CLOs in the Financial Crisis

CLOs in the Financial Crisis

The issuing of collateralized loan obligations (CLO) by the major banks have been considers as the major cause of the financial crisis.

A number of financial operations undertaken by various banking institutions between the periods of 2007/2008 have been associated with the financial crisis that occurred then.

According to Becker and Guill (2009) collateralized loan obligations is made up different high risk commercial risk loans that have varying credit risks and are available for the sale to potential investors. As Longstaff and Rajan (2008) indicates, the high credit risk of these loans explains their high possibility in causing financial crisis in case of any default in payment. The current paper looks at the nature of the collateralized loan obligations and the reasons for the recent growth in the CLO market. A critical analysis of the role played by the CLO in the 2007/2008 financial crisis is also provided to justify the effectiveness of the regulatory approaches put in place to prevent such crisis from future reoccurrence.

The Nature of CLOs

Collateralized loan obligations are structured financial instruments that consist of a number of commercial loans grouped together.  The loans are divided into different slices or tranches to reflect varying levels of seniority that match different reward and risk profile. The different slices are issued to investors and offer a potential for higher returns in case payments are made. However, the underlying loans also assume higher risks to the investors in case of default in payment. According to Yan (2013) CLO are issued by a company to acquire loans for purchase of certain assets. The loans acquired from different investors are pooled together with an objective of getting greater benefits capable for repaying the loans. As Longstaff (2010) indicated, the investor who purchases a higher risk CLO is likely to get higher returns and the reverse holds. Nevertheless, the security that backs the tranches offered to the investors is the major determined for the kind of CLO slice to purchase. Analysis of the risk level of the CLO and the security offered in case of default in payment is therefore necessary prior to making purchases.

The Role Played by CLO in the 2007/2008 Financial Crisis

The financial crisis that occurred between the period of 2007 and 2008 was considered as the worst financial crisis ever after the great depression that occurred in the 1930s. According to Diamond (2014) this crisis was characterized with high cases of default in payment of loans that was a big blow to the housing market in a number of economies. It is reported that the crisis threatened the fall out of various large financial institutions and stock markets across the world. Decline in consumer wealth, increasing cases of unemployment as well as significant failures in business were also reported during this period. Sweet & Maxwell (2014) posited that the major trigger of the crisis was the encouraging home ownership policies that convinced consumers into acquiring loans and mortgages. A number of banking institutions therefore focussed on the sale of debts securities with an objective of availing mortgages to the consumers. Greater benefits were attained in the period when the housing market was buoyant. The decline and the instability of the housing market that was observed resulted into the crisis that did not only have adverse effects on the banking institutions but also on the investors.

It is reported that both mortgage backed securities and collateralized loan obligations contributed toward the financial crisis. However, Pauley and Kroszner (2012) have argued that the CLO had a significant role in the financial crisis that was reported. The major banking institutions in the USA and the UK mainly issued the CLO to the investors in their need to satisfy the housing needs of the consumers with the loan acquired. The division of the CLO offered into different slices presented  different risk levels to the investors involved in the purchase of the securities. While the banking institutions enjoyed some benefits initially, permanent profitability was not attained. The failure by the consumers to repay their mortgages greatly affected the housing prices causing the collateral values to reduce. This increase the losses made by both the banking institutions and the investors following the increasing default in payment that was observed. The double losses resulted into billions of dollars being lost leading to the economic recession that was reported. Issuing of collateralized loan obligations therefore caused the financial crisis reported in the period of 2007/2008.

Subsequent Changes in Regulation put in Place for Future Control of the Crisis

The disadvantages that are brought about by any financial crisis have led to a number of policies being set in place for its control. It is reported that the main cause for the 2007/2008 financial crisis was the issuing of debts by various financial institutions hence the policies set in place to prevent such crisis from reoccurring focussed on addressing the issues of debt issuing by financial institutions. The policies put in place by the UK and the USA governments focussed on controlling the issuance of the debts by the banks to the investors to prevent the losses that may be incurred in case of failure of loan repayment. In fact, it is reported that only certain banking institutions are allowed to offer the CLO and this is based on their financial position. The approach is set to ensure that only those capable of making repayments get involved in the debt issuance schemes.

A policy has also been set in place that control debt retention. The European retention policy dictates that the banking institutions issuing CLO retains certain part of the loan. This approach was put in place to ensure that the bankers have certain amount of capital for loan repayment in case they make losses from their investment scheme. This policy is therefore capable of assisting the baking institutions manage their financial activities while ensuring they repay the loans offered by the investors.

The Dodd Frank Act was also put in place to control the ability of the banking institutions in taking responsibility for any future value of the debt issued. This act requires that the issuer of security retains up to 5% of the economic risk. As Pauley and Kroszner  (2012) points out when the banking institutions owns some part of the debt then they are likely to ensure that it is fairly priced in the future preventing the possibility of incurring losses due to the unfair pricing of the debts. This does not only protect the investors from making losses but also reduces the possibility of economic recession that may arise following the under valuation of the debts.

Reasons for the Recent Growth in CLO Market

Despite the significant contribution that Collateralized loan obligation had on financial crisis, recent development has seen rapid increase in the growth of CLO markets. In fact, it is reported that during the month of March in the year 2014, more than $ 10 billion worth of CLO loans had been issued. This value was higher in comparison with the amount issued in the previous years. The amount has since been increasing with more than $ 12 billion being reported in the month of May (Diamond, 2014). As Fest (2014) points out, the year 2014 saw a steady increase in the value of the CLO loans being issued to investors. This indicates the rapid growth that has since been observed in this market. The causative reasons for the rapid expansion of this market are advanced below.

According to Pinto (2010) the higher yields that can be attained from the CLO justifies their  expansion in the recent past. It is observed that both the issuer and the investors are likely to benefits from any CLO issued if the economic position of the market is to be maintained as at the time of issuing. Diamond (2014) also posited that the current yield that can be currently be acquired from CLO loans is 11 times more than the value that can be attained from the issuing of corporate bonds. This is due to the higher rates that are offered with the CLO loans in comparison with the others available in the market. As Juliano and Wilches (2013) posited, investors have, in the recent past, avoided CLO loans due to the losses they made during the 2007/2008 financial crisis. As such, the yield rate of the CLO has significantly grown to more than 2% of the value that can be attained from the other bank loans. The possibility of attaining higher yield from the CLO loans by both the parties involved justifys the rapid expansion of the CLO market that is currently reported.

Fender and Scheicher (2009) have also argued that the risk involved in the CLO loans are slightly lower than the other loans offered by the banking institutions. In his analysis, he attained that the default rates for CLO loans are lower that the default rates for corporate bonds. As such, investors are attracted more to invest in the CLO laws than the corporate bonds. It is reported that the number of times that the CLO loans have been defaulted is a quarter the number of defaults of the corporate bonds (Festa, Walker & Warbey, 2012). The fact that default cases are lower in the CLO loans makes it less risky than the other loans offered by the banks. Majority of investors are likely to settle on a debt that is less risky hence the expansion of the CLO market that is currently observed.  

Opinion: Current Environmental Difference from the 2005/2006 Environment and the sufficiency of Changes in Preventing Crisis Reoccurrence

While the regulatory changes following the financial crisis have made progress towards avoiding the prevention of the financial crisis from reoccurring, they have been focused only on the original cause of that crisis. This is at the expense of several other potential causes of another crisis. The major cause of the 2007/2008 financial crisis was the increasing demands for housing units that led to a number of banking institutions providing mortgages through issuing of debts to various investors. When the interest rates on housing units rose, default in payment by the households was observed and that led to the banks defaulting to repay the debts issued from the investors leading to the financial crisis. It is true that the policy established thereafter ensured that a financial crisis resulting from the same problem does not reoccur.  These policies range from the limiting of banks that can offer CLO through the European retention policy to the Dodd Franck act and redefine the issuance of Collateral Loan Obligations. Actually, the practical effect of the policy changes was seen in 2008 when nations were recovering from the crisis and the housing boom was put under control. Nevertheless, there remain a myriad of regulatory gaps to be fulfilled in a bid to effectively prevent a future crisis. Actually, the limitation of the problem as resulting solely from defaulted loans is myopic and may deter the comprehensive addressing of the underlying financial problems. Scholars, therefore need to interrogate the possible causes of a financial crisis in detail and thus create a wide range of policies addressing all the findings.

On the question of environmental differences between the periods of 2005/2006, it is evident that a wide difference exists. Economies have currently grown to stability with household status increment observable through increase income per capita as well as purchase power parity among the world populations. Another characteristic of the current environment is that of comprehensive regulatory control that ensures that the issuance and repayment of loans is handled in a manner that greatly reduce default rates and thus preventing a record defaulting of loans from recurring. Important to note is the fact reported by the international monetary Fund (IMF) that economic growth is shifting from the developed world to the emerging economies and the developing world. Reports indicate that the developed economies are in a secular stagnation. This implies that if by chance a financial crisis overwhelms the policies currently in position and originates from the developed world, then it will have a smaller impact on the emerging economies compared to the 2007 crisis.