A Primer: Collateralized Debt Obligations

Article excerpt

During 1997, the financial markets experienced record growth, to $35 billion, of specialized structured transactions called collateralized loan obligations or collateralized bond obligations. This article points out different structures for these transactions and a means to understand what is going on inside them, why it is going on, and how to make sense of it.

In a market that has excess money for investment, billions of dollars continue to flow into collateralized loan obligations (CLOs), also known as collateralized bond obligations (CBOs). Each financial arranger of these transactions tries to outdo the last deal that came to market. Each manager attempts to tailor a deal to areas in which he or she has expertise. In these structures, various elements of risk intermingle and a good understanding of these risk components and their interrelationship is necessary. Included among CLO risk elements are:

* Prepayment rate.

* Ramp-up periods.

* Recovery rates.

* Basis risk.

* Recovery periods.

* Hedging strategies.

* Market value risk.

Because this article seeks to be a thought-provoking primer, it covers only some aspects of the CLO transaction. There is a good deal more from a pure credit analysis point of view that the lender must rigorously analyze. It is important to remember that each deal is different and in these transactions, small items can make a big difference.

The Trust

A bankruptcy remote trust is formed. The trust owns the collateral and issues securities/notes that are the instruments a bank, as an investor, purchases. The collateral in the trust produces an income stream that pays the interest on the security/note. The majority of principal is paid at the end of the life of the trust, usually from final principal pay-offs of the sale of the trust assets. What the investor does not own are the individual assets themselves. Normally, there is a servicing agreement that governs the monitoring of the assets of the trust and in the event of default, the agreement requires that the collateral is liquidated to pay off the liabilities of the trust.

In certain instances, the owner of the trust is a nonprofit organization that may realize value after the trust pays off its liabilities. Normally, there is no residual value for the owner of the lowest piece of debt (a common misconception).

The Manager

For the past several years, mutual funds, asset management firms, banks, insurance companies, and distressed debt funds have grown dramatically. Arrangers market CLO/CBO structures to these firms. Managers effectively sell their expertise to the trust and, by the issuance of the debt securities/notes, receive the funds to make the investments in which they have expertise. As bankers analyze the structure, they should carefully understand the fee arrangement of the structure in which they are investing.

Example. XYZ High-Yield Bank Loan Mutual Fund determines that the growth of its fee income is topping out. An arranger approaches the fund and says that it can raise $500 million to $1 billion and it will receive management fees and bonus fees for performance, if it simply manages the assets of the trust in the same manner in which it manages the mutual fund. The deal goes to market and is transacted, and the money is raised. A new fund is created and the capital markets are used to issue the securities/notes from the trust to the investor base. The process works the same if the example is changed from high-yield bond manager to distressed-debt manager or emerging-market debt manager.

The Investor Base

Even in today's deregulated financial environment, many institutions cannot invest directly in the asset classes owned by CLOs/CBOs because of regulatory prohibition. By using these structures, a new asset class is created that allows these institutions to invest in assets previously unavailable to them. …