The Nature of the Collateralized Loan Obligation and How it Works - Essay Example

Collateralized Loan Obligation al Affiliation Collateralized Loan Obligation Introduction Collateralized loan obligation is a form of low interest loan that comprises of a pool of debt backed up by some form of security. This is among the most popular forms of loans that existed prior to the great economic crisis and is now gaining higher value in the last two years. As the CLO borrowing is becoming higher, it has become a point of focus for many financial analysts as they seek to reveal the probable cause for this trend and the possible consequences. While it is clear that the CLO was among the factors that led to the financial crisis that hit the world, it is clear that it is still a favourable form of loan for many investors. The feeling among many investors is that the development on new regulations to reduce the risk that comes with these forms of loans will reduce the chances of getting into a financial crisis. In 2014, it is evident that investors have ventured into the form of loan due to its higher returns as compared to other forms of loans. In this perspective, we seek to analyse the possible reasons for this trend and how this is likely to impact financial flows in the global arena. The Nature of the CLO and How it Works Collateralized loan obligation is defined as a form of low interest loan that comprises of a pool of debt backed up by some form of security. To design a CLO, commercial group different loans together and sectionalize them into different parts. Each section of the loan bears a different risk, some having higher risks than others. The rationale is that those who pick higher risk sections have higher returns while those who pick lower risk portions have lower returns. Another point to note is the way that cases of default are handled. When defaulters fail to repay the loan, the investor with high risk loan gets less money than one who has a lower risk section. The principle behind the formation of the CLO is to increase the lending willingness of the investors and to lower the interest costs. The banks accomplish these loans through a tranch structure in which different classes of borrowers dear different risks and acquire different level of returns (Pauley & Kroszner, 2012). This loan structure operates much similar to the home mortgage loans that existed in the 1980s. At this time, companies that had good credit ratings were allowed to borrow at lower prices while others borrowed from the banks at much higher interest rates. For this reason, CLO gained popularity prior to the financial crisis in 2008. The Role of the CLO in the Global Financial Crisis The global financial crisis of 2008 is was the cause for the loss of popularity for the CLOs in the world. A number of researchers have paid attention to the role that the CLOs could have played in the global financial crisis. Kolb (2010) points out that the creation of the CLO was without the consideration on how interest loans would impact the world’s credit market. The CLO boom led to increased borrowing and the continuous growth of the credit market. In addition, this forced the banking industry to design lower interest loans to encourage public borrowing. Resultantly, there was an increase in public borrowing while the repayment potential was much lower. As more people borrowed, it became hard to invest due to reduction in business potential. Secondly, more people borrowed home and car loans jeopardizing their ability to repay the loans. In short, the loans borrowed were not used to generate wealth hence becoming a burden to the public. As the CLOs increased, the credit supply became higher and the loan risks increased. From a close look, the increase in borrowing without generation of income culminated into the global financial crisis. The negative impacts on the global financial crisis were felt across the world and more severely in the US. As more borrowers defaulted their loans, the bank industry faced the risk of closure and investors lost their trust on the banking industry (Kates, 2011). This was followed by long queues as bank customers withdrew from the bank as they feared the failure of this industry. The housing market had the prices lowered due to over investment in this industry. As a result, many CLO borrowers could not afford to pay their loans. Therefore, the commercials ended up in loss and the loan securities contributed to increase in the effect of these losses. In the year 2007, the UK stock exchange received a blow as share values declined and the public lost trust in this investment. As a result, the global GDP went low and the world sunk into financial crisis. For instance, the US experienced for the first time a negative GDP growth in 2008 and 2009, which was a big blow to its economy. From the perspective, it is clear that the CLO boom had negative impacts on the credit market and was a major contributor in the financial crisis. New Regulations for CLO to Avoid Financial crisis in Future Notably, the event of the financial crisis was a big lesson for the world. The severe effects of the crisis led to the development of new regulations to save the world from getting into such a crisis. The EU retention rule is among the regulations that affected the CLO securitization procedures. The law required that there be a retention hold as part of the securitization of the CLO. This was an approach to reduce the risk that came with default of the loans and prevent any chances of losses. Secondly, the EU retention laws required that banks keep a part of the debt borrowed within its balance sheet to facilitate the repayment process (Sanati, 2014). Other regulations such as the Credit Rating Agencies Regulations demanded that all structured finance instruments must be rated by two or more agencies to ensure that it is worth the investment. This was an important step in aligning the packaging of the CLO sections which in a great way had contributed to the global financial crisis. Lastly, the Dodd Frank Act impacted measures that would see retention of 5% of the debt by the securitizer of any credit transaction (Festa, 2014). These regulations served the purpose of preventing risky borrowing and facilitate the loan repayment process. The Growth of the CLO Market Since the year 2012, there appears to be a new trend in the CLO market after its fall in the year 2009. There has been a gradual increase in CLO borrowing and there are fears that this market is gaining the same momentum as before the financial crisis. Evidently, the CLO loans reached a value of $10.8 billion in March 2014, which shows a significant growth since the year 2009. More surprising is the rapid growth of the CLO value that the world is experiencing. Between March and May, the CLO loan value increase by about $1.5 billion exceeding the 2006 value (Poblete-Cazenave & Torres-Martínez, 2013). This trend has attracted the attention of many financial analysts as they seek to identify the possible reasons for this increased CLO borrowing. One possible reason for the trend in the higher returns that come with CLO borrowing as compared to other forms of loans. For instance, CLO provides a return value of more than 6 present which is much higher than returns from bank loans. Besides, these loans have lower interest rates making it more favourable for many investors. Lastly, with the development of new securitization regulations, the public and corporates have higher confidence on the CLO loans and face a lower risk of loss. This explains the possible reasons why the CLO loan value in increasing at higher rate than any other forms of loans. Will the CLO Last? A major question that arises today is whether the CLO lending will survive in the long term or there are chances of a future global crisis. One possible argument is that the increase in CLO loans will follow a similar trend as it had in the pre-crisis period. There is a probability that as low risk lending increases, there are high chances that borrowing will increase and the bank will invest more in the CLO market. As a result, the rate of borrowing will far much outbalance the rate of interest increasing the chances of default loans. Although there is evidence that CLOs have higher returns and lower risk, it is possible that the situation may reverse with increased borrowing. However, the proponents of the CLO borrowing have stood out to defend the chances of a global crisis claiming that the new regulations will limit the chances for world getting into another financial crisis. For instance, the government plans to implement new regulations in 2015 that will regulate the borrowing trend (Festa, 2014). The main aim of these laws is to limit the extent to which the banking industry can indulge in the CLO loan to avoid its boom. Therefore, these regulations will be preventive and will ensure that borrowing balances with the investment opportunities. This way, the world can hope for increased investment and eventual growth in the gross domestic product value. With efficient regulations, the CLO will last in the market and will be a booster for the economy. Opinion From a critical point of view, there is need to evaluate the nature of the credit environment and compare it with the 2006 situation. In 2006, the world was behind the motion for the establishment of low interest loans as a strategy to facilitate investment with the business sector (Grant & Wilson, 2012). As the member of public borrowed, the opportunities for investment diminished and it was almost impossible to finance a successful business. Therefore, most of the borrowed money was used for consumption rather than for business. From this perspective, it is crucial to evaluate how the current system embraces investment and the strategy that is required to ensure that there is income generation from borrowed loans. One notable difference in the contemporary environment is that there are stricter regulations regarding the banking indulgence in loan issuance. The World Bank has facilitated new laws to ensure that there is optimal borrowing that matches the opportunities for investment (Kates, 2011). However, there is evidence that there is hunger for borrowing and new regulations need to be put in place. As the public feel a higher sense of security to borrow, it is possible that the world may end up in the same crisis (Zibel, 2014). From this perspective, it is a call on the financial watchdogs to introduce even stricter regulations to prevent the world from entering into the global crisis. Conclusion In conclusion, the CLO loans played a critical role in the development of the global financial crisis. As the rates for loans went down, the public was inspired to borrow more without even the right incentive for investment. The CLO boom resulted due to the attractive return rates and the low interest rates that they offered. However, as the banks provided even more competitive loans, the risk for default became higher and the chances for investment reduced. In this respect, the banks ended up making losses as many borrowers were unable to pay the loans. The CLO issuance completely ceased as the corporates feared the risk of more losses. Resultantly, the public lost confidence on the bank industry and they flocked to collect their money. This made it hard for the banks to survive as most of them closed or rebranded. Therefore, it is crucial that the global financial regulators take this as a lesson as they design regulations to guide the credit market. As the CLO loan value continues to increase in the future, only strict regulations will save the world from a similar financial crisis. Bibliography Festa, D 2014, Final Risk Retention Rules - Implications For US & European Collateralized Loan Obligations, Mondaq Business Briefing, 2014, Business Insights: Essentials, EBSCOhost, viewed 17 January 2015. Grant, W., & Wilson, K, 2012, The consequences of the global financial crisis: The rhetoric of reform and regulation. Oxford, UK: Oxford University Press. Top of Form Kates, S. (2011). The Global Financial Crisis: What Have We Learnt?. Cheltenham: Edward Elgar Pub. Kolb, R. W. (2010). Lessons from the financial crisis: Causes, consequences, and our economic future. Hoboken, N.J: Wiley. Bottom of Form Top of Form Bottom of Form Pauley, J, & Kroszner, K 2012, Collateralized Loan Obligations: A Structure that Works, Journal Of Structured Finance, 18, 2, pp. 89-94, Business Source Complete, EBSCOhost, viewed 17 January 2015. Poblete-Cazenave, R, & Torres-Martínez, J 2013, Equilibrium with limited-recourse collateralized loans, Economic Theory, 53, 1, pp. 181-211, Business Source Complete, EBSCOhost, viewed 17 January 2015. Sanati, C, 2014, Collateralized Loan Obligations: Our Next Financial Nightmare. Available at: Zibel, A, 2014, Rule Governing Collateralized Loan Obligations Challenged. Available at: Read More