Collateralized Loan Obligations - Essay Example

Collateralized Loan Obligations of Collateralized Loan Obligations Introduction The economic recession was a gloomy period especially for the structured product market, which saw a drop in asset prices, the downgrading of ratings and massive spikes in volatility. With investors becoming wary, CLOs acted as structurally required, they paid down key note holders with interest proceeds. Ultimately, with the growth of confidence in the market, prices of Collateralized Loan Obligations increased and fresh issuances gradually began making comebacks. On a leveraged perspective on corporate credit, Collateralized Loan Obligations have begun to gain a firm corporate market. Furthermore, the low-interest-rate environment, more credit spreads, and promising laws have bolstered many performance metrics to better than pre-crisis levels. It is predicted that the asset class will experience growths stemming from the attractive returns offered by the CLOs in comparison to similar collaterals. A collateralized loan obligation can be argued to be the entire structured financial transactions where several degrees of equity and debt are delivered via special service vehicles that are primarily composed of commercial loans. Specifically, a distinction exists between a Collateralized loan obligation and bond obligations or mortgage obligations in that CLO in that they are debt securities that are collateralized by commercial loans. The Collateralized Loan Obligations work on a purchase basis. Typically, the degree and extent of the investment in the Collateralized Loan Obligations depends on the risk tolerance level of the investor, such that, risk tolerant investors receive more returns on their investment relative to risk averse investors. Comparatively, a case of a default on loans leads to the risk averse investors reaping the most (Westerfeld, & Weber, 2010, p. 75) Throughout the third quarter of 2008, the market experienced one of the worst financial crisis ever experienced in the twenty-first century. The crisis was characterized by the failure of major business and reduction in consumer wealth by huge margins (Westerfeld, & Weber, 2010, p. 70). Nevertheless, experts argue that the bursting of the housing bubble in 2006 led to the plummeting of the pricing in the real estate business, an issue that damaged most financial institutions. Key among the players in the causes was the Collateralized Loan Obligations that acted a substantial part in the sub-prime of the housing boom. With the continued growth of the CLO throughout 2005, more focus shifted to the use of subprime mortgages as collateral against consumer loans. This prompted investors to purchase varied trenches of the CLOs that carried different credit ratings making them differ in terms of risks carried by the investment. The multiplier effect that resulted from the increased repackaging had a significant impact on the economy. However, the pressure in the home markets could be sustained for long reducing the buoyancy period of the housing market. With homeowners rapidly falling into massive debts and arrears, house prices began to fall leading to a decline in collateral value. Financial analysts claim that just like most economic variables, the decline in collateral value had a multiplier effect that spread across many segments of the economy leading to the financial crisis. In respect to the dismal performance and the resultant crisis emanating from the actions of the Collateralized Loan Obligations, several legislation were enacted to check on the performance of the collaterals. Legislators considered measures regarding lending practice, insolvency cushioning, taxation policy, low-cost real estate, credit advising and the certifying of loaners. The legislation were intended to influence the nature of the transactions pertaining the legal entities and the equities involved in the mortgage business. Particularly, the regulations were institutionalized to check on the issuance and the treatment of securities that were backed by assets such as CLOs (Ji, X. 2010, p. 29). Among the enacted legislation were the requirements by the EU in terms of risk retention that specifically cushioned the investors against the credit risks of securitization except from sponsor, or the genuine lender in the deal accepts to retain a stakes of more than five percent of the securitized exposure. As such, in case an affected investor goes ahead to commit his funds in a securitization that falls short of meeting the risk retention or due diligence as per the necessities of the European Union, in retrospect to the negligence portrayed, the enforcers are advised to impose a harmonious extra risk weight against the pertinent securitization position that is equal to or more than 250% of the prior risk weight of the position. The EU legislation permit the marketing and selling of the non-compliance securitization transaction to other investors apart from the initially affected investors. Nevertheless, the law does not specify the extent to which the reduction in liquidity and its impact on pricing for a deal at the disposal of non-affected investors. Another relevant legislation pertaining dealership in CLO is the AIFMD that has significantly affected most hedged fund managers that are mandated with the management of funds or in some instances have represented investors within the UE. The AIFMD obliged investment fund managers -in this case the CLO managers-, to upgrade their abidance and operational protocols to include high degrees of compliance with existing regulations such as investor’s reportage duties. As a necessity for the management of risks, there is the requirement for the functional and hierarchical differentiation of the risk management portfolio as a way of ensuring substantial risk mitigation systems that identify, evaluate while monitoring all the risks associated with the CLO (Pauley, & Kroszner, 2012, p. 90). Thereby, the legislation specifies that the originator is expected to hold a net economic interest of not less than five percent. Specifically, the required net economic interest is expected to be evaluated at the origination with a room given for maintenance on a progressive basis. Furthermore, inclusive of the net economic requirement is the retained positions exposure that stipulates that they may not be subject to credit risk mitigation. Just like the AIFMD, the Dodd-Frank Act was enacted to overhaul the securities and banking legislation. Among the provisions of the Act, section 941 instructs that securitizers have to retain a segment of the credit risk of asset-backed securities such as CLOs (Westerfeld, & Weber, 2010, p. 82). Experts argue that in reaction to the lessons learnt from the economic crisis specifically within the housing sector, it was imperative for the sponsors in securitization deals be instructed to remain with a financial stake as a way of enhancing transparent transactions and sticking to the vital underwriting standards in the provision of credit. In an attempt to curb crisis of interest and increase competition, the CRA provides a mandatory registration procedure for credit rating entities. This is in an effort to ensure that any conflict within the system is adequately managed, that the quality of evaluation methodologies and ratings is standardized while increasing the transparency of the rating agencies. It is clear that majority of the amendments and legislation enforced in the financial sector aimed at redistributing risks and responsibilities in relation to the future value of credit. Arguments given in connection with the enactment of the legislation was that giving bankers ownership a portion of the debt would ensure that there is the fair pricing of the debts and see to it that inherent risks are an accurate reflection of the market (J.P. Morgan, 2010) However, despite the criticism levelled against the CLO’s as the perpetrators of the housing crisis and the various legislation enacted to curb the actions of the players in the sector, the CLO’s have experienced a surge in demand and usage in the recent past. A changing market that has seen a modification of the CLO model has seen to it that the resultant shorter reinvestment and non-call stints have favored the equity tranche moguls. Similarly, the demand in most leveraged financial markets have shown indications of attaining a broader investors base that has combined a rising CLO market with new financing via the highly yielding bond market. Statistics shows that the issuance of the CLO had attained an all-time high of $12.3 b in March of 2014, a significant increase from the initial low of 10.8 b in May 2014. The rebirth of the issuance of the collaterals could be explained in twofold in terms of the activities of corporates and the central banks. Typically, in the US market, the government via its financial player the central bank issues T-bonds that are characteristic of being void of risk and less appealing. On the other hand, US companies ready to carry risks are at liberty to issue US A-rated corporate bonds that tend to have defaulting risks culminating at repayment. However, in a period of two years, relative to the government issued T-bonds, the corporate issued A-rated bonds offer 1 percent more yield due to the due to their inherent credit risk. However, unlike the 1 percent return on investment issued by an investment in corporate bonds, the CLO at the moment provide 11 times more yield premium in riskless benchmarks. This implies that given an AAA rated risky bond, a similar CLO has a higher probability of returns to the investor. Given the financial crisis that rocked the market, risk-averse investors have opted to avoid the acquisition of CLO’s and as a form of disposal form are now offering good values for the CLOs. For instance, current market statistics shows that unlike BBB rated bank loans that provide 4 percent yields on the investments, a BBB CLO offers 2 percent extra return on a similar investment. This shows that given the same risk position, a typical CLO promises higher returns when compared to a similar rated bank loan. Proponents of the issuance of the CLO associate low levels of risk to the CLO’s relative to bank loans and corporate bonds. The low risk associated with the CLO is due to the low default rates that are characteristic of them in comparison to the similar rated corporate bonds. Moreover, the same experts have provided metadata that shows the rate of default of BBB rated CLO’s to be a fourth of the default rate of the corporate issued bonds. Thus, the high yield and the low risk associated with the CLO’s have served as magnets that have attracted investors to reconsider their perception of the CLOs. The fact that the CLO’s provide higher returns on investment in a low-risk environment makes them more attractive to any investor. However, of importance is the argument that as the CLO’s market expands as demand increases, the yield spread in the market is expected to break-even. This is in relation to theory in that BBB rated corporate bonds have similar trading probability to similar rated CLOs. as such, in response to renewed interest in CLO’s, the year 2015 is expected to usher in a new era in the CLO market with more legislation expected to be enforced to limit the involvement of players in the market. Specifically, more laws might be enacted to curtail the extent to which banking institutions can intertwine in the provision of the CLO. The key reason for the more legislation in the financial market is to enforce sales and subsequently subdue the pressure on prices of the CLOs. The issue that remains to ask is the difference in an environment faced by the current CLO market relative to the one in the years 2005/2006. Structure asset sourcing and the legislation in the market best describe vital findings in the changed structure of the CLO. For instance, the inclusion of both secured and unsecured bonds within the framework has eased the pressure on leveraged credit evolvement while offering a justification for the more fixed rate tranches. Coupled with lesser reinvestment stints of three years and two years of non-call period, the current CLO market is more comforting to investors. The favorable aspect for equity holders is depicted by heightened equity in the 2014 CLO structure that stands at 20 percent relative to the prior rate of 10 percent (Wirz, 2013). Similarly, the CLO framework had evolved and become more costly than before, whereby an AAA-trance prior to the crisis had a Euribor + 123bps compared to the current 140bps, a concept that that confirms the transition in rating criteria and a standardized costing structure (Bayor, 2010) Arguably, a substantial portion of high-yielding bonds has substituted the leveraged loans market, an aspect that is portrayed with the resurgence of the market over the last few years. However, since it reduces the overall recovery rates, is can be claimed that the leveraging of the loans market may negatively influence the ratings in an effort to attain the required ratings. Of interest similarly is the compliance with the 5 percent risk retention requirement that compels banks and originators to practice honesty in the transactions. Prior to the financial crisis, transactions involving collaterals were based on trust and the concept of good faith, this saw the transaction of highly risky but low yielding bonds in the market. However, with the various legislation that all support the five percent stake for the collateral originator in the transaction, dealership in risky and low yielding collaterals will be managed (Wirz, M. 2013). This serves to show that with such measures and incentives in place, the CLO market will continue to undergo substantial developments due to the sealing of the possible loopholes for the occurrence of another financial crisis that may emanate from the collateral market. Reference list Bayor, D. N. (2010). A case study: After the collateralized debt obligations crisis and the restoration of investor confidence (Order No. 3438387). Available from ABI/INFORM Complete. (840763214). Retrieved from http://search.proquest.com/docview/840763214?accountid=45049 J.P. Morgan Launches First US Collateralized Loan Obligation Index 2014, , New York. Ji, X. 2010, "Collateralized Loan Obligations Can Be A Bargain For Intrepid Investors", Institutional Investor, , pp. 28-29. Pauley, J. & Kroszner, K. 2012, "Collateralized Loan Obligations: A Structure that Works", Journal of Structured Finance, vol. 18, no. 2, pp. 89-94,8. Westerfeld, S. & Weber, F. 2010, "Selecting credit portfolios for collateralized loan obligation transactions: a heuristic algorithm", The Journal of Credit Risk, vol. 5, no. 4, pp. 65-82. Wirz, M. 2013, Volatile Loan Securities Are Luring Fund Managers Again; Collateralized Loan Obligations Offer High Returns--And Risk, New York, N.Y. Read More