Good Collateralized Loan Obligations And Their Impact Over US Economy Essay Example

Finance

About Collateralized Loan Obligations (CLO)
The new financial instrument in the industry that is backed by the pool of debts that often constitutes low rated corporate loans. These securities are similar to Collateralized Debt Obligations except for the different type of underlying loans pooled against the security issue. CLO’s were created with the objective of lowering the cost of borrowing for the businesses and also to reduce the risk of banks as the risk associated with underlying loans are distributed amongst the investors.
CLO’s payments are also made in tranches which are also known as cash waterfalls or slices in the financial industry. Important to note CLO’s are the securities that are issued against underlying loans for which cash flows have been reallocated to different classes known as tranches. Each tranche have a different claim against the cash flow, i.e. each tranche have different maturity and with different risk levels. Each type of tranche signifies the risk level and thus the corresponding level of interest rate to be received by each investor. For Instance, investors in senior tranches have least level of risk involved, while the investors in the lowest tranche absorbs the maximum risk by providing shield for the senior tranche investor. The risk involved in this trance can go up to even eroding the par values and thus, investors in subordinate tranche gets the highest level of interest rate on their investment.
The main advantage of such payouts to different investors is that it allows the investors to select the risk levels to which they want to be exposed and thus, have a control over the investment risk in their portfolio.

Tranche Payments in CLO

As discussed above, a collateralized loan obligation (CLO) has the following structure:
One or more senior tranches
Several levels of mezzanine tranches
A subordinate tranche, also known as equity tranche.
The senior tranche typically comprises of 70% to 80% of the entire CLO structure and is assigned a floating rate payment to attract investors who are looking for a floating rate investment. On the other side, mezzanine and subordinate tranches are assigned a fixed interest rate payment and with two different payouts in the CLO structure mismatch is created. Thus, in order to control the interest rate risk imposed by this mismatch, asset managers use interest rate swaps to convert the fixed rate interest receipts into floating rate payments.

Risk associated with CLO

Just like any other asset class, CLO also contains various risks associated with economic risk of underlying loans combined with the risks afforded from the rules of the structure that affect the disbursement of on-going cash flow. Below discussed are suck risk factors:
Subordination Risk: This risk is embedded in the subordinate tranche where the investors absorb the risk and provide shield to senior tranches. Although these tranches are paid highest interest rate but are also at maximum risk in case defaults take place in the underlying collateral portfolio. In addition, any excess exposure of the low graded underlying loans such as CCC-rated collateral can also erode even the principal investment amount of the subordinate tranche investors and can even reduce the payouts to senior trance investors.
Recovery Rates: There is no assurance relating to recovery rates on any underlying collateral that has defaulted. Thus, any such activity can affect the cash flows for the investors.
Low Liquidity: CLO investments suffer from low liquidity and should only be viewed as a long-term investment, not a trading investment. It is important to note, there is limited market liquidity for CLO’s.
Management Risk: Although the management of CLO’s done by experienced asset managers but many a times these individuals uses their discretion to sell or replace existing collaterals underlying the CLO. These transactions could possibly expose the CLO to net losses thus affecting payouts to the investors.

Collateral Risk: Usually the underlying collaterals held by the CLO in the portfolio are below investment grade.

Interest Rate Risk: While the senior tranches in the CLO are paid on floating rate basis, but the mezzanine and subordinate tranches are paid fixed interest rates. This creates a mismatch which is usually combated by the assets managers using the swaps. However, the payout of swaps is not assured, thus there is always interest rate risk embedded in CLO.

CLO Management

One of the key features of CLO’s is that they are managed actively by the experienced collateral managers. Thus, any CLO issued must have gone through due diligence of the collateral manager while the process of evaluating any CLO investment has a focus area of checking the balance between bottom up credit analysis which is concerned with credit analysis based on individual asset selection and the top-down analysis which is concerned with macro-credit views that drive portfolio decisions, such as:

Interaction between analyst and portfolio managers

Opinion of market pundits
Track record of collateral manager
Investment thesis of Collateral Loan Obligation
Transparency in CLO offering in terms of reports made by external administrator
Management fee of CLO
The fee for managing CLO is around 10-20 bps for senior tranches, 30-40 bps for subordinate tranches. In addition to this fee, a contingent management fee is also charged well if the deal performs well. This fee is determined using Internal Rate of Return(IRR) factor.

Collateralized Loan Obligations- Bad Boys of Financial Crisis

Originally issued in 1990’s, CLO gained traction after the housing bubble set to peak in the United States in 2002-2003. This was the time when banks were lending to almost every applicant which majorly turned out to be sub-prime borrowers. This was the time when unsecured high yield debt was considered too risky for securitization and Collateralized Bong Obligations were replaced with Collateralized Loan Obligations. Courtesy extensive lending by the banks, the amount of CLO issued surged from $1Billion in 1995 to $102 Billion in 2007.
CLO’s have been believed to be the primary participant in magnifying the effects of the financial crisis through their complex structure, excessive leverage and failure of credit rating agency to figure out the risk hidden in them. The need for issuing excessive CLO arose after banks were granting loans to everyone who wished to participate in the housing bubble that began in 2002 in USA. In addition to the banks, even Federal Reserve also supported the action by lowering the interest rates and by relaxing the lending standards that allowed the banks to lend loans to subprime borrowers too. However, knowing the risk involved in such lending practices, banks securitized these loans with the investment bankers who then pooled mortgage payments and other loan proceeds and sold trillions of dollars of CLO which had the subprime and probable default mortgages as underlying assets. Even the banks were actively participating in the proceeds as the money they received from securitizing their loans were then lend to other business clients. In this way, through more securitization, banks were able to increases their income with little risk for them.
Investors who were looking for high yield returns (expecting the bubble to continue forever) invested aggressively in the CLO while the continued repackaging by the banks led to a multiplier effect. Moreover, many investors even adopted the subordinate tranche so as to earn high rate of interest despite knowing that they could even lose their principal amount if the borrowers who had purchased loans that CLO had purchased, this was the audacity of the investors during the bubble.
Finally, as expected, with supply surpassing the demand, and with Federal Reserve increasing the interest rates, the housing bubble finally busted and the returns on CLO turned to zero with investors in subordinate tranche losing even their paramount. This all happened as with higher interest rates and subsequent rise in the unemployment rates, borrowers defaulted on their payments. Thus, not only the mortgage proceeds declined significantly, houses priced tumbled and so does the value of the collaterals.
The nature of Collateral Loan Obligation was itself to magnify the losses and this happened with billions of dollars of investors lost, resulting in second most cruel economic recession after the Great Depression.

Regulation on CLO post financial crisis

The credit dislocation of the 2007-2009 has not only changed the investor profile from a more broad based one to one of distressed funds, it has dramatically changed the future of CLO structures to be simpler in nature and lower in leverage. Thus, we can say that the credit dislocation during the financial crisis has changed the landscape of CLO for good of the investors. Learning from the ill effects and how vulnerable this financial instrument can be, regulators around the glove have introduced new regulations so as to avoid another financial nightmare. Some of the regulations introduced are:

EU retention requirements

Banks must retain a part of the debt on their balance sheets
Alternative Investment Fund Managers Directive
The original issuer of a securitisation must retain 5% of the economic risk
Dodd Frank Act
Securitizer of transaction must retain 5%
Volker rule
Limitations on the trading activities
Credit Rating Agencies Regulation
Structured Finance instruments must be rated by at least 2 agencies
As we can notice from the newly introduced regulations, regulators have ensured that the bankers also take responsibility for the future performance of the asset. In this way, by indulging banks and making them responsible for the asset performance, regulators have somehow ensured that the financial instruments are fairly priced to reflect the inherent risk.

Recent growth in CLO market

The year 2014 was the come-back year for the CLO market as many prominent issuer again issued the CLO in the financial market and witnessed significant growth in the demand. For Instance, CLO issuance in March 2014 reached $10.8bn, the highest level since May 2007 and April, 2014 saw the figure increase to $12.3bn, exceeding the levels last seen in 2006.
The core reason for growing interest of the investors in CLO is that while they are offering much higher return than the risk-free or treasury instruments but are re-launched with justified risk-return profile. For Instance, AAA rated CLO are paying out 11x more yield premium over risk free benchmarks than corporate AAA rated debt. Similarly, BBB rated bond is yielding 4% while BBB CLO are offering 6% yield. In terms of risk, BBB rated bond defaults higher than the BBB rated CLO. Thus, not only the newly launched CLO are offering higher return but also under low risk environment.

Conclusion

Collateralized Loan Obligations(CLO), as we noticed in the above discussed, were originally issued with a bad intent of the bankers which led to billions of dollar lost once the housing bubble burst. However, with new regulations imposed and many more to come in 2015, we can expect the demand for CLO to increase manifold but now under a safe and rational manner and not just a blind-fold investment.

Works Cited

Brown, M. O. (2012). Asset Backed Securities. In C. Institute, Fixed Income Securities (pp. 130-148). Boston: Custom.
Collateral Loan Obligation. (n.d.). Retrieved January 20, 2014, from http://financial-dictionary.thefreedictionary.com/Collateralized+Loan+Obligation
Collateralized Loan Obligation. (n.d.). Retrieved January 20, 2015, from http://www.businesspundit.com/encyclopedia/investing/collateralized-loan-obligation-clo/
Collateralized Loan Obligation - CLO. (n.d.). Retrieved January 20, 2014, from Investopedia: http://www.investopedia.com/terms/c/clo.asp
What are CLOs and how do they work? (n.d.). Retrieved January 20, 2015, from Babson Capital: https://www.babsoncapital.com/BabsonCapital/http/bcstaticfiles/Research/file/CLO%20White%20Paper_CLOWP4309_Jun09.pdf