Collateralized Loan Obligations - Essay Example

Collateralized Loan Obligation Table of Contents Introduction 3 The Nature of CollateralizedLoan Obligation (CLO) 3 Working of CLO 4 The Role of Collateralized Loan Obligation in the Financial Crisis 4 Subsequent Changes in Regulation 5 Recent Growth in the Collateralized Loan Obligation Market 6 Opinion 7 Conclusion 7 Reference List 8 9 Introduction Collateralized Loan Obligations are a type of securitization where the payments from several large and middle sized business mortgages are pooled collectively and passed on diverse classes of possessors in different tranches. It is a form of collateralized liability/debt obligation and is almost similar to them except for the dissimilar kind of underlying mortgage. Trading of bonds supported by riskier corporate loans of the United States have heaved to their maximum level in 7 years, thereby assisting to increase a lending boom which is concerning the regulators. The shareholders look for the assets which give higher yield and the companies take benefit of low borrowing rates. Collateralized mortgage obligations are same as the overflow marketplace of the predetermined product world. Strong trade of obscure products have helped increase investor’s enthusiasm for leveraged mortgages just as the regulators are cautioning about potentially agitated credit markets (Financial times, 2014). The paper aims at providing the nature of collateralized loan obligations and their role during the time of financial crisis. It will also highlight the changes which has taken place in the regulations to prevent the re-occurring of crisis. Further, the reasons behind the latest growth in the collateralized loan obligations market have also been discussed. The Nature of Collateralized Loan Obligation (CLO) Bank are gradually more employing securitization structure of a novel asset known as collateralized loan obligation (CLO) in order to fulfil their financial goals. Collateralized loan obligations allow banks to sell part of huge portfolios of the commercial loans directly in the global capital markets. CLOs provide banks a way of attaining a broad choice of financial objectives, comprising the decrease of regulatory capital needs and requirements, access to a proficient funding base for lending activities, accounting treatment of off-balance sheet, as well as increased liquidity (Kohler, 1998). The rationale behind the formation of collateralized loan obligations was to augment the supply of keen business lenders in order to decrease the price of loans/mortgages to companies and to facilitate banks more frequently to instantly sell loans to the external lenders/investors. This will facilitate providing of money to the business clients and therefore earn price or fee with no risk or little risk towards themselves. Working of CLO A collateralized loan obligation is made of various high risk business loans which are grouped together and sliced into diverse sectors which carry dissimilar credit risk. Investors who buy a slice of higher risk get a high return in comparison to those who buy a slice of lower risk. If the mortgage becomes default, then the shareholders or investors who hold the slice of lower risk will receive their most cash back. In a collateralized loan obligation, the shareholder receives scheduled payments of debts from the fundamental loans but presumes most risks in the occasion that borrowers default. The securities provide the investor better diversity and also the prospective for higher returns. Usually, banks sell collateralized loan obligations with various slices, or tranches, that reflects dissimilar seniority levels to match divergent reward/risk profiles. CLO funds the group of loans/mortgages with capital structure which comprises equity and debt. By pooling several loans and separating them into the tranches, results in the formation of several loans, with comparatively secure ones being paid lesser rates of interests (designed to plea to conservative lenders), and the one with higher risk appeal to higher risk lenders (through providing a higher rate of interest). The main point is to decrease the money cost to companies by attracting both risk taking and conservative lenders (Lucas, Goodman and Fabozzi, 2006). The Role of Collateralized Loan Obligation in the Financial Crisis The economic crisis was categorized by an extraordinarily large part of subprime loans initiated in 2006. The subprime loan/mortgage crisis could be attributed towards different characteristics of loan, appreciation of house price, and borrower characteristic (Demyanyk and Hemert, 2008). The financial crisis stemmed from previous growth of mortgage credit, comprising borrowers who earlier would have problem getting mortgages. It was difficult for the potential homebuyers to get loans if they had underneath average credit records, provided little down payments or required loans of high payments. Unless confined by the government insurance, financiers frequently denied such requests of mortgage. In that period, homeownership swings around 65%, foreclosure rates of mortgage were low, as well as house prices and home construction mainly reflected fluctuations in interest rates of mortgage and income (Duca, 2010). Before the crisis, investment bankers of the United States gathered and sold more than billions of dollars of the debt securities dependent upon several mortgages as well as other debts. Investors purchased dissimilar tranches of debt instrument which bears dissimilar credit ratings and therefore differing risk levels. Continuous repackaging led towards a multiplier outcome. When homeowners fell into default and arrears, house prices dropped and so the value of collateral fell. The character of loan securities was to expand the consequence of losses. The multiplier outcome led to more than millions of dollars of losses thereby resulting in the economic recession. Collateralized loan obligations are the actively handled funds which invest in secured, senior business loans to the American businesses. As contrast to most of the asset classes, collateralized loan obligations performed fine during the economic crisis (Calabria, 2014). According to the Standard & Poor’s the market of CLO represents approximately $300 billion in funding to American businesses. This amount is utilized by corporations in order to generate jobs, thereby contributing towards economic growth. In the collateralized loan obligations market approximately all the financiers are complicated institutional investors, for example the commercial bank. The impact of losses of CLO on important entities is that the insurance companies and banks limit themselves more or less entirely to the highly rated collateralized loan obligation tranches. The tranches which are riskier are usually held by prearranged credit funds and hedge funds (Calabria, 2014). Subsequent Changes in Regulation Subsequent transformations in regulation have been initiated to turn away the reoccurring of such crisis. After the occurrence of financial crisis, a number of new regulations concerning the treatment and issuance of securities which are asset backed, including collateralized loan obligations were introduced. The European Union retention requirement suggests that banks must keep a portion of their debt on the balance sheet. The Alternative Investment Fund Managers Directive (AIFMD) controls fund managers of European Union that directs other investment funds such as private equity funds and hedge funds; fund managers that manages alternative investment finances established in the European Union, and the fund managers that market the shares or units of an Alternative Investment Fund (AIF) in the European Union. The Alternative Investment Fund Managers Directive states that the original issuer of the securitisation should keep 5% of the financial or economic risk. An Alternative Investment Fund is regarded as combined investment undertaking which includes funds of private equity, hedge funds, real estate and investment funds, and funds of retail investment, among others. The Alternative Investment Fund Managers Directive instituted a European Union-wide synchronized framework for supervising and monitoring risks created by AIFs and Alternative Investment Fund Managers (AIFMs) they directs, and for supporting the interior market in another funds (Fca, 2014). The Credit Rating Agencies bear some duty and responsibility for the economic crisis that took place in 2007 and is still ongoing. This is conceded by market participants, agencies, and by policymakers. The main points of Regulation are that the banks may only make use of ratings for regulatory reasons that are issued by Credit Rating Agencies which is registered under the European Union, or gratifies the equivalence criterion in the Regulation. The Regulation entails standards of the internal governance in order to make sure that Credit Rating Agencies manage any disagreements of interests, have sovereign compliance departments, and should also reassess their rating methods periodically (Adbi, 2010). ‘The Dodd-Frank Act’ conveys comprehensive reform towards the parameter of swaps. The act authorises the commodity futures trading commission to regulate the swap dealers, improve pricing and increase transparency in derivatives marketplace, and lower risk towards the American community. The Doss-Frank Act brings the essential market improvement to the swaps markets (Cftc, 2015). Recent Growth in the Collateralized Loan Obligation Market The striking development that the market of leveraged loan has shown over the last decade was accompanied by enhanced transparency and liquidity. The advantages of asset class that encompass prepayment rates, high recovery, and stable prices could be accessed economically by the collateralized loan obligations. During the credit cycle of 2000-2003, collateralized loan obligations on average established more steady performance than both straight corporate bond and high-yield bond. This constancy has encouraged the growth of collateralized loan obligations. During the year 2005, it accounted for more than one-third of main collateralized debt obligation market. The market of leveraged loan has shown significant growth with $295 billion in 2004, which is almost triple the high-yield market of bond. The transparency and liquidity of loan market improved; with several investors growing from 18 to more than 425 during the last 10 years. The main reason for the recent growth in collateralized loan obligation market has been the tough performance of the assets through the previous credit cycle. The drivers of the stability of collateralized loan obligations include prepayment rates, price stability, high recovery, and collateralized loan obligation manager expertise (Rajan, McDermott and Roy, 2007). Opinion Investors are drawn to collateralize loan obligations because they provide comparatively high returns at similar level of risk as the United State Treasury bond. The typical collateralize loan obligation might be made of group of high-risked, leveraged loans, but 65% of them sold to the shareholders are given the rate of AAA. However, this is less from 75% in 2007. It seems that there is a chance of occurrence of another crisis because the stupidity, greed and oversight of slack government have stimulated the mortgage bubble. The similar thing appears to take place today, though this time with junk bonds and leveraged loans (Fortune, 2014). Conclusion Collateralize loan obligations is a type of security supported by various debt, often corporate loans which are low-rated and are almost same as collateralize mortgage obligations. This paper reflects nature of collateralized loan obligation which provide banks a way of attaining a broad choice of financial objectives. The securities provide the investor better diversity and also the prospective for higher returns. The multiplier outcome from the financial crisis led to more than millions of dollars of losses, thereby resulting in the economic recession. However, various regulations authorises the commodity futures trading commission to improve pricing and increase transparency in derivatives marketplace. It has been seen that because of the expansion of collateralized loan/mortgage obligation market, it is liable for more than one-third of main collateralized debt obligation market. Reference List Adbi, 2010. The EU Regulation on Credit Rating Agencies. [online] Available at: < http://www.adbi.org/working-paper/2010/01/26/3446.credit.rating.agencies.european.banking/the.eu.regulation.on.credit.rating.agencies/> [Accessed 20 Jan 2015]. Calabria, M., 2014. ‘Skin in the Game’ Rule Unnecessary for CLOs. [online] Available at: < http://www.americanbanker.com/bankthink/skin-in-the-game-rule-unnecessary-for-clos-1067342-1.html> [Accessed 20 Jan 2015]. Cftc, 2015. Dodd-Frank Act. [online] Available at: < http://www.cftc.gov/lawregulation/doddfrankact/index.htm> [Accessed 20 Jan 2015]. Demyanyk, Y. and Hemert, O.V., 2008. Understanding the Subprime Mortgage Crisis. [pdf] Available at: < https://www.fdic.gov/bank/analytical/cfr/2008/mar/CFR_SS_2008_DemyanykHemert.pdf> [Accessed 20 Jan 2015]. Duca, J.V., 2010. Subprime Mortgage Crisis. [online] Available at: < http://www.federalreservehistory.org/Events/DetailView/55> [Accessed 20 Jan 2015]. Fca., 2014. Alternative Investment Fund Managers Directive (AIFMD). [online] Available at: < http://www.fca.org.uk/firms/markets/international-markets/aifmd> [Accessed 20 Jan 2015]. Financial Times, 2014. Capital Markets. [online] Available at: < http://www.ft.com/cms/s/0/e6602f76-3507-11e4-ba5d-00144feabdc0.html#axzz3PKwSIS7G> [Accessed 20 Jan 2015]. Fortune, 2014. Collateralized loan obligation: Our next financial nightmare. [online] Available at: < http://fortune.com/2014/04/10/collateralized-loan-obligations-our-next-financial-nightmare/> [Accessed 20 Jan 2015]. Kohler, K., 1998. Collateralized Loan Obligations: A Powerful New Portfolio Management Tool or Banks. [online] Available at: < http://pages.stern.nyu.edu/~igiddy/ABS/coll_loan_obl.html> [Accessed 20 Jan 2015]. Lucas, D.J., Goodman, L.S. and Fabozzi, F.J., 2006. Collateralized Debt Obligations: Structures and Analysis. New Jersey: John Wiley & Sons. Rajan, A., McDermott, G. and Roy, R., 2007. The structures credit handbook. New Jersey: John Wiley & Sons. Read More