Good Essay About Collateralized Loan Obligations
ANALYSIS ON COLLATERALIZED LOAN OBLIGATIONS AND ITS INFLUENCE ON THE ECONOMY
Financial institutions offer securities that are backed by a pool of debts mostly those that have low-interest rates. These financial products are called collateralized loan obligations (CLO). Collateralized loan obligations play an important role in influencing the economy. This is through the buying and selling of structured debt instruments by the investment banks and other financial institutions. The CLOs are popular since they can meet the desires of different investors in the economy. Both the conservative and high-risk investors are able to find the suitable debt for them since the tranches are tailored to meet their needs (Hunt 2002). The conservative investors invest in CLOs that have lower risks while the high-risk investors go for higher risk tranches. Without proper monitoring of financial institutions, the collateralized loan obligations can lead to a financial crisis as the case was in the 2007/2008. The demand for structured loans had risen sharply before the crisis due to the housing bubble in the United States that enabled people to own houses (Sirkeci, Cohen & Ratha 2011). The prices of houses were set to have an upward trend thus many investors wanted to get the part of the benefits in the housing industry. However, this did not last for years because the loans were no longer performing. The borrowers defaulted on the loans, and this adversely affected the economy with major banks getting almost to a point of collapsing (Lucas, Goodman & Fabozzi 2010). To avoid such a crisis from recurring, tight measures were put on the financial sector regulation. These regulations limit the trading activities by the institutions and ensure that the banks retain part of the loans they offer on the balance sheet. This ensures that the banks are committed to the management of the debt.
When one invests in a collateralized loan obligation, they assume the default risk in case the borrower does not meet the requirement to pay the loan thus it is a high-risk business product. However, the investor benefits from the above average returns that are offered by the collateralized loan obligations since they offer greater diversity than investments with lower risks (Lucas 2007). In order to mitigate the uncertainties involved in the CLOs, the high-risk commercial loans are divided into various units with each section having varying levels of credit risk (Hankel & Isaak 2011). The different packages are then sold to the investors with those who purchase a higher risk CLO receiving a higher return than those who invest in one with lower risk. But the investor, who invests in lower risk CLO, has an advantage of getting most of their money back in cases where the default risk sets in (Fabozzi 2001). Although the risk-tolerant investors get a higher return on investment, they risk losing their money in cases where the borrowers default (Kolb 2010).
The CLOs were introduced so as to increase the number of suppliers willing to lend money to businesses, allowing banks to earn interest with minimal risks (Kothari 2006). The CLOs work by investing in a pool of broadly syndicated senior secured loans that covers a wide range of issuers and industries (Mellyn 2009). This helps in spreading the risks involved since it is unlikely that all the industries would be performing poorly during the same period. The portfolio of loans is managed by a collateral manager who buys or sells the security based on its profitability (Gastineau & Kritzman 1996). The CLOs finance the pool of loans with a debt structure that consist of debt and equity. The returns are determined by the difference between the yield on the loans and the cost of debt. If the cost of debt is higher than the yield of loan then the venture becomes unattractive to the investors but if the cost is less than the yield then the collateral manager invests in the project (Goodman 2002). The debt agreement is based on the cash flows of the portfolio and not the market value of the products thus the cost of the loans does not impact on the agreement.
The financial crisis of 2008 popularly known as the Global Financial Crisis is known to have been the worst after the Great Depression experienced in the 1930s (Castells, Caraça, &Cardoso 2012). The crisis threatened the collapse of large financial institutions and the stock markets. The government had to intervene and bail the institutions out of the crisis, but the stock market dropped worldwide due to reduced consumer confidence in the financial institutions. The housing market was the most affected in many parts of the world resulting in foreclosures, evictions, and prolonged unemployment. The crisis was triggered by policies that encouraged homeownership including easier access of loan to the borrowers. In addition, the sub-prime mortgages bundles were overvalued based on the theory that the prices of houses were going to increase continually. Investor decisions were, therefore, based on a misconception that the sector would grow, but it failed. Investors in the collateralized loan obligations make decisions based on the risk and return analysis of the investments.
For example, if an organization wants to borrow $ 100 million to aid in purchase of new equipment and assuming that the value of its office premises is $ 20 million, with a cost of debt of 5% and a risk-free interest rate of 1% per annum. The company can structure its debt in such a way that there are the top tranche loans with lower risks and the bottom tranche loans with higher risks. At the top tranche category, the company may consider an amount of $ 40 million which is to be recovered by sale of its premises in case of defaults with investors getting an interest rate of 2.5% per annum. On the bottom tranche, the company may consider a value of $ 60 million, with an annual interest rate of 6% but on condition that in cases of default, the investors lose their investment. The company’s cost of debt can, therefore, be calculated as (60%x6%) + (40%x2.5%) =4.6% that is lower than the average cost of debt. In such a situation, a risk-averse investor may consider the lower rate of return on investment since it has a higher return than the riskless rate but with minimal risk. On the other hand, a lender, who is risk-tolerant, may prefer the higher return tranche since the returns are superior to those of non-structured debts.
The collateralized loan obligations contributed greatly to the 2007/08 financial crisis. The US sub-prime mortgage crisis saw the banks lose about $ 223 billion, plunging of property prices and a slow economic growth (Culp 2011). The crisis resulted from the change in the way mortgages were funded leading to more defaults by the borrowers thus the huge losses by banks. The crisis saw a decrease in the gross domestic product of the US in 2008 and 2009, but the trend changed in 2010 when the GDP started increasing but it was still very low. Before the crisis in 2007/2008, debt securities based on a pool of mortgages and other loans worth trillions of dollars were sold by investment bankers (Admati & Hellwig 2013). They sold different packages to the investors and this continuous repackaging of the debt instruments led to a multiplier effect. The homeowners started defaulting on the loans, a fact that made the house prices and collateral values to decrease. Due to the multiplier effect of the different collaterals offered, the economy went into a recession because the investors lost billions of dollars in the trade.
In order to avoid recurrence of such a crisis, there have been several changes in financial regulations. The laws on issuance and treatment of CLOs and asset-backed securities were introduced. As a way of reducing the balance sheet risk and enabling the financial institutions do more business, the mortgage-backed securities, commercial loans, and other loans were removed from the balance sheet. However, after the global financial crisis, it is now a requirement that banks must retain part of the debt they issue on their balance sheets so as to enable investors make sound decisions (Hawley 2011). Further, the alternative fund investment manager directive requires that the original issuer of a security must retain 5% of the estimated economic risk. The Dodd-Frank Act is another regulation that was put in place to improve the openness of financial institutions thus protects the consumers from unfair practices in the financial sector (Altman et al. 2013). Further, there were two agencies formed to monitor the systematic risk. These are the office of financial research and the stability oversight council. The stability oversight council is mandated with identifying threats to the financial system of the US, responding to emergency risks and promoting the discipline in the financial sector. The office of financial research o the other hand is mandated with providing technical, administrative and budget analysis of the councils that regulate financial services (Avgouleas 2012). The Volker rule that was incorporated in the Dodd Frank Act also plays a key role in restricting commercial banks and their affiliates from proprietary trading, investment in hedge funds and private equity (Wachter, Cho & Tcha 2014). Further, the Act directs the Federal Reserves to enhance provisions of non-bank institutions engaged in such activities. The credit rating agencies also have a responsibility of ensuring that they rate the structured finance instruments. The debt instruments must be rated by at least two agencies before they can be sold to the investors. The new regulations were enforced to ensure that bankers ensure that they analyze a security in terms of its future earnings. With the banks owning part of the debts, they ensure that they price it fairly to reflect the inherent risks involved.
As a result of these regulations in the financial sector, the demand for CLO in the market has recently increased, for example, in March 2014 the CLO issued was worth $ 10.7 billion, the highest level issued since 2007(Wachter, Cho & Tcha 2014). This can be attributed to the higher rates offered by the CLOs relative to bank loans. CLOs with the same risk as the banks loans offer higher returns thus investors go for the higher returns. In addition, the default rates for BBB rated CLOs are lower than the BBB-rated corporate bonds. The central bank has had an influence on the growth of the collateralized loan obligations since it is involved in the regulation of activities carried out by the banks and other financial institutions. Following the global financial crisis in 2008, majority of investors lost their confidence in financial institutions for fear of insolvency (Canuto & Giugale 2010). As a result, the performance in the stock market dropped, and the central bank has been trying to gain the confidence of consumers back through prudence regulation of the financial institutions. The new regulations implemented in the financial sector to prevent recurrence of the crisis also contribute to the growth in the CLOs because many investors feel confident that their finances are safe. However, the demand for the increased growth for the CLOs may not live long because, as the market for the CLOs increases, the yield spread is bound to drop. In theory, both the corporate bonds and the collateralized loan obligations should trade at the same level. Currently, the CLOs trade at a higher level than the corporate bonds thus the demand for the CLOs will go down to a level where they are equal. In addition, the new regulations, that will take effect this year, will limit the extent to which financial institutions can trade with the CLOs. This is expected to reduce the prices and demand of CLOs down.
The current economic situation is different from what the economy experienced in the 2005/2006. Some sectors such as the stock market which were affected by the crisis are yet to return to where they were in the 2005/2006 season. During the period, investment companies made huge profits from the trade of securities but the current situation is different. The incentives, that encouraged people to own homes led to the increased demand for the security-backed mortgage loans and the borrowers later, defaulted on the payments. With the new regulations in the financial sector, chances of having another financial crisis are low. The financial institutions are not allowed to sell securities before the credit rating agencies review on the probable risks associated with structured financial instruments. The close monitoring of financial institutions by the various regulators such as the stability oversight council will ensure transparency in the way the institutions operate. The current market for the CLOs will overtake the amount of CLOs traded in the period between 2005 and 2006 since the new regulations have increased consumer confidence in financial markets.
Conclusively, the collateralized loan obligations have a great impact on the economy. This is reflected in the way the rise in demand for the securities affected the economy leading to a major financial crisis. The probability of such a crisis recurring is minimal owing to the fact that there have been new regulations implemented to ensure that financial regulation is upheld. The investors have more confidence in the financial institutions such that the sale of leveraged debt securities will overtake the number of securities traded before the global financial crisis.
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