Collateralized Loan Obligations: A Primer

Abstract

In recent years, collateralized loan obligations, or CLOs, have become the largest nonbank lender in the U.S. This added source of financing, which lies outside the purview of banking regulation, has given rise to the concept of a “shadow banking system.” And the lack of transparency and regulatory oversight of CLOs and shadow banking have led to concern that this growing market might contribute to a financial crisis similar to the GFC of 2007-2008, which was triggered by the securitization of subprime mortgages.

The authors provide a first look at CLOs and their distinctive features as a securitization vehicle that allowed them not only to weather the 2007-2008 financial crisis but to thrive in the post-GFC world. Though the collateral performance of CLOs suffered during GFC, their recovery was faster and stronger than that of mortgage-backed CDOs. Furthermore, the return performance of CLO tranches has in general also been superior to the returns from the comparable leveraged loans upon which CLOs are based—though there are difficulties in measuring returns for CLO tranches since transaction prices are not public information, especially in the case of the equity tranche.

After describing their remarkable growth, the authors focus on two fundamental risks posed by CLOs. The first risk relates to the reliability of credit ratings—though it's important to note that the extensive due diligence behind leverage loans versus mortgage loans effectively reduces CLO investors' reliance on the rating agencies. The second risk relates to the systematic risk borne by the CLO investors, which is lower than that of MBS if only by virtue of the fact that CLOs are based on shorter-term floating rate instruments than 30-year mortgages. More important, what happens in most MBS, CLO managers can actively manage their loan portfolios in the secondary markets, and effective and active management of collateral works to limit both default risk and the possible effects of systemic shocks.