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January 29, 2015

How the Republican Campaign to Gut Dodd Frank is a Huge Gimmie to Banks and Private Equity Funds

The Republicans have been quick and shameless in using their control of both houses to try to crank up the financial services pork machine into overtime operation. The Democrats at least try to meter out their give-aways over time.
Their plan, as outlined in an important post by Simon Johnson, is to take apart Dodd Frank by dismantling key parts of it under the rubric of “clarifications” or “improvements”* and to focus on technical issues that they believe to be over the general public’s head and therefore unlikely to attract interest, much the less ire. However, as Elizabeth Warren demonstrated in the fight last month over the so-called swaps pushout rule, it is possible to reduce many of these issues to their essential element, which is that Wall Street is getting yet another subsidy or back-door bailout.
Today’s example is HR 37, with the Orwellian label “Promoting Job Creation and Reducing Small Business Burdens Act”. We’ve attached it at the end of this post. The Republicans sought to get it passed in the House on Wednesday using a fast track process referred to as a suspension of the rules, which is used for supposedly non-controversial bills. But the Republicans overplayed their hand. Enough liberal and banking reform groups lobbed objections to secure enough votes to prevent the bill from passing.
CLOs are a type of collateralized debt obligation. They are made of risky corporate debt exposures: leveraged loans, junk bonds, or credit default swaps on high-risk corporate borrowers. Their structures are less risky than the type of asset-backed CDOs that blew up the global financial system. The flip side is that because the CDO meltdown was so dramatic and had such devastating consequences, the fact that CLOs took big mark to market losses in the crisis has been largely ignored (and like other complex, risky securities, the realized losses, which in the end were inconsequential, would almost certainly have been higher had the Fed not engaged in such heroics to goose asset prices and enable weak borrowers to refinance cheaply.
As Better Markets explains in a useful backgrounder, CLO exposures are concentrated at the biggest banks:
And they play two critical roles: helping banks finance private equity deals, which are a huge business for them, and as trading vehicles for their own account. As a Bloomberg article in February 2014 explained, tightening up on CLOs would restrict private equity funds’ ability to get cheap credit.
To unpack this issue a bit, let’s turn again to the Better Markets backgrounder:
What are CLOs?
  • CLOs are investment funds that consist of “leveraged loans”, (huge, low-rated, corporate loans) which can be swapped in and out by the manager throughout the life of the fund. Investing in a CLO is functionally identical to investing in a hedge fund that invests in this kind of loan.
  • CLOs held by banks were – and continue to be – proprietary positions. Beneficial capital treatment of CLOs meant that banks could borrow cheaply and hold high-yielding CLOs on their books, capturing the difference as profit.
  • The specific features of CLOs (when it will mature, the kinds of investments it can make, the rights and protections for each class of investor, etc.) are not publicly disclosed and are non-standardized, so it is impossible to know how many CLOs exist with any given feature.
  • Importantly, it isn’t clear which CLOs, or how many, would be affected by any change in the rule.
  • Keep in mind that CLOs that consist entirely of loans are excluded from the Volcker Rule. But a bank would generally create that type of CLO only for sale to third parties, so they would seem to fall outside the Volcker Rule on that basis (ie, this provision was a belt0-and-suspenders measure to clear up any ambiguity).

Read the full Naked Capitalism article by Yves Smith here.

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