Collateralized Loan Obligation (CLO) Defined
A CLO is a security that is backed up by the collateral of a set of debt instruments like bonds and mortgages. It is a credit derivative.
A Little More on Collateralized Loan Obligation
The issuer of the CDO mainly uses it in covering a portfolio of assets with credit risk, but it can also be utilized in entering a short position against that debt. Individual assets are transformed into a CDO through securitization that takes place outside the banks’ balance sheet and for which a specialized company is formulated with the purpose of managing and structuring the assets at risk.
CDO possess cash flows which are backed up by a portfolio of assets containing debt which consists of any debt instrument or even another type of a CDO. However, the CDOs that are backed by other CDOs are commonly referred to as synthetic CDOs.
This process is similar to that of mortgaging a house except that it is the bank is doing the mortgaging. For example, the bank wants to mortgage its house. What it does to get money is securitizing that house through issuing bonds that are backed by that house such that if they fail to pay, the buyers of the bond keep the house.
To create the CDOs, a bank forms a company and tasks it with the responsibility of buying those bonds that it has issued to securitize the previous house and other houses. Later the company secures all these bonds and issues new bonds that are backed by the earlier bonds. This is because the company cannot pay but instead keeps the bonds backed by the houses.
In the creation of CDOs, the debt instruments are packaged and subdivided by the issuer into different classes that can be assimilated in various steps. Each step depicts a different order priority from the portfolio to which they are linked as well as different exposure to the default risk of the assets of the portfolio. These bonds are not only made with the debt of the houses, but also with many other types of assets.
Types of Collateralized Loan Obligation – CLO
There are different CLOs according to the securitized asset:
- Collateralized bond (CBO)- Bonds
- Residential mortgage-backed securities (RMBS)- Home mortgages
- Commercial mortgage-backed securities (CMBS)- commercial mortgages
- Asset-backed securities (ABS) – which includes different assets such as credit cards.
Usually, a CDO with a structure appearing in the lower scheme where there are different steps is common. These steps or tranches include senior debt, mezzanine debt and stocks and every one of them respond differently depending on the step.
- Senior debt: These contain the best credit quality since they possess the least risk and are the safes. They are mostly given a triple-A rating
- Mezzanine debt: These have a higher risk compared to the previous one and thus pay a higher coupon than the previous.
- Actions: This contains the highest risk, and it is the first to incur losses. It is not rated.
The restructuring process involves buying the portfolio or collateral from the bank. Suppose this portfolio contains about 200 million dollars that have been structured in the three steps. It will be as follows:
- Senior debt that has a triple-A rating and promises an interest of 4% will have around 160 million dollars
- Mezzanine debt that has a double B rating and promising an interest of 7% will have about 30 million
- The shares that are not rated will have the remaining 10 million dollars.
References for Collateralized Loan Obligation
Academic Research on Collateralized Loan Obligations
- Risk and valuation of collateralized debt obligations, Duffie, D., & Garleanu, N. (2001). Financial Analysts Journal, 57(1), 41-59. This paper illustrates the effects of correlation and prioritization on valuation and then presents a discussion of the diversity score in a simple jump diffusion setting for the correlated default intensities.
- Default risk sharing between banks and markets: the contribution of collateralized debt obligations, Franke, G., & Krahnen, J. P. (2007). In The risks of financial institutions (pp. 603-634). University of Chicago Press. This paper contributes to the economics of financial institution risk management by examining how loan securitization protects their default and systematic risk as well as their stock prices.
- Collateralised Loan Obligations (CLOs)-a primer, Jobst, A. A. (2002). This article studies the different types of loan securitization and also provides a working definition of CLOs. It presents a description of the theoretical foundations of this type of loan securitization that is specialized.
- Innovations in credit risk transfer: Implications for financial stability, Duffie, D. (2008). Innovations in credit risk transfer: Implications for financial stability. This paper attempts to examine the design, prevalence and the effectiveness of credit risk transfer by focusing on the costs and benefits for efficiency and stability of the financial system. It provides an example to illustrate the CLO design.
- Securitization without adverse selection: The case of CLOs, Benmelech, E., Dlugosz, J., & Ivashina, V. (2012). Journal of Financial Economics, 106(1), 91-113. This paper presents an investigation of whether the securitization was associated with risky lending in the market of corporate loans through an examination of the individual loans that are possessed by collateralized loan obligations. It argues that the securitization of corporate loans is different from the securitization of other assets classes since the securitized loans are fractions of syndicated loans.
- Securitized banking and the run on repo, Gorton, G., & Metrick, A. (2012). Journal of Financial economics, 104(3), 425-451. This paper refers to the combination of securitization together with repo finance as ‘securitized banking’ and then argues that these activities were at the forefront of the panic of 2007-2008. It uses a data set consisting of credit spreads belonging toy hundreds of securitized bonds to trace how the crisis moved from subprime-housing related assets to markets having no connection to housing.
- Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues, Jones, D. (2000). Journal of Banking & Finance, 24(1-2), 35-58. This article presents a discussion on the essential techniques that banks utilize in undertaking capital arbitrage and the difficulties that face the bank supervisors when they try to deal with these activities under the existing capital framework.
- Credit risk in private debt portfolios, Carey, M. (1998). The Journal of Finance, 53(4), 1363-1387. This paper presents the default, loss severity and the average loss rates belonging to a large sample of privately placed bonds and then compares them with loss experience for publicly issued bonds. The paper also estimates the chance of large portfolio losses and various determinants of these losses are analyzed.
- Bank lending during the financial crisis of 2008, Ivashina, V., & Scharfstein, D. (2010). Journal of Financial economics, 97(3), 319-338. This study shows how the new loans to large borrowers reduced by 47% during the peak period of the 2008 financial crisis when compared to the previous quarter and by 79% compared to the peak of the credit boom.
- Information, liquidity, and the (ongoing) panic of 2007, Gorton, G. (2009). American Economic Review, 99(2), 567-72. This paper investigates the increase in repo haircuts during the panic of 2007 that caused massive deleveraging through examining the breakdown in the arbitrage foundation of the ABX.HE indices during the panic.