Collateralized loan obligation - AbsoluteAstronomy.com

Collateralized loan obligations (CLOs) are a form of securitization

Securitization

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...

where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranche

Tranche

In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...

s. A CLO is a type of collateralized debt obligation

Collateralized debt obligation

Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...

Leveraging

Each class of owner may receive larger payments in exchange for being the first in line to lose money if the businesses fail to repay the loans. The actual loans used are generally multi-million dollar loans known as syndicated loan

Syndicated loan

A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers....

s, usually originally lent by a bank with the intention of the loans being immediately paid off by the collateralized loan obligation owners. The loans are usually "leveraged loans", that is, loans to businesses which owe an above average amount of money for their kind of business, usually because a new business owner has borrowed funds against the business to purchase it (known as a "leveraged buyout

Leveraged buyout

A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...

") or because the business has borrowed funds to buy another business.

Rationale

The reason behind the creation of CLOs was to increase the supply of willing business lenders, so as to lower the price (interest costs) of loans to businesses and to allow banks more often to immediately sell loans to external investor/lenders so as to facilitate the lending of money to business clients and earn fees with little to no risk to themselves. CLOs accomplish this through a 'tranche' structure. Instead of a regular lending situation where a lender can earn a fixed interest rate but be at risk for a loss if the business does not repay the loan, CLOs combine multiple loans but don't transmit the loan payments equally to the CLO owners. Instead, the owners are divided into different classes, called "tranches", with each class entitled to more of the interest payments than the next, but with them being ahead in line in absorbing any losses amongst the loan group due to the failure of the businesses to repay. Normally a leveraged loan would have a fixed interest rate, but potentially only a certain lender would feel that the risk of loss is worth the interest that is charged. By pooling multiple loans and dividing them into tranches, in effect multiple loans are created, with relatively safe ones being paid lower interest rates (designed to appeal to conservative investors), and higher risk ones appealing to higher risk investors (by offering a higher interest rate). The whole point is to lower the cost of money to businesses by increasing the supply of lenders (attracting both conservative and risk taking lenders).

CLOs were created because the same "tranching" structure was invented and proven to work for home mortgages in the early 1980s. Very early on, pools of residential home mortgages were turned into different tranches of bonds to appeal to various forms of investors. Corporations with good credit ratings were already able to borrow cheaply with bonds, but those that couldn't had to borrow from banks at higher costs. The CLO created a way for companies with weaker credit ratings to borrow from more institutions than just banks, lowering the overall cost of money to them.

Demand

With the subprime mortgage crisis

Subprime mortgage crisis

The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

, the demand for lending money either in the form of mortgage bonds or CLOs has nearly ground to a halt. It appears that the "tranches" in past structures were inaccurately created, resulting in far higher losses to the riskier classes than ever anticipated. At this time it is unclear if there will be a return to many of the same structures. In particular, collateralized debt obligations, which could be thought of as a "second layer" structure which bought multiple forms of bonds and other structures and itself pays out income in various tranches, may never appear again. However, the eventual return of CLOs is believed by some to be very important, as they are the primary way syndicated and leveraged loans can be sold to other investors besides banks.

Leveraging

Rationale

Demand

See also