Collateralized Loan Obligations Essay ⋆ Business Essay Examples ⋆ EssayEmpire

A collateralized loan obligation (CLO) is a debt security, a promissory note, with a pool of commercial loans as its collateral. The backing of the promise of the borrower to repay the loan is guaranteed by debt instruments they own. Historically collateral was some type of asset, such as bank deposits in gold or silver, land, building, businesses, cattle, horses, or other forms of tangible assets. However, contemporary financing has come to accept debt owned by the borrower as an asset (collateral) for new debt. In the case of a CLO, which is a debt security, the debt backing the CLO(s) is a pool of commercial loans.

CLOs are like collateralized debt obligations (CDOs) and collateralized mortgage obligations (CMOs) because they are all debt securities. They differ in the kind of debt that is being used for collateral. Both CDOs and CMOs use a pool of mortgages as assets rather than a pool of commercial loans, which are registered on the CLO’s originator’s books as receivables.

Banks around the world have, until the credit crisis of 2008, found CLOs to be useful for several reasons. They allow them to avoid the capital requirements demanded by regulators to meet calls on their demand deposits. It also allows them to reduce their risks on their commercial lending because the CLO is a sale of a portion of their commercial loan portfolio.

Investors in CLOs can expect to receive a cash flow from the CLO. However, it is a common practice to securitize the payments into different levels of tranches. This somewhat resembles preferred stock, where the preferred stock is paid a dividend before the common stock. However, with the tranches of CLOs it is more like having several levels of preferred stock getting different levels of dividends and the common stock receiving no dividends but still having an investor appeal because of the speculative risk and rewards that can come from trading the CLOs.

The commercial loans that are used to collateralize CLOs are medium and large business loans. The loans are multimillion-dollar loans commonly called syndicated loans. A bilateral loan is between a bank and a borrower and a participation loan is between a borrower and a group of banks. A syndicated loan is one between a group of lenders and a group of borrowers.

Once they are securitized they are sold to different investors with different tranches.

Loans made though CLOs are usually leveraged loans and involve very short-term loans. They are also leveraged borrowing, where the borrower is borrowing more than could be repaid, but is still accepted as creditworthy because it is more likely that the borrower will succeed than fail. The risk with leveraged loans is that the borrower is using the company as collateral and may be borrowing much more than the company is worth. Lenders receive a return on the loan that is representative of their risk in the case of a default.

Collateral loan obligations were created in order to finance projects with lower interest rates and an increased supply of lenders. The reasoning was that if the risk could be spread it would increase the number of willing business lenders and also reduce the cost of borrowing. The goal was for banks to lend money to businesses and then to use their commercial loans as collateral for the CLOs that were then sold to outside investors. If both financially conservative risk aversive and risk taking lenders could be attracted to the lending action then the supply of lenders could be increased. The outside lenders may be a variety of institutions needing a place for investment. In using the CLO the lending banks could earn fees and also receive some of the tranches. New types of CLOs are being developed for the market after the post-2008 credit crisis. These are being promised as safer investments.

Bibliography:

Frank J. Fabozzi and Vinod Kothari, Introduction to Securitization (John Wiley & Sons, 2008);
Frank J. Fabozzi, ed., Investing in Asset-Backed Securities (John Wiley & Sons, 2001);
Jason H. P. Kravitt, ed., Securitization of Financial Assets (Wolters Kluwer Law & Business, 1995).

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