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Trading and Capital-Markets Activities Manual

Instrument Profiles: Collateralized Loan Obligations
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Collateralized loan obligations (CLOs) are securitizations of large portfolios of secured or unsecured corporate loans made to commercial and industrial customers of one or more lending banks. CLOs offer banking institutions a means of achieving a broad range of financial objectives, including, but not limited to, the reduction of credit risk and regulatory capital requirements, access to an efficient funding source for lending or other activities, increased liquidity, and increased returns on assets and equity. Furthermore, institutions are able to realize these benefits without disrupting customer relationships. CLO structures generally fall into two categories: cash-flow structures and market value structures. Cash-flow structures are transactions in which the repayment and ratings of the CLO debt securities depend on the cash flow from the underlying loans. Market-value structures are distinct from cash-flow structures in that credit enhancement is achieved through specific over collateralization levels assigned to each underlying asset. Most bank CLOs have been structured as cash-flow transactions. 

To date, most bank-sponsored CLOs have been very large transactions-typically ranging from $1 billion to $6 billion-undertaken by large, internationally active banking institutions. However, as the CLO market evolves and the relative costs decline, progressively smaller transactions may become feasible, and the universe of banks that can profitably use the CLO structure will increase significantly. 

CHARACTERISTICS AND FEATURES 

In a CLO transaction, loans are sold, participated, or assigned into a trust or other bankruptcy remote special-purpose vehicle (SPV), which, in turn, issues asset-backed securities consisting of one or more classes, or tranches. Alternatively, a CLO may be synthetically created through the use of credit derivatives, for example, default swaps or credit-linked notes, that are used to transfer the credit risk of the loans into the trust or SPV and, ultimately, into the capital markets. 

Figure 1-Collateralized Loan Obligation

Typically, the asset-backed securities issued by the trust or SPV consist of one or more classes of rated debt securities, one or more unrated classes of debt securities that are generally treated as equity interests, and a residual equity interest. These tranches generally have different rates of interest and projected weighted average lives to appeal to different types of investors. They may also have different credit ratings. It is common for the bank to retain a subordinated or equity interest in the securitized assets to provide the senior note-holders with additional credit enhancement. This provision of credit support by the sponsoring bank triggers regulatory ''low-level recourse'' capital treatment. 

Conceptually, the underlying assets collateralizing the CLO's debt securities consist of whole commercial loans. In reality, the underlying assets frequently consist of a more diverse mix of assets which may include participation interests, structured notes, revolving credit facilities, trust certificates, letters of credit, and guarantee facilities, as well as synthetic forms of credit. 

One or more forms of credit enhancement are almost always necessary in a CLO structure to obtain the desired credit ratings for the most highly rated debt securities issued by the CLO. The types of credit enhancements used by CLOs are essentially the same as those used in other asset-backed securities structures-''internal'' credit enhancement provided by the underlying assets themselves (such as subordination, excess spread, and cash collateral accounts) and ''external'' credit enhancement provided by third parties (principally financial guaranty insurance issued by mono-line insurers). In the past, most bank CLOs have relied on internal credit enhancement. 

Bank CLOs can be further divided into linked and de-linked structures. In a linked structure, the sponsoring bank provides some degree of implicit or explicit credit support to the transaction as a means of improving the credit rating of some or all of the tranches. While such credit linkage may improve the pricing of a transaction, the bank's provision of credit support may constitute recourse for risk-based capital purposes, thus increasing the capital cost of the transaction. In contrast, the CLO issuer in a de-linked structure relies entirely on the underlying loan assets and any third-party credit enhancement for the credit ratings of the debt securities. 

CLO transactions are evolving into highly customized and complex structures. Some transactions that may appear similar on the surface differ greatly in the degree to which credit risk has been transferred from the bank to the investor. In some cases, the actual transference of credit risk may be so limited that the securitization meets the regulatory definition of ''asset sales with recourse,'' thus requiring the bank to hold capital against the securitized assets. 

TYPES 

CLOs Using the Master Trust Structure 

CLOs are complex transactions that typically use a master trust structure. Historically, the master trust has been used for revolving, short-term assets such as credit card receivables. This format affords the issuer a great deal of flexibility in strucEagle Tradersg notes with different repayment terms and characteristics, and provides for the ongoing ability to transfer assets and offer multiple series, which allows for greater diversification and minimized transaction costs. Consequently, securitizations through a master trust structure are often assigned series numbers, such as 1998-1, 1998-2, etc., to identify each specific securitization. These transactions may have many interrelated components that make them particularly difficult to analyze. 

CLO master trust applications need to be carefully designed. In contrast to typical master trust assets such as credit card receivables, corporate loan portfolios are less diversified, cash flows are not as smooth, and lower yields generate less excess spread. 

The CLO master trust also needs to be structured to mitigate the resulting mismatches between the maturities of heterogeneous collateral assets and liabilities, and to pay all series by their stated maturities. 

The master trust structure can be contrasted with other types of trusts, such as the grantor's and owner's trusts, that restrict the types of asset-backed securities that can be issued or have other limitations. The simplest trust form requires the straight pass-through of the cash flows from trust assets to investors without any restrucEagle Tradersg of those cash flows. 

A distinguishing feature of CLOs using the master trust structure is the transferor's (seller's) interest, which represents the selling bank's required retained interest in the assets transferred to the master trust. One purpose of the transferor's interest in credit card securitizations is to ensure that the principal balance of assets in the trust is more than sufficient to match the principal balance of notes that have been issued to investors. In addition, the transferor's interest is essentially a ''shock absorber'' for fluctuations in principal balances due to additional draws under credit facilities and principal pay-downs, whether scheduled or not. In definitional terms, the transferor's interest is equal to the total trust assets less the investors' interest, or that portion of the pool allocated to backing the notes issued to investors. The issuing bank is usually required to maintain its transferor's interest at a predetermined percentage of the overall trust size, usually 3 to 6 percent in a CLO transaction. As such, the transferor's interest within the master trust framework is on an equal footing with the investors' interest. 

However, the use of a master trust structure and the creation of a transferor's interest in a CLO transaction may create some unique problems. The very existence of the two interests (transferor's and investors'), the non-homogeneity of the loans being securitized, and the comparatively concentrated nature of commercial loan portfolios suggest that the distribution of those loans between the two interests must be reviewed and monitored carefully. It is critical to understand the basis for the distribution of credits between the two interests and the conditions under which this distribution may change over the life of the securitization in order to determine whether the transaction contains embedded recourse to the bank. 

Figure 2-CLO Master Trust Structure

In order for issuers of CLOs to attract institutional investors, for example, insurance companies and pension funds, the securities being issued are often rated. Rating agencies consider the credit quality and performance history of the securitized loan portfolio in determining the credit rating to be assigned, as well as the structure of the transaction and any credit enhancements supporting the transaction. 

In CLO transactions, the three most common forms of credit enhancement are (1) subordination, (2) the funding of a cash collateral account, and (3) the availability of any excess spread on the transaction to fund investor losses. Subordination refers to securitization transactions that issue securities of different seniority, that is, senior note-holders are paid before subordinated note-holders. It is common for the issuing bank to retain the most junior tranche of the investor notes. This interest is included in the investors' interest. It is distinct from the transferor's interest and is held on the transferor's balance sheet as an asset. Thus, third-party investors gain assurance that the bank will maintain the credit quality of the loans when the bank retains the first-loss exposure in the investor interest. 

In addition to retaining the most junior tranche of investor notes, the bank may fund a cash collateral account. The cash collateral account functions as another layer of credit protection for the investors' interest. If there is a shortfall in loan collections in any period that prevents asset-backed note-holders from being paid, the cash collateral account may be drawn down. 

Finally, the yield of the loans placed in the trust often exceeds the total coupon interest payments due investors on the asset-backed notes issued. The residual yield is called excess spread and is usually available to fund investor losses.1 

Synthetic CLO Securitizations 

Recent innovations in securitization design have resulted in a class of synthetic securitization that involves different risk characteristics than the standard CLOs described above. One type of synthetic securitization uses credit derivatives to transfer a loss potential in a designated portfolio of credit exposures to the capital markets. The intent of the transaction is to transfer credit risk on a specific reference portfolio of assets to the capital markets and to achieve a capital charge on the reference portfolio that is significantly lower than 8 percent. 

In the example in figure 3, the banking organization identifies a specific portfolio of credit exposures, which may include loan commitments, and then purchases default protection from a special-purpose vehicle. In this case, the 

Figure 3-Synthetic CLO Securitization

1. Note that any loss position that a bank retains in its own securitization is subject to low-level recourse capital treatment. A loss position would include retention of the most junior investor notes, the cash collateral account, and excess spread, if recorded as an asset on the bank's balance sheet. (See SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,'' for more information on the sale of assets and the recording of resulting assets and liabilities on the balance sheet.)

credit risk on the identified reference portfolio is transferred to the SPV through the use of credit-default swaps. In exchange for the credit protection, the institution pays the SPV an annual fee. 

To support its guarantee, the SPV sells credit-linked notes (CLNs) to investors and uses the cash consideration to purchase Treasury notes that are then pledged to the banking organization to cover any default losses.2 CLNs are obligations whose principal repayment is conditioned upon the default or non-default of a referenced asset. The CLNs may consist of more than one tranche, for example, Aaa-rated senior notes and Ba2-rated subordinated notes, and are issued in an amount that is sufficient to cover some multiple of expected losses-typically, about 7 percent of the notional amount of the reference portfolio. 

There may be several levels of loss in a synthetic securitization. The first-loss position may be a small cash reserve that accumulates over a period of years and is funded from the excess of the SPV's income (that is, the yield on the Treasury securities plus the fee for the credit-default swap) over the interest paid to investors on the notes. The investors in the SPV assume a second-loss position through their investment in the SPV's notes. Finally, the banking organization retains the risks associated with any credit losses in the reference portfolio that exceed the first- and second-loss positions. 

In figure 3, default swaps on each of the obligors in the reference portfolio are executed and structured to pay the average default losses on all senior, unsecured obligations of defaulted borrowers. Typically, no payments are made until maturity, regardless of when a reference obligor defaults. A variation of this structure uses CLNs to transfer the credit risk from the transferring bank to the SPV instead of using credit-default swaps as in the above structure. In turn, the SPV issues a series of floating-rate notes (''notes'') in several tranches to investors. The notes are then collateralized by a pool of CLNs, with each CLN representing one obligor and its credit-risk exposure (such as bonds, loans, or counterparty exposure). Thus, the dollar amount of notes issued to investors equals the notional amount of the reference portfolio. 

The institution has the option to call any of the CLNs before maturity so long as they are replaced by CLNs that meet individual obligor and portfolio limits. These limits include concentration limits, maturity limits, and credit-quality standards that must be met to maintain the credit ratings of the notes. If the CLNs no longer meet collateral guidelines, there are early amortization provisions that will cause the transaction to wind down early. 

If any obligor linked to a CLN in the SPV defaults, the institution will call the note and redeem it based either on the post-default market value of the reference security of the defaulted obligor or on a fixed percentage of par that reflects the average historical recovery rate for senior unsecured debt. The fixed percentage method is used when the linked obligor has no publicly traded debt. Finally, the term of each CLN is set such that the credit exposure to which it is linked matures before the CLN, ensuring that the CLN will be in place for the full term of the exposure to which it is linked. 

Synthetic CLO structures differ from many traditional CLO structures in two significant ways: 

1. In most CLO structures, assets are actually transferred into the SPV. In the synthetic securitizations, the underlying exposures that make up the reference portfolio remain on the institution's balance sheet. The credit risk is transferred into the SPV through credit-default swaps or CLNs. In this way, the institution is able to avoid sensitive client relationship issues arising from loan-transfer notification requirements, loan-assignment provisions, and loan-participation restrictions. Client confidentiality may also be maintained. The CLN-backed synthetic CLO also simplifies the legal work involved by avoiding the transfer of collateral and the creation or perfection of a security interest in anything other than the CLN. 
2. In many CLO structures, the opportunity to remove credit risk from-or add credit risk to-the underlying collateral pool is severely limited. In the CLN-backed CLO, the institution may actively manage the pool of CLNs, thereby managing the credit risk of the linked exposures on an ongoing basis. In this way, the structure can be used to free up credit lines for core clients with whom the institution would like to conduct more business. 

2. The names of corporate obligors included in the reference portfolio may be disclosed to investors in the CLNs. 

RISK-TRANSFERENCE ISSUES 

Reallocation of Cash Flows 

One of the provisions commonly associated with complex CLOs is the provision for the reallocation of cash flows under certain circumstances. Cash-flow reallocation may take a number of forms, but is usually provided to ensure that senior note-holders get paid before junior note-holders. For example, if loan collections are insufficient to fund the payments of the senior notes of a CLO and other credit enhancements have been exhausted, or the securitization has entered an amortization phase, the servicer may be required to redirect payments from junior note-holders to senior note-holders. In some structures, principal payments on loans that are originally allocated to paying down the principal balance of the junior notes may be reallocated to the payment of current (or delinquent) interest on senior notes. This re-characterization of principal to interest may be a source of recourse if investor note balances are not reduced for the principal payment, due to the fact that a loan underlying the investor interest has paid off and is no longer available to support outstanding investor principal balances. Therefore, the bank will be required to provide new loans to back the investors' interest, either from the transferor's interest or from its own balance sheet. 

Another distinguishing feature of CLOs that use the master trust structure is the revolving period. During the revolving period of a CLO, the investor notes are only paid interest, that is, the notes have not yet entered the amortization phase.3 However, some of the underlying loan balances are actually being repaid during this time. During the revolving period, such repayments are automatically reinvested in new loans to maintain the principal balance of loans backing the investor notes. In some securitizations, this allocation of cash flows may be interrupted. Specifically, under certain conditions, such as a deteriorating collection rate, a collateral deficiency, or non-compliance with rating-agency guidelines, principal repayments on loans may be withheld from the transferor during the revolving period. Thereafter, if the deficiencies remain uncorrected, the funds thus withheld may be available to pay down investor notes. Examiners need to carefully review the conditions under which cash flows are reallocated and circumstances under which normal flows are interrupted to determine the overall impact on the credit-risk transference achieved in CLOs. 

3. Investor notes may either mature at a point in time or may amortize over a specific period, usually one year. In either case, principal payments on the underlying loans may begin to accumulate a few months before maturity or the commencement of an amortization period in order to provide additional assurance that contractual principal payments can be made. 

Early Amortization 

A standard feature of CLO securitizations is a provision for early amortization. Early amortization provisions are designed to protect note-holders in the event the loans in the trust experience significant difficulty, diminishing the prospects for repayment of investor notes. When an early amortization event occurs (for example, defaults in the loan pool reach a certain predetermined level), collections on the underlying loans are reallocated so that investors are paid off at an accelerated rate. Typically, cash flows are allocated based on the proportional share of the trust that the transferor and investor interests represent when the early amortization event occurs. The allocation percentage thereafter remains fixed. This mechanism works to favor the investor interest, as additional draw-downs on facilities in the trust cause the transferor interest to increase (that is, additional lending under existing lines participated into the trust is assigned to the transferor's interest). Therefore, the size of the transferor interest grows rapidly relative to the size of the investor interest, but cash flow from the entire pool of trust assets continues to be allocated based on the fixed percentage that was determined when the early amortization event occurred. For example, assume the current allocation based on the relative size of investors' and transferor's interest is 80 percent and 20 percent, respectively. If early amortization were triggered, this percentage would be used to allocate all future principal collections, regardless of the actual relative size of the transferor and investor interests at any future date. While the existence of early amortization provisions has not been treated as recourse for regulatory purposes, early amortization is viewed in the marketplace as a form of credit enhancement. Credit-rating agencies indicate that such provisions can reduce the amount of credit enhancements or recourse needed to secure a given rating by more than half. 

While early amortization provisions alone have not been deemed recourse to the bank, they have been recognized as creating conditions that might result in the transferring bank's retaining a degree of credit risk.4 When a securitization triggers an early amortization event, the bank has two choices. It can allow the early amortization to proceed, causing the securitization to unwind. If a bank were to allow an early amortization to occur, its access to the asset-backed market in the future could become impaired and more expensive. Alternatively, the bank may choose to voluntarily correct the deficiency leading to the early amortization condition. Banks may be willing to support their securitizations, notwithstanding any legal obligation to do so, to preserve their name in the marketplace. However, such actions may have regulatory capital implications. 

Other Issues 

In some CLO transactions, it may be unclear whether a significant portion of underlying credit risk has been passed along to investors in the asset-backed securities. Assume that a $4 billion CLO has been completed in which the average underlying loan is rated BB. Further, assume that interests in these loans were segregated into a traditional CLO structure (see figure 4). In this case, the underlying loan pool has been transformed 

Figure 4-Distribution of Risks

transformed into interests in the securitization vehicle (trust or other SPV), and all of the securities issued to investors are rated equal to-or higher than-the average rating of the loans in the pool. The only other interests in the pool are retained by the issuing bank, that is, the subordinated piece of the investor interest and the transferor's interest. These interests are typically unrated. However, since the investor securities are all rated above the average loan rating of the loan pool, one could reasonably presume that the implicit credit rating of the bank's retained interests are lower than average. Further, since the dollar volume of the bank's retained interest is usually much smaller than the investors' interest, one might reasonably conclude that the implicit credit rating of these interests is much lower than the investor interest. In such cases, it is not clear whether the investors have assumed a meaningful portion of the credit risk of the underlying loans. Hence, the issue is not recourse in the traditional sense, but whether significant transference of risk has occurred in the first place. 

In some situations, certain trust covenants may function as credit support, leading to recourse to the securitizing bank. For example, the trust may require the bank to maintain the average credit rating of the loans in the trust. This may be accomplished by a requirement to remove deteriorating loans from the trust and replace them with higher-quality loans. Alternatively, the deteriorating loans may be ''reallocated'' to the transferor's interest, with the bank providing new loans of higher quality to the trust to back the investors' interest. In either case, the potential for recourse to the issuing bank is significant.5 

To obtain a favorable credit rating, covenants may place limitations on the amount of credit extended to a particular industry as well as on the maximum exposure to any particular obligor. For example, rating agencies may require that total credit exposure to any particular industry not exceed 5 percent of the trust in order for the notes issued to achieve a particular rating. Any exposures over the limit may be assigned to the transferor's interest as an ''over concentration'' amount. Because revolving credit facilities vary in size over time and their balances tend to be large, industry over concentration appears to be common in these structures. The end result is that the investors' interest remains well diversified at all times, while the transferor's interest absorbs all over concentration amounts. In this case, the risk of the transferor's interest and the investors' interest is not the same. However, such industry concentration limits by themselves generally will not result in a determination that the bank is providing recourse to the trust. 

Similarly, trust documents may limit the exposure of any particular obligor in the trust. Obligor concentration limits may become problematic when the limit assigned is a function of the credit rating of the obligor. When a credit in the trust is downgraded below a defined threshold level, the ''excess'' exposure to the obligor may either be removed from the trust by the issuing bank or may be assigned to an over concentration amount within the transferor's interest. In this case, it is not only possible that the transferor is absorbing credit exposures that exceed industry concentration limits (as described above), but it may also absorb exposures to credits that are deteriorating. If these requirements function in a manner that tends to reallocate deteriorating credits to the transferor's interest before default, the transaction may meet the regulatory definition of asset sales with recourse. 

In addition to the common structural features described above, there may be other conditions under which loan balances may be reallocated between transferor and investor interests. Further, unique contractual requirements may specify how losses will be shared between the two interests in the event of default (or some other defined credit event). Through these contractual provisions, the bank may continue to have significant or contingent exposure to the securitized assets. 

In summary, while examiners may be able to highlight recourse issues, it is not always clear where the lines should be drawn, as the mechanisms involved in these transactions are not always transparent. The issue is further complicated by the fact that banking organizations outside the United States are engaging in these transactions, and the treatment applied by foreign bank supervisory authorities may not parallel U.S. supervisory treatment.

4. See SR-97-21, ''Risk Management and Capital Adequacy of Exposures Arising from Secondary Market Credit Activities,'' July 11, 1997.
5. One factor in determining whether transactions include recourse is the sharing of loss that occurs when deteriorating assets are sold from the trust. If the loss is shared proportionately between investor and transferor interests, it is less likely that the transaction will be deemed to have recourse to the bank.

USES 

Banks have used CLOs to achieve a number of different financial objectives, including the important goal of maximizing the efficient use of their economic capital in the context of the current regulatory capital rules. Considering the small margins on commercial loans relative to other banking assets, the high risk-based capital requirement of these loans, especially those of investment-grade quality, makes holding them a less profitable or efficient use of capital for some banks. Using a CLO to securitize and sell a portfolio of commercial loans can free up a significant amount of capital that can be used more profitably for other purposes, such as holding higher-yielding assets, holding lower risk-weighted assets, making acquisitions, paying dividends, and repurchasing stock. As a result, this redeployment of capital can have the effect of reducing capital requirements, and/or improving return on equity and return on assets. 

Issuers also obtain other advantages by using CLOs and synthetic securitizations, including accessing more favorable capital-market funding rates and, in some cases, transferring credit risk; increasing institutional liquidity; monetizing gains in loan value; generating fee income by providing services to the SPV; and eliminating a potential source of interest-rate risk. In addition, CLOs can be used for balance-sheet management and credit-risk hedging, that is, securitizations enable the sponsor to transfer assets with certain credit-quality, spread, and liquidity characteristics from the balance sheet while preserving relationships with borrowers. In this manner, the bank can reduce its exposure to risk concentrations.

From the viewpoint of investors, CLO spreads are attractive compared with those of other, more commoditized asset classes and can offer portfolio-diversification benefits. The various tranches represent a significant arbitrage opportunity to yield- seeking investors, and investment-grade CLOs can provide a spread premium to investors who are limited by regulatory or investment restrictions from directly purchasing individual non-investment-grade securities. In addition, the performance history of CLOs has so far been favorable-an important factor in attracting investors, especially in the lower, supporting mezzanine or equity tranches in a CLO capital structure. These subordinated investors demand a premium return that is commensurate with the higher risk they bear.

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