CLOs follow CDOs, not just alphabetically

Escrito el 18 julio 2007 por Juan Toro en Financial Markets

CDOs have been hit hard recently. In the last week the underlying backing many deals has been revised on their creditworthiness and the CDO market is in a downward spiral that is rattling the markets. But risks are not just limited to this market. Another market that is been followed closely and has resemblance with the CDO market is the market for collaterized loan obligations (CLO). CLOs are debt securities backed by a pool of commercial loans. A recent report by the Bank of England (www.bankofengland.co.uk/publications/quarterlybulletin/mo07may.pdf) pinpointed resemblances between the market for sub prime mortgages and that for poorly rated corporate credit, highlighting concerns about the CLO market. Similar to a CDO, in a CLO banks assemble pools of corporate debt, and then break them into tranches. Investment firms (acting merely as intermediaries) will sell them to investors. Among the different tranches, those carrying more risk are those with no credit rating and referred as equity. The return on these tranches has been high in the last years, exceeding 20 %. But high returns go hand by hand with high risks. If loans go bad, losses are immediately suffered by investors holding equity tranches. Last year just 1.3 % of investment firms with credit rating below investment grade defaulted on their loans but this percentage might be on the rise.

Corporate borrowing has soared in recent years and CLOs have been a fundamental instrument for this growth. Behind this sharp growth is the frenetic LBO (Leveraged buy out) issuance. For many CLOs has been good and has dispersed risk across a wider number of investors. With CLOs banks are not any more the only holders of corporate borrowing and risk has been spread. For others the phenomenon of the CLOs is equivalent to what happened to the saving and loan institutions that imploded in the 1980s with the buyout boom. In the early 90s two main factors were behind the saving and loan debacle: corporate defaults and a real state downturn.

In the last three years over 219 billions dollars of corporate debt has been packaged in the form of CLOs whereas prior to 2004 the yearly average did not exceeded 20 billions. What explains this phenomenal growth? It seems that in the last years there has been a deterioration of the underwriting standards. This sloppiness implies that the newly created CLOs probably carry a higher risk than older ones. The straightforward conclusion is a potential higher number of loan defaults and a credit squeeze that might evolve similarly to how the CDO crisis has evolved.



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