For now, banks that have investments in CDO securities that are issued by funds that are invested in trust preferred securities (TruPS CDOs) have dodged a bullet. On Dec. 10, 2013, federal regulators issued the long-anticipated final Volcker Rule. An implementation of Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Rule establishes limitations on proprietary investment and trading activities on the part of banking entities that benefit from federal deposit insurance.
In something of a surprise the final rule provided that financial institutions must phase out their investments in TruPS’ CDOs.
Being forced to divest themselves of these holdings, even though not required until a compliance period that will start in 2015, would, in the minds of some accounting departments, have required an immediate accounting hit, as the banks would have to recharacterize such investments as being available for sale, rather than held for portfolio. For banks that had invested in TruPS CDOs prior to the financial crisis and held them on their books at prices higher than the current price, the accountants warned, it would be necessary to recognize a loss reflecting that reduced value, even before the required time for divestiture.
The response was fast and furious. Legislation was introduced in both the House and Senate, seeking a carve-out or exemption allowing banks to continue to hold the CDOs. A bi-partisan group of Senators sent a letter to Treasury Secretary Jack Lew and Federal Reserve Chairman Ben Bernanke, arguing that the “Volcker Rule is not the appropriate vehicle for the regulators to revisit how community banks manage their portfolios of TruPS.” And the American Bankers Association filed a lawsuit seeking suspension of the controversial provision.
The outcry led to a joint statement from the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission on Dec. 27 that the regulators planned to reconsider, followed by an interim final rule by those same regulators issued on Jan. 14, 2014.
Under this new rule, TruPS CDOs may be retained by a banking entity provided all of these things are true:
- The TruPS CDO was established, and the security held by the bank was issued, before May 19, 2010.
- The banking entity reasonably believes that the offering proceeds received by the TruPS CDO were invested primarily in trust preferred securities and subordinated debt instruments that were themselves issued by a mutual holding company or a depository institution holding company before May 19, 2010, the issuer of which had total consolidated assets under $15 billion as of the end of each reporting period within the year preceding the date of issuance.
- The banking entity acquired the interest in the TruPS CDO on or before Dec. 10, 2013.
Why it matters: For banking entities that hold TruPS CDOs this will largely avert the need to sell those securities or to recognize losses for accounting purposes. It will be important to check that all of the conditions are satisfied, as to the nature of the TruPS CDO, the date of issuance and the primary character of the underlying TruPS held by the CDO. Since TruPS CDOs acquired after Dec. 10, 2013 will not benefit from this new rule, there will be little appetite for their purchase within the banking industry.
To read the new rule, click here.
For a list of 86 TruPS CDOs identified by the regulators as meeting the criteria for exclusion from the Volcker Rule’s prohibition, click here.