because of the change.

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"That will be less money available to lend to their communities," said Ganz. Roughly 21 banks with assets of less than $25 billion own CLO securities. "If the price of CLO debt securities were to drop by only 10%, banks holding CLO debt securities would face potential cumulative losses of up to $7 billion, which losses would be driven solely by imposition of the rule."

Rep. Maxine Waters, the ranking Democrat on the panel, asked one witness whether he was "willing to work with us to address" concerns with CLOs. Rep. Jeb Hensarling, R.-Texas, the chairman of the panel, also raised concerns about the CLOs.

However, regulatory observers argued that while Democrats might be willing to exempt community banks from the CLO restriction, Republicans are seeking to provide an exemption for all banks, including the largest ones. A Senate bill introduced by Sen. Mark Kirk, R-Illinois, allows banks to keep their investments in CLOs as long as they were issued prior to Dec. 10, 2013.

This raised the ire of Securities Industry and Financial Markets Association CEO Ken Bentsen, who told The Deal that bifurcating the industry would be "nonsensical," adding that the CLO market is an important commercial funding market and to bifurcate it based on the size of an institution would hurt access to the loans. "Do you not want large banks to make loans?" he asked.

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