A Collateralized Loan Obligation as a Form of Collateralised Debt Obligation - Essay Example

Managing business finance Contents Contents 2 Introduction 3 Answer The nature of CLOs 3 Answer 2: The role of CLO’s in the financial crisis 4 Answer 3: Changes in regulations 5 Answer 4: The reasons behind the growth of the CLO market 7 Answer 5: Discussion on whether the current investment environment is sufficient to prevent another economic crisis 8 Conclusion 9 References 10 Introduction A collateralized Loan obligation is a form of collateralised debt obligation. Collateralized Loan Obligations are securities which are backed by a pool of borrowings. These pools of debts are most commonly corporate loans with low interest rates. Collateralized Loan Obligations (CLOs) are financial instruments which have similar features like collateralised mortgage obligations. The only difference between the two is that the types of the underlying loan or these two obligations are different. Answer 1: The nature of CLOs Collateralized Loan obligations (CLOs) are types of securitization in which the payments from a number of large sized and middle sized business loans are collected and passed on to varied classes of owners. In a Collateralized Loan Obligation, an investor is entitled to receive periodic debt payments as interests from the underlying loans and at the same time assume the major part of the risks related to the underlying loans in the event of the default of loans. The Collateralized Loan Obligations offers higher benefits and opportunities for the investors by creating the scopes for greater diversity and the chances of returns which are higher than the average returns from other securities. Banks sell these securities with slices and tranches which reflect varied levels of seniority in respect of matching the risk versus rewards profiles of the loans. The following example can be used to understand the working of the Collateralized Loan Obligations. Assume that a corporation is willing to take a debt of USD 100 million to finance its business expansion process and that this corporation has assets which have a valuation of USD 20 million. The cost of debt for the loan is taken to be 5% per annum and the risk free rate of return is 1% per annum. The corporation issues a USD 100 million of debt structures which includes a top trance of USD 40 million and a bottom tranche of USD 60 million. The top tranche would be backed up by the assets of the company so that in the event of credit default, the investors can pay off the loan by selling off the assets to recover the investment. The interest rate in this case is 2.5% per annum. The bottom tranche of USD 60 million does not have any backing even in the event of credit default. For this case, the interest rate per annum would be 6%. For the Collateralized Loan Obligations, the rate of interest would be calculated as follows: Cost of Collateralized Loan Obligation = 60% x 6% + 40% x 2.5% = 4.6%. This cost of debt is lower than the cost of debt calculated in average. Therefore, it is cost effective and attractive for investment purposes. The investors can opt for the 2.5% return on the tranche backed by the assets to remain riskless. Also, the investors can opt for the 6% return on the bottom tranche so as to represent higher value for money. This creates a win-win situation for both the investors and the corporation. Answer 2: The role of CLO’s in the financial crisis The increase in the spread values of the CLOs is identified to be one major cause of the intensification of the subprime crisis in the United States of America. Before the Great Financial Crisis of 2008, the investment bankers in the United States sold huge volumes of debt securities that were based on pools of debts and mortgages. These collateral back securities were mainly the Mortgage Backed Securities (MBSs) and Collateralised Debt Obligations (CDOs). The assembly and sale of trillions of dollars of collateral backed securities were done in the market and the investors purchased various tranches of these securities which had different credit ratings and as such, different degrees of risk associated with them. This kind of continuous repackaging led to the development of a multiplier effect in the lending market of the United States and worked only until the real estate market in the country remained buoyant. When the borrowers were unable to pay back the loans, the prices of the real estate properties which were held as collaterals automatically fell. The collateralized nature of the debt securities further intensified the effect of these credit defaults and the decrease in the collateral values (Zandi, 2009). The multiplier effect resulted in the loss of billions of dollars for the lenders which finally led to a spiral economic downturn. Though the role of the Collateralised Debt Obligations is profound in the Great Financial Crisis (GFC) of 2008, it should be mentioned here that the Collateralised Debt Obligations acted as lesser risky debt securities in the economic recession as compared to the mortgage backed securities because these loan obligations did not continue being repackaged and sold on. However, the Mortgage Backed Securities acted as the main driving force for the creation of the financial downturn in the economy due to the above discussed multiplier effect. Answer 3: Changes in regulations The financial crisis of 2008 started in the United States and subsequently affected the global economies creating decreases in revenues for companies, downturns in economies and losses of job in various countries across the globe. Considering the huge impact that this recession had on the global economies, the government and regulatory authorities functioning in the United States as well as the international regulatory authorities like the International Monetary Fund (IMF) quickly investigated into the reasons behind the recession and introduced new reforms and regulations that are expected to prevent this kind of financial crisis in the future years. A number of new regulations were proposed and introduced in the financial and capital markets regarding the treatment of the collateral backed securities and regarding the issuance and sale of all types of debt securities including the Collateralised Debt Obligations (CDOs). The most significant regulations introduced after the United States subprime crisis are discussed as follows. As per the requirements propose by the European Union retention program, the banks and other financial institutions have to mandatorily retain a part of their borrowings in their balance sheets. The Alternative Investment Fund Managers Directive was introduced as a regulatory policy that would ensure that the main issuer of the debt securities would retain 5% of the total economic risk incurred by these securities. The Dodd Frank Wall Street Reform & Consumer Protection Act was passed in 2010 as an immediate response to the economic crisis of 2008. It is one of the most significant regulatory policies introduced by the US government in order to protect the investors and businesses in the financial markets. This Act brought about major changes in the financial regulatory environment in the country. The Volker rule was introduced as a type of federal regulation which put limitations on the lending and trading activities in the United States market. The Volker rule prohibits the banking institutions from carrying out creation investment activities and restrains their limit of ownership and making speculative investments (Lewis, 2010). The Credit Rating Agencies Regulation was introduced as a measure to ensure that the financial instruments traded in the market should be rated properly by at least two well known agencies in this sector so that the risks associated with these financial instruments can be assessed and controlled. Answer 4: The reasons behind the growth of the CLO market As computed in the first quarter of 2014, the issuance of the Collateralised Debt Obligations in the financial market of the United States reached an impressive USD 10.8 billion. This is the highest number of issuance in the country since 2007 i.e. after the Great Financial Recession. On the second quarter of 2014, the issuance of the Collateralised Debt Obligations saw a further increase in numbers with the values of these securities reaching USD 12.3 billion. The growth in the sale of Collateralised Debt Obligations can be explained by comparing the yields of these securities with other financial debt instruments like the Treasury bonds, corporate bonds and other similar securities traded in the US financial market. The graph given below illustrates how the yields of the debts carrying risks and that of the riskless debts differ (Figure 1). The treasury bonds or T-bonds are issued by the government of the United States and thus, are riskless securities traded in the market. The A rated corporate bonds are traded by companies which carry the associated risks that may materialize in case the companies default on repayment. But, it can be estimated that over 2 years, the yield of the Corporate bonds will be approximately 1% higher than that of the Treasury bonds because of the credit risks inherent to the corporate bonds. However, the credit rating agencies in the current scenario rates that the Collateralised Debt Obligations offer 11 times higher yield premium for the investors as compared to the corporate debts which are rated as AAA by these credit rating agencies (Paddy, 2012). Also, a BBB rated Collateralised Debt Obligation can give a yield of 6% which is 2% higher that the yield of 4% that is provided by a BBB rated bank loan. Therefore it can be inferred that since the Collateralised Debt Obligations have started giving higher returns with the same level of risk and are now much safer to invest in because of the stringent regulatory environment in the country. Together, these factors have boosted the growth of the Collateralised Debt Obligations market to a huge extent (Lemke and Smith, 2014). Answer 5: Discussion on whether the current investment environment is sufficient to prevent another economic crisis The current environment for the trading of the financial instruments as well as for investment activities seems to be much regulated and monitored. The introduction of a wide number of regulations to protect investors, businesses, consumers as well as the overall economy seems to have acted in a beneficial manner thereby leading to the development of a more regulated and protected investment market in the country. The different types of investment options including the Collateralised Debt Obligations and Mortgage Backed Securities now offer higher returns on investments while imposing lower risk levels. As such, this has created a win-win situation for both the lenders and borrowers functioning in the capital markets. Also, more regulations are to be introduced in the year 2015 which are likely to further protect the interests of the investors and limit the extent to which the financial institutions can actually get involved in the Collateralized Debt Obligations markets. Conclusion Thus, it can be mentioned that the regulations introduced by the government of the United States and other international regulatory authorities after the United States subprime crisis have acted in significant manner for improving the financial and capital markets of the United States of America. Nevertheless, more innovative regulations and continuous monitoring of the functioning of the financial markets including the trading of different securities like the mortgage backed securities and the Collateralised Debt Obligations are also necessary to ensure that a similar economic crisis is not triggered in this market. References Lemke, L. & Smith, I. 2014. Regulation of Investment Companies. Ohio: Matthew Bender. Lewis, M. 2010. The Big Short: Inside the Doomsday Machine. New York: W.W. Norton & Company. Paddy, H. 2012. Crisis explainer: Uncorking CDOs. Minnesota: American Public Media. Zandi, M. 2009. Financial Shock. London: Financial Times Press. Read More