Collateralized Debt Obligations Structures and Analysis - Literature review Example

Managing Business Finance affiliation: Introduction Goodman (2002 p. 5) defines Collateralised Loan Obligations as forms of security from pooled business loans mostly low-rated corporate loans. They are similar to Collateralised Mortgage Obligations, and they could be personal or commercial loans. The banks sell these loans to the investors who assume risks in case of a default, and investors receive payments on maturity. The higher the risk of investor purchase, the higher the returns although in the case of a default the lower risk-taker gets most money back. The CLO manager’s objective is maximising the cash flow initiating credit selection, portfolio management, and any loss mitigation. There is a flow of loan repayment similar to a waterfall from the top down with each cash proceeds from these loans goes to fees and tranches of debt. The CLO arrangement permits attaining surplus cash to run from the loans to liabilities like CLO Bonds. The junior investors obtain the surplus cash flow after paying the higher-risk tranches. Therefore, as long as the costs in issuing debt remain lower than the loan portfolio, the CLO equity tranche will receive the excess cash. Nevertheless, the checks and balances structure may assist in preventing losses to the bondholders. During the 2007/8, financial crisis, the CLOs played a big role in the U. S Subprime crisis, and this was the first financial crisis in history after the Great Depression. Bank credits contribute in households accumulating debt relative to net worth with firms increasing their projects hence over-speculation and over-investment. The Community Reinvestment Act 1977 gave incentives to investors to extend loans to low-income earners. Therefore, instead of the banks applying more prudent and credit evaluations, they became flexible in their loaning through CLOs. This act saw an increased demand of loans with very many defaulters. These loans to people with poor borrowing credit history or the subprime caused a plunging of property prices that slowed down the U. S economy, and the banks losses amounting to $223 billion. These losses were due to the changed lending basis by the banks in mortgage that exposed the massive defaulters. Between 2002 and 2004, the U. S interest rates were low, and so the people speculated the low rates would remain low hence they did a lot of borrowings (Kolb 2010 p. 28). The banks introduced the CLOs selling loans to investors especially in the housing sector. Unfortunately, the government increased the interest rates in 2004, and the house owners would default the payments. This default saw the banks, and the investors lose huge sums of money. The house prices fell causing a fall in the collateral values. In 2007, there was a huge turbulence in the stock market causing subprime debt fear, and the banks stopped lending amongst each other. A good example is the Northern Rock that had to ask for financial assistance from the Bank of England to fund its liquidity crisis. On the other hand, the customers wanted to withdraw their money for fear liquidation, and the bank had no money to pay its customers. The ripple effects saw the collapse of the bank stocks. To restore this bank’s trust and liquidity, they nationalize it using these public funds allow the process. This bank sold 743 million Euros to Virgin. In order to ensure that no reoccurrence of such a credit crisis, some changes in regulation include the introduction of CLOs to regulate the issuance and treatment of asset based loans. In addition, the European Union recommended the banks to retain a portion of the debts in their balance sheets. They also introduced alternative funds manager’s directive demanding that the initial loan issuer must retain 5% of the economic risk. The Dodd-Frank Wall Street Reform and Consumer Protection Act signed by President Obama in 2010 is the upshot of the financial reform required to resolve the financial crisis. This act modifies the present regulatory arrangement through hosting new agencies while eliminating and integrating others to streamline the process. In addition, the act increases the identification of specific institutions that are prone to risks. It aids in amending the Federal Reserve Act while promoting transparency among others. The Dodd-Frank Wall Street Reform and Consumer Protection Act institutes precise standards and supervisions protecting consumers, investors, and business. In addition, the act provides a warning system on a potential economic crisis, and ends taxpayers funded bailouts. Lastly, it sets rules on corporate governance and executive compensations. New regulations set in order to prevent crisis essence included ensuring that the banks take full responsibility for the future value of their debts. These regulations ensured that in case of partial ownership of the debt, they would ensure fair pricing that reflects all the inherent risks. Other approaches included formation of new agencies like the Bureau of Consumer Financial Protection, Office of Financial Research, and Financial Stability Oversight Council. These agencies help in monitoring the financial systems (Bieleki 2011 p. 24). By March 2014, research shows that the issuance approached its highest level of $10.8 billion since 2007 crisis. By April same year, the issuance went up to $12.3 billion, and the AAA CLOs offered eleven times more yield compared to the risk-free benchmark. In addition, the investors continue taking more precautions after the first beating, end, therefore offering good value for their CLOs. The primitive views play a vital role in this game change because the retailer sentiments played a prominent role in the housing bubble. After all, research shows that individual optimism in the stock markets over values hence abnormally low equity returns according to statistics. Other beliefs include the fact that credits are cheap especially with high tolerance risks, and this affects the market behaviour in stock markets. In addition, optimism by the retail traders equally plays a big role because the bank, hedge funds, and mutual funds agents among others delegate credit decisions. Therefore, analysing the credit price takes to account these agent’s incentives, and household beliefs and preferences. A study by Lucas et al. (2006 p. 35) shows that financial innovation is another factor of CLO growth, which despite its immense advantages to the consumers has a dark side especially in the development of rules not captured by existing rules. Therefore, the Central Banks should be on alert in case of a rapid growth in any product that has not fully developed. The investors buying CLOs may develop models and incentive schemes to lure their customers like the Pay-In-Kind interest features. Secondly, changes in regulation may spur further innovation because market participant’s attempts minimizing costs incurred during the implementation of the new rules. These changes may open loopholes whereby the alternatives may exploit the existing instruments. Lastly, the change in the economic environment tends to alter the some risk-taking incentives in decision-making by agents. A good example is the prolonged low-interest rates that can cause the agents to take longer risks or apply extensive financial leveraging. Reasoning affects every individual’s thinking on any underlying mechanism. According to Greenwwod and Hanse (2012) argue that credit spreads help in forecasting excess returns on bonds. Through quantifying risk-taking in credit markets, the institutions or banks may create a tip-of-the-ice caveat. Therefore, investors should be able to analyse the markets, while interpreting every clue accordingly. Watching the government bond markets may be a useful barometer considering its long history in the market. In the case of a heating bond market, the investor should stay warned on probably overheating in other stock markets. The prevailing knowledge continues playing a big role in the investment sector hence more demands in the CLOs. Currently, every organization requires gazetting of its turnover to the public, and this helps the investors to understand a collapsing institution. The internet equally helps in accessing the vital reports that bring awareness to the public. In addition, people are no longer ignorant of market trends especially after the 2007/8 crisis, and, therefore, they are in a better place to analyse the market trends. This knowledge helps in weighing of the risks undertaken in any loan. In addition, there is a prevailing knowledge of financial instruments through enhanced economic academics, and Orji (2011 p. 415) argues that investors have trust in current capital market professional, and therefore investing more on CLOs. Legal certainties according to the new regulations may equally play a vital role in the increased CLOs demands (Avgouleas 2012 p. 12). According to the laid out procedures, the banks, and the investors may face serious legal consequences in case they become liquidated. The central bank is responsible for ensuring every bank’s liquidity status, and, therefore, they should take responsibility I case of a collapsing bank. A Department in the Central Bank is responsible for checking the balances on a daily balance to ensure they banks meet the requirements. In addition, transparency on the market, together with the counterparty risks, and price discovery may contribute to the increased CLOs. Any person taking these loans has all information at hand, and this may serve as incentives to the consumers. Consequently, this elimination of unwanted risks may have played a big role in increased CLO transactions. The Securities and Exchange Commissions (SEC) investigators should continue checking whether financial institutions hide, certain risks illegally like through the bonds. Many governments want to understand the operations in Wall Street because it is clear that these rogue traders and the speculators played a big role in the credit crunch of 2007/8. It is clear that most of these institutions negotiate these instruments directly between the client and the bank and not through an open platform. Therefore, each government should equally investigate whether these financial institutions are cheating customers through mispricing of financial instruments. The Central bank as earlier mentioned should intervene fully in case of any suspicions. The central Bank should check the balance sheets on a daily basis to ensure good performances by these institutions Conclusion CLO played a big role in the 2007/8 financial crisis causing the collapsing of many banks. Many banks and financial institutions offered loans to people of low credit worthy and one the government interest rates went up, most of the people defaulted repayments. Consequently, the collateral values fell drastically, and this affected the economy. However, interventions like the creation of Dodd-Frank Wall Street Reform and Consumer Protection Act came to rescue. The Act introduced new regulations and identified institutions prone to collapse. This reassurance may have contributed to the increased CLOs in the current market. References AVGOULEAS, E. (2012). Governance of global financial markets: the law, the economics, the politics. Cambridge, Cambridge University Press. BIELECKI, T. R., BRIGO, D., & PATRAS, F. (2011). Credit risk frontiers subprime crisis, pricing and hedging, CVA, MBS, ratings, and liquidity. Hoboken, N.J., Wiley. http://dx.doi.org/10.1002/9781118531839. GOODMAN, L. S. (2002). Collateralized Debt Obligations Structures and Analysis. New York, John Wiley & Sons. http://public.eblib.com/choice/publicfullrecord.aspx?p=141387userid=^u. KOLB, R. W. (2010). Lessons from the financial crisis causes, consequences, and our economic future. Hoboken, N.J., Wiley. http://site.ebrary.com/id/10412506. LUCAS, D. J., GOODMAN, L. S., & FABOZZI, F. J. (2006). Collateralized debt obligations structures and analysis. Hoboken, N.J., Wiley. Orji, Herbert O. 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