The Role That CLOs Played in the US Subprime Financial Crisis - Example

Collateralized Loan Obligations (CLO) By of [Word Count] Introduction Five years after the 2008 financial crisis, financial programs such as collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs) and collateralized loan obligations (CLOs) still elicit uncertainty and fear among investors (Lo, 2012). CLOs are pools of debts backed by a security (Lemke, 2013). These financial products still carry negative connotation for some investors. Nonetheless, changes in this mentality and attitude towards CLOs. CMOs and CDOs have been reported in recent times. The reason for this change in mentality is the introduction of regulatory changes and programs, which have dramatic effects on the usage and effects of CLOs, CDOs and CMOs (Lo, 2012). For instance, in the US, the federal government has a Quantitative Easing (QE) program, which has significantly changed investors’ attitude towards these financial products. In this programme, the federal government buys assets, removes government bonds from circulation and forces investors into riskier credit products for yield (Kromov & Yavas, 2012). This paper discusses the CLOs with respect to what they are and how they function, the value they offer and how they affected the financial crisis of 2008. In addition, the paper discusses the changes so far implemented in the regulation of CLOs and the recent growth and composition of CLOs. 2. The Nature and Functioning of CLOs A type of debt collateralization, Collateralized Loan Obligation (CLO) is a security in which several big and middle-size business loans are combined and passed to groups of owners in different tranches or slices. If businesses default in payment of the CLO-purchased loans, an owner stands a chance of receiving high yields for the risk of loss undertaken (Adair & Hutchison, 2005). Collateralized loan obligations (CLOs) are like collateralized mortgage obligations. However, CLOs have a different type of principal loan. Essentially, in CLOs, an investor receives programmed debt payments from the principal loans but undertakes most of the risk in case borrowers default in repayment. The purpose of the securities is to give investors greater diversity and the probability for above average returns (Goolsbee, 2007). Normally, banks sell CLOs with different slices, which mirror diverse levels of superiority to match different risk and reward profiles (Adair & Hutchison, 2005). Dissimilar to other areas of the securitized markets, the performance of leveraged loans and the value of the collateral backing the debts have proven to be better than other securitized collateral such as subprime mortgages that went bad (Demanyank, 2009).  In 2013, the irregular 12-month default rate for U.S. leveraged loans stood at an average of 2.5% for the last two decades with 2009 recording the highest default rate of 9.6%. Meanwhile, the recovery on defaults in the same period averaged 70% with a low of 50% during the crisis. The collateral in CLOs is quite diversified and may be actual loans to individually rated companies, companies with full loan indentures, those with observable prices, and industry diversification (Ogonna, Brooks & Charles, 2013). The issuance of CLOs peaked in 2006-2007 in which $185 billion-worth of CLO was issued (Ogonna, Brooks & Charles, 2013). In 2009 and 2010, this amount fell to $1.1 billion and $2.9 billion respectively while in 2013, more than $250 billion worth of U.S. CLO debt outstood (Ogonna, Brooks & Charles, 2013). With investors out to increase their yields, the issuance of CLOs picked up in 2012 during which the issuance hit $50 billion. By March 2013, the issuance had reached $22 billion, representing an annual rate of $100 billion (Ogonna, Brooks & Charles, 2013). The Role That CLOs Played in the US Subprime Financial Crisis The US Subprime crisis was a countrywide banking sector emergency, which occurred in the 2007-2009 recession. The main cause of the crisis was a drop in home prices, which made mortgage quite delinquent (Demanyank, 2009). The dropping home prices also caused the devaluation of housing securities and the foreclosure of these securities. The pre-crisis period was also marred by decreasing investment in residential houses and reductions in household expenditures and general investment in different business fields (Demanyank, 2009). CLOs and mortgage-backed securities financed the expansion of household debt (Lemke, 2013). Although CLOs and the mortgage-backed securities initially had good rates that attracted investors by way of high interest rates, they were later affected by lower credit quality. Hence, there were many defaults in repayment (Demanyank, 2009). Among the main causes of the crisis were factors and practices in the housing and the credit markets (Talbott, 2003). Key among these causes is homeowners’ inability to pay their mortgages (Krainer & Wei, 2004). Homeowners defaulted in payment because of overextending, predatory lending, speculation and adjustable-rate mortgage resetting among others (Lemke, 2013). The other causes of the US Subprime crisis were overbuilding during the boom, high-risk mortgage products, high corporate and personal debt levels and bad monetary and housing policies (Adair & Hutchison, 2005). CLOs played a role in causing the crisis by creating a culture of excessive consumer housing debt. Mortgage-backed security and credit default swap also contributed to this effect of CLOs (Demanyank, 2009). The role that CLOs played By September 2013, the sales of sliced corporate loans reached an all-time high since the pre-crisis period of 2007 with the sales hitting $88.94 billion. The rush for sliced- and diced-corporate loans was occasioned by a desire for higher returns on investment. This increase in CLO sales resulted in worries of CLO’s being recipe for another financial crisis. Although there were fears that companies would not repay their loans after the crisis of 2008, skeptical banks still welcomed the record CLO sales in 2013. Currently, bundled corporate loans have re-emerged in the US with banks, pension funds and insurance companies developing methods of boosting returns on their investment even as the Federal Reserve keeps the interest rates low (Ogonna, Brooks & Charles, 2013).  Just before the financial crisis, collateralized debt obligations or CDOs were complicated investments that were backed by terrible mortgage loans (Koehler, 2008). However, they were stamped with stellar credit ratings, which later turned out to be underestimated and catastrophic risk once they defaulted in numbers, taking down financial institutions (Adair & Hutchison, 2005). CDOs were ruined in the financial crisis because quite many underlying mortgage loans were discovered to be worthless. CLOs suffered mark-to-market losses as they became too difficult to sell. These losses were similar to a bank run, resulting in the market drying up. However, their principal loans performed well. At the start of the 21st century, low interest rates made loans cheap and freely available, sustaining the a housing boom and mortgage refinancing. Hence, housing prices skyrocketed as speculations resulted in house flipping. Banks and other financial institutions started to combine these home mortgages to form residential mortgage-backed securities (RMBS). They then sold the shares to investors. When homeowners paid their mortgages, the money would flow through to the investor. Banks made money on the sale of RMBS and transferred the risks of mortgage default to investors. Upon noting the opportunity, investment banks repackaged the mortgage-backed securities into CDOs, creating various tranches, of investment, based on the investor’s appetite for risk. Although many investors from all over the world bought them, the CDOs mostly held mortgages that credit rating agencies rated lower than AAA. Although they provided higher returns to investors, the CDO attracted a higher rating because it clustered diversified mortgage-based securities. It was believed that this diversification provided extra safety. Although the idea sounded good, it turned out to be false because the homes needed to be in different geographies for proper diversification of real estate (Pagourtzi et al., 2003). A housing market slump in one area does not necessarily mean it is occurring elsewhere (Talbott, 2003). The problem was that investment banks diversified across different securities backed by real estate sometimes concentrated in one market (Pagourtzi et al., 2003). In other terms, there was never a realistic diversification of risk for CLOs and CDOs. The implication is that the CLOs and the CDOs were assigned higher ratings than they were. Only the investment banks issued them and pocketed high fees. Only the defaulter risk was passed on to investors (Lewis, 2010). 3. Subsequent Changes In Regulation to Prevent Financial Crises from Reoccurring The expected gradual growth in CLO in 2013 was slowed down by new regulatory mechanisms that the federal government enacted and implemented. The regulations made it quite difficult and expensive for banks in the US to invest in CLO funds (Brooks & Katsaris, 2005). One such regulation by the Federal Deposit Insurance Corporation became effective in April 1, 2013. The regulation makes it more costly for banks to own AA-rated slices of CLO. Notably, AAA-rated CLOs are the safest and the biggest high-yield and high-risk corporate loans. The regulation also increased the spread on the top-ranked pieces by 30 basis points. The Dodd-Frank legislation is the other CLO regulation that might affect the CLO market. In particular, this regulation has new risk-retention rules that will hugely affect the US CLO management landscape. In essence, this rule will affect the operations of new and non-capitalized CLO management firms and individuals. First, the Dodd-Frank legislation requires CLO managers to retain a 5% interest in all CLOs sponsored to be help horizontally in the equity of first-loss slice (Ng & Mollenkamp, 2008). This portion is also vertically held via single security with interests in every slice issued in the capital structure. The other CLO regulation, which is quite contentious, is the Volcker Rule, which has a purpose to prevent banks from engaging in speculative investment, which apparently led to the 2008 financial crisis. Some provisions of the rule limit banks’ ownership of hedge funds and private equity funds, which are considered ‘covered funds.’ Notably, the definition of the term ‘covered funds’ in the rules is contentious. Because most many senior CLO-issued senior debt securities have the right to sack the investment manager, CLOs should fall under ‘covered funds.’ 4. The Reasons for the Recent Growth in the CLO Market and the Composition of the Market, Focusing Upon Both Corporate and Central Bank Activity Currently, CLOs are quite popular among investors for several reasons. First, CLOs yields have multiplied in other spread products (Morgenson & Rosner, 2011). Hence, investors have been forced to invest in other areas of the credit spectrum to other classes of assets including non-agency mortgage-backed securities and commercial mortgage-backed securities (Lemke, 2013). Obviously, investors have had to invest in leveraged loans and CLOs. The other reason for the prominence of CLOs is that CLOs have floating interest rates. Currently, investors prefer being exposed to floating rate products, especially for fixed-income managers fearful of the unavoidable increase of interest rates (Shiller, 2005). CLOs are considered the new logical course of action for fixed-income investors facing financial oppression. Although investors initially shied away from new CLO issues, current data show a trend in which fixed-income investors seek more CLO deals, especially in form o inquiry for more equity. Conclusions and Opinion The CLO market is also promising further growth because, just like other structured markets, it permits fixed-income investors to expand their investable universe. Through CLO, an investor can take many loans, even hundred of them then shave off the riskiest of these loans and place them in a security. By this strategy, an investor is able to develop a fixed-income security similar to equity.] In the foreseeable future, CLO’s outlook shows potential for growth because CLOs are still attractive to investors on an extended basis. The bright future for CLOs is attributed to an environment of negative net supply for spread products. Despite the fact that the credit market has heated up, the default environment is expected to remain benevolent for a few more years. Additionally, with sustained fears of increasing interest rates, CLO’s floating rate-nature is expected to give the instrument an added appeal to investors. CLO’s future also depends on its appeal of CLOs of achieving high-yield credit spread devoid of taking the interest rate risk. References Adair, A., and Hutchison, N. (2005) "The Reporting of Risk In Real Estate Appraisal Property Risk Scoring." Journal of Property Investment & Finance (Emerald Group Publishing), 23(3): 254. Brooks, C., and Katsaris, A. (2005) "Trading Rules From Forecasting the Collapse of Speculative Bubbles for the S&P 500 Composite Index". Journal of Business, 78(5): 2003. Demanyank, Y. (2009) Ten myths about subprime mortgages. Federal Reserve Bank of Cleveland. Goolsbee, A. (2007). "Irresponsible Mortgages Have Opened Doors to Many of the Excluded". Economic Scene (The New York Times).  Koehler, C. (2008) "The Relationship between the Complexity of Financial Derivatives and Systemic Risk." Working Paper: 17. Krainer, J., and Wei, C. (2004). House prices and fundamental value. Federal Reserve Bank of San Francisco. Kromov, N., and Yavas, A. 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