It hasn’t taken long for the final Volcker Rule to send ripples through the financial markets – specifically through markets for asset backed securities. These markets were famously used to package and sell the subprime ‘toxic assets’ that contributed so much to the financial crisis. Although the mortgage securitization market has shrunk greatly thanks to the disastrous record of mortgage backed securities during the crisis, securitization remains significant in other areas. Industry lobbyists are trying to portray these impacts of the Volcker Rule as somehow unintended or accidental. But in fact the Volcker Rule was intended (and properly so) to affect banks involvement in securitization markets, which were central to the 2008 crisis.
The Volcker Rule’s impact on securitization doesn’t result from the widely publicized provisions on speculative trading. It comes from the part of the rule that forbids bank investments in external funds, like hedge funds. These provisions are at least as important as the more widely discussed restrictions on speculative proprietary trading. Restrictions on external investments are necessary to make speculative trading controls work. If investments in external funds aren’t controlled, banks can just do their speculation at one remove, in ways that are more difficult for regulators and counterparties to understand. And there’s no question about the relevance of these restrictions to the financial crisis. Opaque and non-transparent connections between major banks and external entities like hedge funds and securitization vehicles were central to the problems at major banks during the 2008 financial crisis.
The Volcker Rule’s definition of an external fund includes the ‘special purpose vehicles’ used to organize securitizations. (The vehicles are essentially trusts that hold the loans or other assets backing a securitization). That means that without specific exemptions granted by the regulators, banks won’t be able to own asset backed securities or play a central role in securitizations. In the final rule they just passed, regulators granted such a special exemption. But the exemption is only intended to accommodate ‘plain vanilla’, relatively simple securitizations where special purpose vehicles hold only loans and a limited range of derivatives. These kinds of securities can still be quite risky, and there’s an argument that regulators already went too far in their exemption. But the exemption would still rule out many of the more complex securitizations that were important triggers of the financial crisis.
The first wave of public industry opposition to the final rule is coming from banks who own such complex securitizations. This week, a wave of lobbyists hit the Hill to decry the Volcker Rule’s impact on banks who own ‘Trust Preferred CDOs’ (a securitization called a Collateralized Debt Obligation, or CDO, that holds Trust Preferred Securities, or TRUPS).
The history of the Trust Preferred CDO market offers a tour of the worst aspects of the pre-crisis financial system. Trust Preferred Securities took off when banks tried to circumvent limits on borrowing by issuing a kind of debt dressed up to look like loss-absorbing capital – essentially promising creditors reliable payments while telling regulators that payments to creditors could be cut off if the bank ran into trouble. Since, unsurprisingly, it was difficult to find investors willing to take this deal, banks trying to sell TRUPS asked Wall Street investment banks to design CDOs that bundled the securities into a product that could be sold as less risky than the basic security. The investment banks in turn pressured the credit rating agencies to certify their risky new CDOs as investment grade by using misleading performance assumptions. To make matters worse, many of these CDOs were purchased by other banks, doubling down on the already high risks of the instrument. (All the gory details are available in this paper).
Thanks to Senator Collins and then-FDIC chair Sheila Bair, strong controls were placed on new TRUPS issuance in the Dodd Frank Act. But about 200 banks – some 3 percent of all U.S. banks — still hold old TRUPS CDOs, which have suffered huge price declines. In many cases their regulators have none the less permitted them to hold these CDOs at historical prices rather than marking down losses based on current market prices. Since the Volcker Rule will force the sale of these assets by 2015, banks that bought them in the past may now have to sell and suffer losses. That’s unfortunate in the case of community banks, since smaller banks who purchased such CDOs were in some ways victims of the Wall Street securitization complex. And it may be possible to work out a way of grandfathering these legacy assets. But it’s crucial that neither regulators nor Congress undermine the Volcker Rule controls on securitization just to ease this transition period.
A second wave of opposition to the new Volcker Rule controls is coming from participants in markets for Collateralized Loan Obligations (CLOs). CLOs generally hold ‘leveraged loans’ made to corporations who do not have strong enough credit to directly issue bonds. (Many of these leveraged loans are used to fund private equity takeovers). The CLO market is now considered one of the riskier securitization markets around, as leveraged loan practices have been targeted for numerous regulatory warnings over the past few years. Once again, it seems like controls on this market might not be a bad idea. While CLOs that hold only loans can qualify for the existing Volcker Rule exemption, it turns out that many CLOs hold a range of other non-loan securities and thus won’t be permissible holdings under Volcker.
Last night, regulators issued a guidance reiterating the terms of their securitization exemption, and pointing out that financial engineers might be able to find ways to make complex securitization products fit within the terms of that exemption. While that’s not totally reassuring, it still indicates that the regulators are willing to hold to the limits they just created on bank involvement with potentially toxic securitizations. That’s the right approach. Those limits aren’t an accident – they’re one of the central new protections created by the Volcker Rule.