As First Volcker Rule Victim Emerges, Implications Could "Roil The Market"
Yesterday afternoon, Zions Bancorp, Utah's biggest lender, stunned the financial community with a regulatory filing in which it announced that as a result of the final Volcker Rule implementation, it will need to make some very dramatic changes to its balance sheet, which would also have a follow through, and quite adverse, impact on its income statement. To wit:
Zions Bancorporation (NASDAQ: ZION) (“Zions” or “the Company”) today announced that it believes substantially all of its portfolio of bank and insurance trust preferred collateralized debt obligation (CDO) securities, and certain other asset-backed CDO securities, will be considered disallowed investments under the revised, final “Volcker Rule” of the Dodd-Frank Act, which was released jointly by the Federal Reserve and a number of federal regulatory agencies last week. The final rule requires banking entities to divest such assets by July 21, 2015, unless, upon application, the Federal Reserve grants extensions to July 21, 2017.
Under the published rule, the Company would no longer have the ability to hold disallowed securities until the anticipated recovery of their amortized cost. Therefore, as of December 15, 2013, Zions anticipates that in the fourth quarter of 2013 it will reclassify all covered CDOs that currently are classified as “Held to Maturity” into “Available for Sale,” and that all covered CDOs, regardless of the accounting classification, will be adjusted to Fair Value through an Other Than Temporary Impairment non-cash charge to earnings. The net result would eliminate substantially all of the accumulated other comprehensive income adjustment to equity related to the covered securities.
In short: Zions can no longer keep TruPS (and perhaps any other kind) of "disallowed" CDOs on its books to maturity, explicitly in its "Held to Maturity" book and will instead be forced to dispose of these, in the process pushing them off to their "Available for Sale" inventory, and since this involves a Mark-To-Market repricing, hitting the Net Income line due to the P&L impact of moving a netting Comprehensive Income line item into the broader income statement where it would impair earnings materially on a non-cash basis (impacting equity, not cash).
This touches on several key regulatory loopholes that we have written about in the past, but more importantly, it exposes some key new ground that may lead to major impacts on bank capital and net income in the quarters to come, especially if indeed Zions is correct in its interpretation of Volcker, which suggest neither the Utah bank nor any of its peers will be able to hold either TruPS or potentially any other CDOs.
First of all, recall our recent series on unrealized bank "profits" (and losses) from Available for Sale books (courtesy of FAS 115), which recently plunged as a result of the surge in rates, hitting bank holdings of rate-sensitive securities held in AFS books. If indeed the Zions case study is a harbinger of things to come, look for this negative number (which in the past week dropped to the lowest cumulative total since the August near 3% on the 10 year blow out), to get even more negative.
But more importantly, should Zions be the canary in the coalmine on what Volcker means for bank prop holdings, then this is likely just the first shot across the bow of surprising announcements as one bank after another announces its intentions to reclassify and dispose of assets it had hoped to keep under the rug until Bernanke's reflation effort pushes their prices to their prior peak levels at which point they would no longer impair earnings even on a MTM basis.
To be sure, when it comes to just TruPS CDO holdings, it appears that Zions is the leader. Bloomberg reports:
Zions owned $1.23 billion of bank-issued trust-preferred CDOs as of Sept. 30, the most among all U.S. banks, according to analysts at Sterne Agee & Leach Inc. About 3 percent of U.S. banks held similar CDOs and a sudden sale by Zions could roil the market, Sterne Agee said.
“They are the 800-pound gorilla in this space,” Sterne Agee’s Matt Kelley said in an interview. “They have a lot at stake and they have an incentive not to tip their hand.”
The assets must be divested by July 21, 2015, unless regulators grant a two-year extension, Zions said.
“We’re not going to just go out and dump those things tomorrow,” Arnold said. “We’ll be exploring a variety of ways to come into compliance with the Volcker Rule, not all of which may involve the sale in the market.”
When anything could "roil the market", especially a market as illiquid as the current one, people pay attention. Even if for now the same people are happy to stick their heads in the sand and, unlike Zions, pretend Volcker does not apply to them. Sure enough:
All banks may not interpret the Volcker Rule the same way, according to Jason Goldberg, an analyst at Barclays Plc.
“There’s a lot of pages,” Goldberg said in an interview. “It’s going to take some time to figure this all out.”
Of course, if more banks end up with the same conclusion as Zions, then a roiling of the structured market is virtually assured.
At the end of the day it will all depend on a bank's interpretation of FAS 115 (and how Volcker accentuates this relationship) which, in a nutshell - see primer below - does not apply to unsecuritized loans. However, mortgage loans converted to mortgage-backed securities are subject to FAS 115 provisions. Furthermore, due to potential for impairment, interest only and super-premium MBS are not typically classified as "held to maturity." As of this moment neither are TruPS. What other securitization categories will emerge as having been held in HTM books and now have to be reclassified as AFS? We eagerly await the answer!
Which brings us to point #2, one which is likely far more important:
Under the Volcker rule and the bank’s own rewritten guidelines, Zions would give a lot more scrutiny before buying any more structured securities, Arnold said. “We haven’t bought any CDOs really since almost pre-crisis probably, and certainly wouldn’t touch them today,” he said.
Paraphrase: Volcker may have just frozen any future CDO-strucutred issuance in its tracks. Why is this a problem? Because as readers may recall, one of the necessary (if not sufficient) QE exit conditions is not only the return of housing as "high-quality collateral", a status it lost in the crash, but also the associated securitization machinery. Recall from page 30 of the May TBAC presentation appendix:
Simply said: without securitization, banks will have a far more difficult time assisting the Fed in its exit from the bond market (where it is the marginal buyer), which in turns means QE may never be exited period. Sure, banks may be able to structure housing exposure on a levered basis using some whole loan structuring instrument, however if Collateral Debt, which be definition is pure leverage defined, is not one of the financial tools, kiss the Fed's handover of excess leverage to the private sector goodbye.
Expect to hear much more about this in the coming weeks if even one more bank were to admit that Zions' take on Volcker is indeed accurate, and CDOs - either TruPS of generally - are suddenly non-grata.
We will write more about bank securitized trading book exposures shortly, and just how pervasive of a problem this may become.
In the meantime, a bonus: our 2009 primer on SFAS 115:
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