Role of Collateralized Loan Obligation in Financial Crisis - Assignment Example

Collateralized Loan Obligation Question How CLOs work CLO is an acronym for Collateralized Loan Obligation. Using simple term CLO is a collection of both commercial and personal loans that backs a security. The loans usually are low-rated which means have low-interest rate. Collateralized Loan Obligation involves many players and thus requires brilliant people in its management to reduce the risk associated with the buying and selling of loans. In CLO, the payment from loans are packaged and sold to investors. Investors normally purchase several loans from several lenders and pool together (Fridson, Garman, & Wu, n.d). The loans at this stage are regarded as Collateralized Loan Obligation; the pool is managed by a CLO manager. A decision regarding the sale, and purchase of other loans is vested on him so long as one can account for the decision. The loan is made up of high risked commercial loan that are grouped together, and sliced into various sections. The slicing into sections varies with the credit terms associated with the given slice. Credit terms simply refer to the principles governing the issuing and borrowing of loans. A slice with a high return is risky, and an investor assumes the losses if the loan is defaulted. A slice with low return is less risky. The reason behind Collateralized Loan Obligation was to secure banks from defaulters and also make loans accessible to other potential investors. Profits are generated from the difference in the cost of debt and the repayment of the loan. Nature of CLOs In analyzing the nature of CLO, it is important for one to have a clear mind on the operations surrounding it. First CLO is a form of debt security this means the loan offered to another party is a security for the other loan. Banks offer those slices or tranches to secure the loans given to individuals who may default. So the loan given to them, by the investors who purchase the slice, secures the bank against its lenders. Secondly managing CLO is tricky and, therefore, requires a professional in loans. Though human is to error, it is better to have a qualified personnel to manage CLO since it will minimize the risk associated with loan granting. Question 2 Role played by Collateralized Loan Obligation in financial crisis Financial crisis is a situation where the value of a financial instrument drops rapidly. This is caused by many factors, but the investors have a hand to such situations. In some cases, the value of an asset increases. The anxiety of investors to sell their assets or withdraw from a financial institution results to a financial crisis. Collateral Loan Obligation involves issuing, and receiving of loans from different parties. It is a rule of the thumb that loans generate income through the interests. CLOs provide an opportunity for a risk-taking-investor who wishes to have a high return to lend money or other assets as a security for other loans. Investors in different sectors get attracted by the level of income generated by the CLOs, and thus decide to invest in it. The effect of this is that the financial asset (shares, bonds) held by them at a go and thus devaluing the financial instrument. This can be linked to the 2008 financial risks where the stock suffered severely with the falling in stock prices. Banks failed to give loans for fear of default and devaluation of other assets. Collateralized Loan Obligation can be blamed for that crisis, continuous repackaging of loan to have different slices impacted on the financial system of the Unite States. The primary aim of the repackaging was to make the loan accessible to all class of investors. As loans were available for investors at a favorable rate loan application as high and demand for CLOs rose in that period. The law of demand and supply clearly dictates as the demand for a product increases supply also increases till they are at equilibrium. The demand for CLOs increased and with its lucrative income investors were attracted and sold other financial instruments at their disposal so as to invest in the CLO. The supply rose as the demand for CLOs rose too. Stock market and mortgage suffered the withdrawal of investors and house owners could not repay their mortgage loan. Prices of shares in the New York stock exchange fell rapidly. The default rate was higher and banks were no willing to lend more loans because of the anxiety surrounding loan repayment. Question 3 New regulation to curb any future reoccurrence of financial crisis The financial crisis had severe effect to the economy of the United States and the government had to get back to the drawing board for solutions. The solutions were not supposed to stabilize the financial market at that time, but rather have long lasting effect in the control of the financial market. A point to note is that the crisis did not impact on the United States’ economy only rather it did affect other financial market in the world. This is because of the integration in the financial market globally. The issue concerning the regulation of the financial market got a heated debate in the house of congress. Some of the members believed the financial market should be left alone and it will stabilize with time. Others were of conflicting opinion and demanded regulation to curb such scenarios from repeating in the future. The following are the measures that were taken to avert future repetition; introduction of European Union retention requirements, Dodd Frank Act, Credit Rating Agencies regulations and Alternative Investment Fund Managers Directive. European Union retention requirement The requirement from the European Union made it necessary for banks to retain part of the debt on their balance sheet. The requirement was a brilliant idea to avert any financial crisis in the future. Members of the European Union analyzed the crisis critical and identified failure of the banking institutions. Since banks had relieved all debt of loans to the investor, they had little control over debt transferred to the investors. Banks were considered to have taken a “resting position” during the inception of the crisis (Logue, & Merville, n.d). Therefore, it was thought if banks retain part of the debt in their balance sheet they will exercise their responsibility in stabilizing financial market thus averting recurrence of such crisis. Dodd Frank Act The Act was designed to regulate swaps. Swaps refer to the exchange of one security over the other for three main objectives changing qualities of the securities, change of maturity of the security or change in investment objectives. Swaps were considered to have impacted on the 2008 financial crisis, where investors moved assets from one financial institution and invested in the CLO thus creating an imbalance in the financial market (“The Financial Crisis of 2008, Credit Markets and Effects on Developed and Emerging Economies”. n.d.). The Act directly affects swap dealers and participants. Swap dealers are required to be registered for them to conduct their service. The participants of the swap need to be listed. The dealers of swap are required to do the record keeping and reporting information concerning swaps. This information will be critical in decision making regarding the state of the financial market. Dodd Frank Act is beneficial to the entire American public since the control of the financial market will stabilize the economy and reduce instances of inflation. Credit Rating Agencies Regulations The regulations are enshrined in the Credit Rating Agency Act that was signed into law by former President of United States George Bush in 2006.” ….the Act though was signed into law before 2008 financial crisis and failed to avert the crisis, it is still a pillar in ensuring future crisis does not occur…”(Prasch, n.d.). The Act regulates the interest rate attached to various financial instruments thus protecting the investors. It can be noted that issuance of CLOs rate varied depending on the level of riskiness attached t o a given slice. In my opinion, this played a part in the 2008 financial crisis. Reasons being the ratings were “seductive” to the investors and more and more investors were willing to invest in CLOs. If the Act had regulated the rate in the beginning to a reasonable one, the number of investors in the CLOs would not have outgrown the way it did. Question 4 Reason behind the current growth in CLOs In March 2014, the issuance of CLOs was up to $10.8 billion the highest level to be recorded since May 2007. The growth in CLOs was exceptional bearing in mind the recent financial crisis that had impacted negatively on investors. These figures need to be analyzed to find out the motivating factors for the sharp increase after a predicament. In April 2014, the figure rose to $ 12.3 billion surpassing the level witnessed in 2006. The figures are believed not lie and, in this case, the future of the Collateralized Loan Obligation, is still in course and investors have faith in its returns. The following are the reasons for it recent growth; The rate offered Proceeds from an investment are what determine the extent and an investor is willing to invest. The rates offered by CLOs are lucrative and thus attracts more investors across different sectors of the economy. (Fridson, M., Garman, M., & Wu, n.d ) argued the higher return offered by CLOs are just meant to retain the faith investors had on the CLO market, but this can be disputed. This is because, after stabilization of the financial market, issuance of CLOs has experienced a steady increase. The rates offered are by CLOs are high as compared to corporate or bank loans with the same level of riskiness. For instance, currently AAA rated CLOs offers eleven times more yield premium over risk-free benchmarks than corporate AAA rated debt. Investing requires bold step and investors understand the riskiness involved to fetch the return he/she desires. Comparing returns offered by financial institutions and CLOs on a security with the same rate of riskiness. Investors will opt to continue investing in CLOs than other security. For instance, investing in shares the level of risk associated is high due to the uncertain in the firm’s performance. Putting these pieces together makes an investor prefer CLOs. Default rates Defaulting simply refers to the tendency of a loan borrower failing to honour the agreement and thus consequences have to be attached to the act. Defaulting rate is determined to charge the defaulter for defaulting. According to (Prasch, n.d.), uncertainty in the financial market is inevitable and, therefore, investors who borrow money for investment should not be considered uniquely. He further argued that investors may not be able to repay their dues as per the agreement. Conventional debt over the years has been always higher. Investors are brainy people who will search for favourable credit terms across possible lenders especially on defaulting. The best solution for them has been CLOs which offer low default rate as compared to banks. Taking for instance, the default rate for BBB CLOs are low as compared to those of corporate bonds rated BBB. It should be noted both have equal value of security, but difference is in the default rate and level of return. The high default rate has resulted to high number of defaults experienced by banks as opposed to the number recorded by CLOs. Question 5 Opinion of the current environment of Collateralized Loan Obligation The current performance of the CLOs is prosperous as evidenced by flocking of investors in the CLOs market. The big question most investors ask is the sustainability of the market or and chances of financial crisis to reoccur. Answers to those two questions are as hard as imagining the consequences it might have on the investments. But what one should understand the uncertainty surrounding financial market while investing in CLOs. In my opinion, the sustainability of the current CLOs market cannot be guaranteed because of two reasons. One is investors are the controller of the financial market, and since they hold the financial instruments. Trading of the financial instruments was linked to the 2008 financial crisis, and thus sustainability of CLOs will depend on the continuous investment in the CLOs market. Withdrawal of a big percentage of investors will result to the decline of the market. The second factor is the effectiveness of the regulation in place the European Union requirement for retention of part of the debt by banks; to financial analysts this was a brilliant idea. Implementation of the requirement will ensure banks remain in touch with trading within financial markets to protect them from incurring losses. Regulation on the rates of Slices offered in the CLOs market will control investment level, and ensure balance in other in the financial market. References Byström, H. (n.d.). The Microfinance Collateralized Debt Obligation: A Modern Robin Hood? World Development, 2109-2126. Fridson, M., Garman, M., & Wu, S. (n.d.). Real Interest Rates and the Default Rate on High-Yield Bonds. The Journal of Fixed Income, 29-34. Logue, D., & Merville, L. (n.d.). Financial Policy and Market Expectations. Financial Management, 37-37. Prasch, R. (n.d.). The Dodd-Frank Act: Financial Reform or Business as Usual? Journal of Economic Issues, 549-556. The Financial Crisis of 2008, Credit Markets and Effects on Developed and Emerging Economies. (n.d.). Journal of Financial Stability, 120-120. Read More