An Introduction to Collateralized Loan Obligations

Collateralized Loan Obligations (CLOs) are now the largest nonbank lender in the U.S. This added source of financing, which lies outside the purview of banking regulation, is part of the “shadow banking system.” Lack of transparency and regulatory oversight of CLOs have given rise to the concern that this growing market might contribute to another financial crisis like the Global Financial Crisis (GFC) which was triggered by securitizations of sub-prime mortgages. In this paper, we provide a first look at CLOs for anyone wanting to better understand their distinctive features as a securitization vehicle that allowed them not only to weather the GFC but thrive in the post-GFC world. Collateral performance of CLOs suffered during GFC, except their recovery was faster and stronger than that of mortgage-backed securitizations. We offer several observations about loan securitization using CLOs that we think will make them much more accessible to interested readers:1. CLOs naturally fulfil a need, or they would not exist. 2. CLOs rely on pooling, tranching and overcollateralization to create new securities with investment risk ranging from AAA to equity risk. 3. CLOs are quite different from the sub-prime mortgage securitizations that triggered the global financial crisis: a. The asset being securitized is different. CLOs securitize portfolios of short-term, floating rate corporate loans made to borrowers from a diverse set of industries compared to sub-prime mortgages based on a single industry, residential real-estate. b. CLOs are more transparent. CLOs provide monthly reports to their investors detailing their loan portfolios and the quality of the collateral pool is monitored regularly. c. Finally, CLO asset managers actively manage the composition of the collateral portfolio whereas mortgage-backed securitizations are typically passively managed. There is much that we do not fully understand about the risks posed to investors and the overall economy by CLOs. First, CLOs are very reliant on credit ratings, so it is crucial to the health of the market for CLOs that these ratings be dependable. Second, CLOs securitize “subprime” bank loans which has dramatically increased the availability of credit to this class of borrowers which may pose unwelcome risk to the economy. Third, the CLO collateral loan portfolio is diversified across industries; however, this diversification does not reduce economy-wide or systemic risk. Finally, price and return data for CLO tranches are not readily available which makes it very difficult to estimate actual investment returns to the various tranches