Collateralized Loan Obligation - Essay Example

Collateralized Loan Obligation Introduction Collateralized Loan Obligation (CLO) is a form of financial security in which the receivables from different business loans are unified and passed on to various classes of owners. They can be described as structured financial dealings which aim to reduce the risks which arise out of the loan default. In other words, the receivables of a firm are sold in order to gain loans. Returns on loans are paid in tranches. Since the last twenty years, the asset backed securities market is seen to grow enormously. The asset backed securitization, offers reducing risks in a more diversified manner than normal restructuring of the balance sheet or any type of general security portfolio. The CLOO’s are seen to function in a similar way as Collateral mortgages. The only difference is in respect of the underlying loans. CLO offers investors with higher than standard returns. Banks sell CLO’s with different tranches which correspond to different levels of seniority and for matching different risk and reward policies. The use of such securities causes financial institutions and the corporate finance structures to move increasingly towards the capital markets (Duffie and Garleanu, 2001). The financial crisis had led towards a decline in investment funds, causing enhanced competition for low risk borrowers. The liberalization, de-regularization and technological growth of the financial markets have elevated the market efficiencies, making it possible for investors to prevent loses. Functioning of CLO Several high risks embedded commercial loans together make up a CLO. The CLO contains sections of loans which have been sliced and grouped together on the basis of their respective credit risks. These sections are then sold to investors. Those investors who engage in purchasing a high risk embedded section of the CLO are given higher returns, than the ones who select to purchase a low risk sections. On the event of default of the loan, the investors who own the low risk section are likely to receive higher returns (Longstaff and Rajan, 2008). The concept of CLO can be better understood through a simple example. Consider that a company wants to acquire £100 million for financing a new project. The office premises of the firm are valued at £20 million. Consider that the cost of debt is 5% and the riskless rate of interest is at 1%. If the firm acquires £100 million as debt finance, the entire loan can be divided into two tranches. The top tranche of £40 million is backed by the firm’s premises. The investor has the option of selling the premises and recovering the investment. The rate of interest paid on this tranche is 2.5%. The bottom tranche of remaining £60 million has no backing and is high risk laden. Interest on this segment is paid at the rate of 6%. Accordingly the net cost of CLO would be as follows: 60% x 6% + 40% x 2.5% = 4.6%. Since the cost of the CLO is lower than the cost of debt, it is considered to be an attractive investment. Investors may consider the 2.5% rate of return be better than the riskless rate of 1% applicable upon the top tranche. Similarly on the lower tranche also, the investors may consider 6% return to have similar risks as the 5% rate offered by the non structured deal. The CLO mechanism therefore is seen to provide the firm with a win-win situation for the parties (Goodman and Fabozzi, 2002). Role of CLO in the financial crisis The U.S subprime crisis had led to a fall in the price of properties and had slowed down the overall economy. The crisis is stated to have emerged from the fundamental way in which mortgages were funded. The restructuring had facilitated an increase in the level of default loans. Prior to the 2007 financial crisis, the investment bankers of the U.S had acquired and sold debt securities which were worth trillions of dollars. The debt securities were backed by mortgages and other high risk debts whose values had plunged down due to the failing economic conditions. Investors engaged themselves in purchasing different tranches of such debt securities, bearing different types of credit risks (Lucas, Goodman and Fabozzi, 2006). Repeated repackaging had led to multiplying the rate of defaults making many of these securities highly risky. As the collateral values fell, the losses expanded. The nature of such asset backed securities or CLO’s was such that they magnified the effect of losses. CLO’s were however considered to be less risky as compared to the mortgage backed financial instruments. Post the crisis; it was observed by financial regulatory authorities that derivative instruments such as CLO’s spread risks and uncertainty related to the price of the underlying asset. During the crisis period, credit rating agencies could not accurately estimate the risk levels and assumed that the low risk tranches of many CLO’s would get diluted (Vasicek, 2002). However mortgage risks are seen to be highly correlated, and therefore when one of the mortgage defaulted, others were also seen to default as all the mortgages are affected by the same fundamental financial set up. Due to the wrong appropriation of risks, banks were also misled. The crisis had necessitated a fundamental change in the manner in which rating agencies identified the risks associated with mortgage underwriting. Since the exact figures of loses and were becoming increasingly difficult to predict CLO’s during the financial crisis were seen to increasingly become risk embedded. Almost half of 300 million dollars worth of tranches which were issued between the years 2005 and 2007 was declared to be safe investments by the rating agencies (Tavakoli, 2008). However by the year 2009, majority of these tranches turned out to be of less value. Since returns could not be fetched, many of these securities became illiquid, hampering the economic conditions. Change in regulation to prevent crisis Post crisis, financial regulators have implemented a number of regulations to manage asset backed securities in a better way. The reform measures introduced were seen to facilitate better management of the CLO’s (Bystroem, 2008). The European Union had imposed that banks must retain a considerable portion of debt in their balance sheet rather than selling it off under derivative mechanism. As per the Alternative Investment Fund Managers Directive, the original issuer of securities such as CLO’s must retain a minimum of 5% of the economic risks. The Dodd Frank Act was also seen to state the same in respect of holding back economic risks. Trading activities were further regulated by the Volker’s rule. The credit rating agencies had also made it obligatory that structured financial instruments are required to be rated by at least two rating agencies. The main purpose of majority of these regulations is that bankers must take at least part responsibility of the future value of debts. When banks themselves take part responsibility of the issued debts, it becomes feasible to ensure that securities are fairly priced and also reflects inherent risks more transparently. Banks were seen to be the big buyers of the CLO securities. Structured investments vehicles, insurance companies and hedge funds were also large investors of the CLO markets. The proposed regulations which require banks to hold a significant portion of their capital against the losses arising out of CLO’s would make it expensive for banks to hold such securities. Financiers are expected to back away from the CLO market. The new rules implemented require banks and other financial institutions to calculate capital requirements without basing it upon the information provided by rating agencies. Under existing Basel rules, large banks are required to use internal rating models and set aside approximately 0.56% of the net value of a highly rated CLO security. The requirement under the U.S system is seen to be 1.6%. If the cumulative losses of a CLO security is seen to exceed 4% then the minimum requirements would increase to 8%. Regulators are seen to want a system which requires banks to hold more capital once the underlying assets begin to make losses (Benmelech and Dlugosz, 2009). Recent growth and composition of the CLO market CLO issuance had reached $10.8 billion in the month of March 2014, which was the highest since the year 2007. The figures had risen to $12.3 billion in the month of April (Coffey, 2014). Changes in the regulations have resulted in the rise in a number of opportunities in the CLO markets for investors. The structure of the CLO’s issued today is fundamentally different from those which had been issued during the crisis period. CLO collateral pools of investments are seen to be composed of diversified portfolio. Majority of such portfolios consists of assets which have witnessed tremendous growth in the recent times. The bank loans are found to be much similar to the securities existing in mutual fund portfolios. The new rules have enhanced the transparency by which the prices of the underlying assets are depicted. The manner in which prices are depicted under the new system being more efficient, have made it easier for investors to take financing decisions. Also under the new regulatory concept, assets values and the risks existing in the CLO securities are managed by efficient asset managers. Under the new system it is possible to gain access to data related to manager performance which is seen to be increasingly used in the CLO investments. The enhanced efficiency of the CLO markets has facilitated mitigation of risks and also to navigate through difficult economic times with ease. CLO investors are provided with detailed trustee reports which are regularly updated in terms of prices. In the last few years the number of defaults in the CLO portfolios has remained low. Under the new regulations it is observed that higher returns are available for the securities which had the same risks as earlier. CLO’s under the current reformed system propose a win-win situation for investors. Default rates of corporate bonds are more than rates of default existing in case of low or medium rated CLO’s. Due to such factors, it is seen that the investments made in CLO’s have enhanced significantly in the recent times. Furthermore, the new regulations coming into force in 2015, is expected to lower banks participation in CLO markets. This is expected to enhance the sales volumes significantly. The CLO’s containing subprime home loans are not expected to be back in the capital markets as long as the new systems eff3ectively function. Even though the CLO market has induced considerable risks in the market, it is not expected to be eliminated from the markets completely. This is due to the fact that CLO are an important source of finance, especially in the U.S markets. The financial crisis has revealed that changing marketing conditions necessitate regularization of the manner in which the CLO markets function. This would facilitate keeping the risks factors existing in the market under check (Wilson, Wu and Prejean, 2014). Opinion/Changes in the current environment and prevention of crisis The changes implemented for regularizing and decreasing the risks arising out of CLO have benefitted the growth of the securities backed markets. The regularization has facilitated in reducing the risks and the rates of default existing in this market. Although the new policies have made the CLO market more attractive than the conditions which existed in 2007/08, investors must remain careful and invest only after going through all the details of a portfolio. The changes implemented are likely to prevent the rise of another liquidity crisis due to changes in the value of the underlying assets. In the financial markets of 2005/2006, it was observed that regulatory authorities focused mainly on increasing market transactions and controlled the derivatives market in a liberalized manner (Benmelech and Dlugosz, 2009). The long term impacts of price fluctuations or demand condition were not analysed properly. The crisis had made regulatory authorities realise that enhanced transparency and reporting are necessitated. The CLO markets are expected to become a strong source of financing in the coming times, if the new regulations can maintain market stability. However the existence lacks of investors have impacted the issuance of new CLO’s. Active participation of the government firms in the CLO market is expected to inspire commercial investors to participate in investing in such asset backed securities more actively. Conclusion The increased levels of transparency have facilitated investors to acquire all possible information relating to the loans existing in a particular CLO portfolio. The momentum with which the CLO market is seen to grow indicates that in the future, CLO funding is likely to be accompanied by a number of other funding activities. This would include refinancing and merger related activities. There is also a trend of rising demand for commercial mortgage backed securities. Such securities are associated with the real estate debts existing for commercial complexes, shopping malls and other such buildings which are seen to be less impacted in the crisis period. Residential property backed securities are not expected to come back into the market of CLO and similar derivative instruments, making the market secure. Reference List Benmelech, E. and Dlugosz, J., 2009. The alchemy of CDO credit ratings. Journal of Monetary Economics, 56(5), pp. 617-634. Bystroem, H. N., 2008. The microfinance collateralized debt obligation: a modern Robin Hood?. World Development, 36(11), pp. 2109-2126. Coffey, M., 2014. CLOs and Regulation: A Risk Retention Case Study. The Journal of Structured Finance, 19(4), pp. 18-21. Duffie, D. and Garleanu, N., 2001. Risk and valuation of collateralized debt obligations. Financial Analysts Journal, 1(1), 41-59. Goodman, L. S. and Fabozzi, F. J., 2002. Collateralized debt obligations: structures and analysis. New Jersey: John Wiley & Sons. Longstaff, F. A. and Rajan, A., 2008. An empirical analysis of the pricing of collateralized debt obligations. The Journal of Finance, 63(2), pp. 529-563. Lucas, D. J., Goodman, L. S., and Fabozzi, F. J., 2006. Collateralized debt obligations: structures and analysis. New Jersey: John Wiley & Sons. Tavakoli, J. M., 2008. Structured finance and collateralized debt obligations: new developments in cash and synthetic securitization. New Jersey: John Wiley & Sons. Vasicek, O., 2002. The distribution of loan portfolio value. Risk, 15(12), pp. 160-162. Wilson, L., Wu, Y. W. and Prejean, S., 2014. Are the Bailouts of Wall Street Complements or Substitutes?. Atlantic Economic Journal, 42(1), 21-38. Read More