On December 10, 2013, the final Volcker Rule was adopted by the federal banking regulators, the SEC, and the CFTC to implement Section 619 of the Dodd-Frank Act.  The Volcker Rule generally prohibits banking entities from engaging in “proprietary trading” and making investments and conducting certain other activities with “private equity funds and hedge funds.”

One unintended consequence appears to be the treatment of Collateralized Debt Obligations (CDOs) backed by Trust Preferred Securities (TRUPs) as “covered funds” under the Volcker Rule.  As a covered fund, banking entities of all sizes will no longer be able to own TRUPs CDOs as of July 21, 2015.  Moreover, because of this obligation to divest by July 21, 2015, banks are no longer able to say they will hold such investments to maturity and therefore will not be able to split out their other than temporary impairment between credit losses and market losses.  Any market losses in the CDO security (which is currently reflected only in other comprehensive income) will be reported as a loss through Tier 1 capital.  Banks holding TRUPs-backed CDO’s are encouraged to reach out to their accountants to discuss the potential accounting impact.

It is not clear the extent to which the regulators contemplated this consequence, or understood the significance.  The adopting release is silent as to the explicit impact of the Volcker Rule on TRUPs-backed CDO’s, but the Federal Reserve’s Summary of the Community Bank Applicability notes that “only a small number of community banks own” CDO’s backed by TRUPs that meet the definition of covered funds.  Regardless, in light of the time necessary for the various regulators to reach agreement on the final rule, the rapidly approaching year-end financials, and the general regulatory dislike of TRUPs, it seems unlikely that modifications (if any) would be done in a timely manner.

Direct investment in TRUPs (as opposed to CDO tranches) remains permissible under the Volcker Rule (so long as the securities are held for investment as opposed to proprietary trading).