CLO a Type of Collateralized Debt Obligation - Assignment Example

5 sections Contents Introduction 3 Discussion 3 Answer 3 Answer 2 4 Answer 3 7 Answer 4 8 Answer 5 9 Conclusion 10 References 11 Introduction CLO atype of Collateralized debt obligation stands for collateralised loan obligation. CLO is a type of security instrument which bundles the high risk loans of different corporate and slice them into pieces for selling the same to investors. The advantage that CLO offers especially from the view point of the companies is that after the introduction of CLO the companies with low credit ratings too can get loan at cheap rates. In an aim to prevent financial crisis occurring in future the FED has released a set of rule known as Volcker rule that governs among other financial instruments CLOs. Discussion Answer 1 CLO stands for collateralised loan obligation. CLO is a type of Collateralized debt obligation. Different companies require finance. The finance requirement of the company is met either through equity or debt. The company which have high credit ratings can easily get the loans that they require at low cost from the banks. However this becomes a problem for the company who have low credit ratings. For the companies which have low credit ratings getting a loan is very costly. CLO is a type of security instrument which bundles the high risk loans of different corporate and slice them into pieces for selling the same to investors (Sanati, 2014a). The underlying loan papers are of different rating and thus belong to different risk classes. The potential reward that these different loan papers offer is also different. In fact higher the risk higher is the rate of return. Accordingly these underlying loan papers are bundled into various CLOs which are offered to the investors. The investor chooses a type of CLO according to the amount of risk he wants to or is willing to take in order to have higher return. It is obvious that if the investor wants to have higher return he will go for a CLO which has higher risk. The insurance companies or pension funds will take on less riskier CLOs and other investors will take on riskier CLOs. The main point why underlying loan papers are bundled and then distributed in segmented form is to distribute risk amongst investors. The advantage that CLO offers especially from the view point of the companies is that after the introduction of CLO the companies with low credit ratings too can get loan at cheap rates. The functioning of CLOS is explained as follows. The fund managers purchase round about 150 loans. Some of these loans are used to finance buyouts; some are used to pay dividend to equity share holders. After buying these different kinds of loans the manager bundles them to create a pool just like a portfolio investment fund. The retail investors then buy a portion of this pool that is made up of these different loans grouped together. According to the amount of the risk the investor is willing to take he gets a portion of the pool with particular payout and restriction. If at times the underlying loans on which the pool had been formed begin to struggle, the fund save cash by keeping the payouts from the investors who hold the riskiest part of the loan pool. The manager of the fund can later use the funds to buy new loans. The advantage of this strategy is that it prevents the fund heading for liquidation at troubled times. Answer 2 One of the prime instruments that are blamed for the subprime mortgage crisis is collateralized debt obligation. The collateralized debt obligation is a type of instrument which collects different debt instruments and creates a portfolio investment for the individual investor to invest. The collateralized loan obligation is a type of collateralized debt obligation. In a collateralized debt instrument the portfolio manager collects funds from institutional investors and creates a fund to invest. The fund manager then takes the pool of fund collected from the investors and invests in mortgage instruments. To understand the concept an example of champagne bottles can be taken. The champagne bottle contains all the different securities in the form of mortgaged home loans. The asset manager takes fund pool from different investors and puts it in the champagne bottle. That is with the fund collected from the investors the manager invests the same in the various mortgage properties. Then the manager creates various classes of securities. Some securities are rates as AAA and are considered least risky, and then the next class of securities is called AA and so on. The investors who originally invested to create the fund are given a type of security depending on the risk that they are willing to take. In fact the securities can be compared to wine glasses which are arranged in the shape of a pyramid with the top rated ones at the top of the pyramid. When the mortgaged houses starts generating income in the form of interest payments this fund is distributed amongst the investors. The generated interest payout can be compared to champagne that is poured from the top glass. The first glass obviously gets filled up first followed by the next in line and so on. Now let us see what happens when some people who have taken mortgage loan defaults. When this happens the champagne bottle does not generate the amount of champagne that it normally does. With less amount of champagne generated the bottom glasses does not get filled and the investors who brought those instruments aren’t paid. Fund manager Mortgage instruments CDO Investors Then there is another kind of asset manager who creates a portfolio from the asset backed securities. The structure works similar to that of the previous example. The only difference in this case is the asset class in the champagne bottle that is actual mortgage properties is replaced by mortgaged backed securities or champagne glasses. Now if the original mortgaged properties do not generate any income as the loan takers default on their interest payment then obviously a portfolio made of those mortgages backed securities will also not make any income. Still they are rated as AAA. Fund manager Mortgage backed securities CDO This is the problem that occurred in the subprime crisis. Most of the people who took loans to buy their properties defaulted on their loan payment. At the same time the housing industry also went bust and there was no resale value of the defaulted properties (Treanor, 2008). This meant that all the investment by the various investment bank and investors into these classes’ of securities went in vain and were of no value. This is what triggered the crisis. Role of CLO in the crisis (Marsh, 2007) Answer 3 In an aim to prevent financial crisis occurring in future the FED has released a set of rule known as Volcker rule that governs among other financial instruments CLOs. Normally the CLOs include a bundle of leverage loans that are made to the company (Media, 2014). However, sometimes the banks included bonds in the portfolio to increase the yield and hence attractiveness of these instruments for the potential investors. However, as per the new set of rules issued under the name of Volcker rule demands that the banks should eliminate bonds from the portfolio of CLO. The Volcker rule prohibits the banks from owning and trading a no. of different kind of assets in an attempt to prevent so called preparatory trading. Among the new bunch of CLOs that are being issued by the banks 60% of them do not have bonds. The federal reserve and the office of the controller of the currency has issued new guidelines that are aimed at cutting the riskiest leveraged lending that is undertaken by the banks (Dalloway, 2014b). The Volcker rule is actually a part of Dodd-Frank financial reform act. The Volcker rule says that banks can’t own certain risky assets and investments. Normally CLOs falls under debt instruments however the fact that they are actively managed investors can do a lot of things that are similar to equity. So, government says that according to definition CLO falls under the list of banned instruments (Wishing and et al., 2014.). However as per the given deadline if Volcker is to be implemented by July 2015 and that means banks have to stop issuing CLOs and sell the CLOs that they are currently holding. Banks say that doing this would incur them heavy losses and so they are not prepared to do this. In view of these concerns by the banks the deadline has been increased by 2 more years. Answer 4 After the financial crisis that took place CLOs market along with CMO and other such instruments faced a downturn. In between 2008 and 2010 CLOs worth less that $3 billion were sold. This is in comparison to the figures of $100 billion that represent the sale figure of CLOs at the market peak. However since the financial crisis has passed the CLO sale has bounced back and there is a resumed boom in the market. For example in 2012 the total no. of CLOs issued is expected to amount to $35 billion (NAIC, 2012). This amount as can be found is greater than the combined sales figures of 2008-2011. In 2013 a total of $83 billion of CLOs were issued. In fact JP Morgan has increased its predictions regarding CLO and said that as much as $115 billion is the total value that might be arranged (Hauns, 2014). Now the question arises is how did the CLO market bounce back so well and easily. One reason is that when the financial crisis occurred the CLOs did not blow like the CDO or other collateral instruments. In fact it so appeared that CLOs actually remained true to what they promised that is higher returns with risks less than individual loans. Non investment grade leverage loans within the CLO have to be firm in times of stress. While in the time of financial stress the asset prices fee and the investors became wary of CLOs as well the CLO remained firm and actually gave good returns. CLOs equity holders actually posted returns of around 16% during 2006 to 2008. The banks market the CLOs by saying that they that is the banks to hold a portion of the CLOs that they sell. The banks reason that the banks would not hold on to CLOs unless the banks considered them as safe investment instruments. Investors are drawn to CLOs because they feel that CLOs offer relatively high rate of returns at around the same risk level as a US treasury bond. Any CLO is normally made up of junk bonds or non investment graded bonds but the banks and the rating agencies still package 65% these bonds with a rating of AAA. This is very curious indeed. The grading has slightly downgraded from pre crisis period when 75% of the asset class were sold as AAA rated securities. CLOs are actually less risky than individual corporate loans. The default rate of individual loans is 8% where as the default rate of CLO is 6% in 2009. Answer 5 Banks often claim that after the financial crisis the CLOs that they are issuing are far safer as compared to that of the pre crisis period. This is evident from the fact that the banks are now holding on to more no. of CLOs than ever. In fact out of the $ 300 billion CLOs currently available in the market $70 billion worth of CLOs are available with the banks (Sanati, 2014b). However the mere fact that banks are holding more no of CLOs than ever after the financial crisis does not mean that these CLOs has become any less risky. In fact banks held on to a lot of CDOs even before the crisis, a fact that had made them so vulnerable and the crisis so wide spread. The holding of the bank to the CLO can mean that the banks aren’t able to find buyers who are ready to buy these securities or they had become victim of their own trap. Whatever the banks may say about the new CLOs being safe investment opportunities, the fact remains fact that companies with lot of debt on their books aren’t a safe investment opportunity for any investor and has the chances of going bust any time if economic downturn occurs. The difference that has happened, if any is the fact that before the crisis 75% of CLOs were classified as AAA and after the crisis the percentage has decreased to 65%. The only way in which another crisis brought into effect by the CLO market going bust can be ensured is by reducing the demand for CLOs. This can be ensured either raising interest rates so as to reduce the yield of these instruments or by forcing the bank to stop selling the CLOs. Since Volcker’s rule have come out 7 of 11 CLOs that have come out does not include bond (Dalloway, 2014a). So it can be said that although there has been some initiatives from the part of Fed these initiatives have not been enough to prevent another crisis from occurring. Conclusion CLO a type of Collateralized debt obligation stands for collateralised loan obligation. One of the main factors that led to the previous global financial crisis is CDO or collateralised debt instrument. The only way in which another crisis brought into effect by the CLO market going bust can be ensured is by reducing the demand for CLOs. Although Fed has taken initiatives to ensure that there is no repeat of the crisis these initiatives have not been enough. References Dalloway, T., 2014a. Banks respond to new rules with Volcker-friendly CLOs. [Online] Retrieved from< http://www.ft.com/intl/cms/s/0/057865a6-7c83-11e3-b514-00144feabdc0.html#axzz3P3eWi0q6> [Accessed on 17th January 2015]. Dalloway, T., 2014b. CLO surge prompts regulatory concerns. [Online] Retrieved from< http://www.ft.com/intl/cms/s/0/e6602f76-3507-11e4-ba5d-00144feabdc0.html#axzz3P3eWi0q6> [Accessed on 17th January 2015]. Hauns, K. 2014. JPMorgan Increases 2014 CLO Issuance Forecast for U.S. [Online] Retrieved from< http://www.bloomberg.com/news/2014-09-09/jpmorgan-boosts-clo-issuance-forecast-to-as-much-as-115-billion.html> [Accessed on 17th January 2015]. Laughlin, L. S., 2013. A boom-time debt product is back with a vengeance. [Online] Retrieved from < http://fortune.com/2013/01/11/a-boom-time-debt-product-is-back-with-a-vengeance/> [Accessed on 17th January 2015]. Marsh, B., 2007. Housing busts and hedge fund meltdowns: a spectator’s guide. [Online] Retrieved from [Accessed on 17th January 2015]. Media, D. 2014. Fed gives banks more time on Volcker rule detail. [Online] Retrieved from< http://www.reuters.com/article/2014/04/07/us-fed-volcker-idUSBREA361R820140407 > [Accessed on 17th January 2015]. NAIC, 2012. U.S. Structured Finance Issuance and Statistics. [Online] Retrieved from< http://www.naic.org/capital_markets_archive/120611.htm> [Accessed on 17th January 2015]. Sanati, C., 2014a. The rise of leveraged loans. [Online] Retrieved from [Accessed on 17th January 2015]. Sanati, C., 2014b. Collateralized loan obligations: our next financial nightmare. [Online] Retrieved from< http://fortune.com/2014/04/10/collateralized-loan-obligations-our-next-financial-nightmare/> [Accessed on 17th January 2015]. Treanor, J. 2008. Toxic shock: how the banking industry created a global crisis. [Online] Retrieved from< http://www.theguardian.com/business/2008/apr/08/creditcrunch.banking> [Accessed on 17th January 2015]. Wishing, J. C., and et al. 2014. Mortgage and structured finance. [Online] Retrieved from< http://www.lowenstein.com/files/Publication/5b98c446-8445-4a7e-aa0d-2fb543d218a1/Presentation/PublicationAttachment/d4fe162e-5ba2-4451-b359-37d31ec50562/Mortgage%20and%20Structured%20Finance%20Client%20Alert.pdf> [Accessed on 17th January 2015]. Read More