Managing Business Finance - Essay Example

Managing business finance Collateralized loan obligations – Working process Collateralized loan obligations (CLO) represent a pool of debt (such as low rated corporate loans) that is backed by security. CLO’s have common characteristics as that of collateralized mortgage obligations but the underlying loans are different in CLOs and CMOs. As far as CLO is concerned, investors receive payments on a scheduled basis from the underlying securities. However, they have to assume risky positions in the event that the borrowers might default on their loan. The underlying securities within a CLO offer the investors with greater degree of diversity as well as the opportunity to earn higher returns. Usually banks engage in selling CLOs with different tranches that represent various ranks of seniority in terms of reward/risk profile (Duffie and Garleanu, 2001). CLO’s involve three key entities; banks, CLO managers, investors and borrowers. Now, in order to understand how CLO’s work it is important to explain the way in which securitisation works. At the very beginning a CLO manager approaches various investors in order to pull up funds from them and use them to buy loans (rather issue loans). These funds are pooled in one place sometimes also called as the securitisation vehicle which serves as the source of loans for potential borrowers. This vehicle generates interests every month which are paid back to the investors in terms of the riskiness assumed by them. There are various tranches of investments which are graded according to their risk/reward profile (Coval, Jurek and Stafford, 2009). Such as a AAA rated loan is less risk and less reward generating security whereas a BB rated loan is high risk high reward generating security. This means that when the securitisation vehicle generates interest every month, the investor assuming the exposure to a highly rated loan (less risky) is paid first but at the cost of a lower interest rate. On the other hand the investor assuming the exposure to a low rated loan (highly risky) is paid at the last but with a high interest rate. The fact here is that there is greater chance for the highly rated securities to pay out the return whereas there are lesser chances that the low rated investment tranches will generate a return (Antczak, Lucas and Fabozzi, 2011). Due to the demand for loans bank managers prefer to issue loans by pooling up funds from different sources in order to share the risk of default. They pool funds from their syndicates which involves (also termed as syndication) other banks, hedge funds and CLO managers. A loan is then divided into different tranches and then offered to the borrower. The CLO manger over here assumes his part of the exposure and puts it back into his securitisation vehicle (Duffie and Garleanu, 2001). This process of syndication is how collateral loan obligations work. 2. Contribution of CLO in the US subprime crisis In the old system when a homeowner paid their mortgage every month, the money was transferred to the local lenders and since mortgages took decade to repay, lenders became careful. However, in the new system lenders started selling the mortgages to investment banks. The investment banks combined a numerous of mortgages and other loans including student loans, car loans and credit card debt so as to create complex derivative products referred to as the collateralized debt obligations (CLOs) (Fratianni and Marchionne, 2009). The investment banks thereafter sold these CLOs to investors. Therefore when homeowners paid their mortgages, the money went to investors based all over the world. The investment banks paid the rating agencies in order to evaluate the CLOs. Many of those CLOs were given AAA rating which is the highest possible investment grade. This made lenders care less about whether or not borrowers could repay and that is why they started making riskier loans. The investment banks apparently cared less about this ticking time bomb in the system as more CLOs sold by them meant more profit for the company. The rating agencies which were paid by the investment banks had no liability if their ratings for those CLOs proved to be incorrect (Crotty, 2009). There was another risky scenario in the system triggered by the American Insurance Group (the world’s largest insurance company). The company was selling huge quantities of derivates called credit default swaps. This derivate instrument worked like an insurance policy for investors who owned CLOs. An investor who purchased credit default swap paid AIG a quarterly premium. If the CLOs failed, AIG assured investors that they would be compensated for their losses. However, contrasting to general insurance, speculators also bought credit default swaps from the company in order to bet against CLOs not under their possession (Fratianni and Marchionne, 2009). Given the fact that credit default swaps were unregulated, AIG did not have to put aside any money to cover for the losses. Instead AIG paid its executives huge cash bonuses as the contracts were signed. Later on when homeowners started defaulting on their loan, the value of the mortgages were not enough to compensate for the losses incurred by the lenders. This in turn deteriorated the quality CLOs and they later went bad. This meant that AIG had to pay a huge some of the money to the investors who owned CLOs as well as the speculators who just betted on the CLOs (which they did not own) by buying the credit default swaps. Having to pay huge sum of money to the investors and speculators made AIG insolvent following which the company filed for bankruptcy. This generated the onset of the global financial crisis (Fratianni and Marchionne, 2009). 3. Regulations enacted after the subprime mortgage crisis The subprime mortgage crisis which took place in the US exposed many aspects of the financial system in the country which were highly unregulated. The onset of this crisis and the economic situation in the aftermath compelled regulatory authorities to enact certain regulations that were aimed towards bringing stability within a disoriented financial system. The first of those regulations required banks to retain a part of the debt that they issue to borrowers, on their balance sheet. This was required in order to ensure the fact that bankers assume a part of the responsibility for the future value of the debt that is issued to borrowers (Korngold, 2009). The underlying rationale behind this is that if bankers are responsible for a part of the debt, they will be more attentive towards ensuring that the debt issuances are reasonably priced in order to reflect the innate risk associated with this instrument. Thereafter, the alternative investment fund manager’s directive was enacted which required the original issuer of a securitisation instrument to retain 5% of the economic risk (Langley, 2009). The underlying rationale behind this directive was to ensure that a part of the risk of default is also shared by investment fund managers. Having a share of the risk would make the managers conduct the securitisation business with more transparency (Langley, 2009). The Dodd Frank Act was approved as a response to the global financial crisis. It made major changes in the American financial regulatory settings which affected all federal financial regulatory establishments and every part of the country’s financial services industry. The aim of this legislation was to promote the financial stability of the US by enhancing transparency and accountability in the financial system. The act was aimed towards ending the theory of too big to fail, to protect the taxpayers in the country by restricting bailouts, to protect consumers from abusive financial service instruments and practices (Wilmarth Jr, 2010). The act is also effective in terms of providing an early warning regarding strengthening the stability of the economy. The Dodd Frank Act also formulates rules that are directed towards restricting executive compensation and enhancing corporate governance as well as eliminating loopholes that led to the 2007-08 global financial crises (Langley, 2009). The government in the US also stated that structured financial instruments such as CDOs, CLOs and CMO’s have to be rated by at least two rating agencies in order for investors to be absolutely certain about the risk reward profile of the financial instrument. 4. Recent growth in the CLO market After the 2007-2008 financial crises, the development structured financial instrument market came to a stall virtually. Since 2013, there has been a reappearance of the CLO market. The underlying reason behind this recent growth in the CLO market is largely due to the yield-hungry investors based in Asia who have been exhibiting a bigger appetite for such papers (Bloomberg, 2014). The re-emergence of the CLO market in the US over the last two years or so has triggered a significant augmentation in interest among instructional investors in Asia who are concerned particularly to buy CLOs (Incisive Risk Information Limited, 2015). The growth has reached to such an extent that a BBB rated bank loan is expected to yield 4% whereas a BBB rated CLO will yield 6% (Abramowicz, 2014). People are assuming same risks but CLOs are generating higher returns. The ever increasing demand for the CLOs especially from the Asian market has influenced corporations as well as banks to increase the rate of returns that is to be offered to investors on their possession of CLO tranches (Husband, 2014). The flow of credit has eased up within corporations, banks and investors which in turn have enabled them to engage more in CLO business (Calabria, 2014). However, the repercussions may again be severe if the business is not regulated. New regulations that are yet to be enacted in 2015 will set a restriction to the extent to which banks can get involved in the CLO business (Shimamura, 2014). This may lead to a further decline in sales which may result in downward price pressure. 5. Opinion Considering all the aspects that have been covered in this study, it can be said that the current economic environment in the US is quite different than the situation that prevailed in the US economy prior to the crisis. The financial system in the country is much more regulated currently with more laws being passed by the government in order to prevent opaque business practices. The new regulations have proven to be largely effective in keeping a control over the financial practices conducted by banks and corporations. The regulations have also helped consumers become more aware of their exposures to certain structured financial instruments. It is believed that which such form of transparency and consumer awareness, the US financial system will stay far from another global financial crisis. Reference List Abramowicz, L., 2014. Loan Market Losing on All Fronts as CLO Rule Change Looms. [online] Available at: [Accessed 20 January 2015]. Antczak, S. J., Lucas, D. J. and Fabozzi, F. J., 2011 Collateralized Loan Obligations.Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives, pp. 81-104. Bloomberg, 2014. Syndicated loans. [online] Available at: [Accessed 20 January 2015]. Calabria, M., 2014. Skin in the Game Rule Unnecessary for CLOs. [online] Available at: [Accessed 20 January 2015]. Coval, J., Jurek, J. and Stafford, E., 2009. The economics of structured finance. The Journal of Economic Perspectives, pp. 3-26. Crotty, J., 2009. Structural causes of the global financial crisis: a critical assessment of the new financial architecture. Cambridge Journal of Economics, 33(4), pp. 563-580. Duffie, D. and Garleanu, N., 2001. Risk and valuation of collateralized debt obligations. Financial Analysts Journal, pp. 41-59. Fratianni, M. and Marchionne, F., 2009. The role of banks in the subprime financial crisis. Review of Economic Conditions in Italy, 1, pp. 11-48. Husband, S., 2014. Leveraged Loans: As CLO Market Digests Risk Retention, Lawyers Eye Holy Grail. [online] Available at: [Accessed 20 January 2015]. Incisive Risk Information Limited, 2015. CLO market appeals to yield-hungry investors. [online] Available at: [Accessed 20 January 2015]. Korngold, G., 2009. Proposed Regulatory Solution: Legal and Policy Choices in the Aftermath of the Subprime and Mortgage Financing Crisis. SCL Rev., 60, pp. 727-1217. Langley, P., 2009. Debt, discipline and government: foreclosure and forbearance in the subprime mortgage crisis. Environment and planning, 41(6), pp. 1404-1419. Shimamura, T., 2014. Resurgent US leverage finance market. [pdf] NRI. Available at: [Accessed 20 January 2015]. Wilmarth Jr., A. E., 2010. Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-to-Fail Problem, The. Or. L. Rev., 89, p. 951. Read More