Collateralized Loan Obligation - Explained (2024)

A CLO is a security that is backed up by the collateral of a set of debt instruments like bonds and mortgages. It is a credit derivative.

Back to:INVESTMENTS & TRADING

How Does a Collateralized Loan Obligation Work?

The issuer of the CDO mainly uses it in covering a portfolio of assets with credit risk, but it can also be utilized in entering a short position against that debt. Individual assets are transformed into a CDO through securitization that takes place outside the banks' balance sheet and for which a specialized company is formulated with the purpose of managing and structuring the assets at risk. CDO possess cash flows which are backed up by a portfolio of assets containing debt which consists of any debt instrument or even another type of a CDO. However, the CDOs that are backed by other CDOs are commonly referred to as synthetic CDOs. This process is similar to that of mortgaging a house except that it is the bank is doing the mortgaging. For example, the bank wants to mortgage its house. What it does to get money is securitizing that house through issuing bonds that are backed by that house such that if they fail to pay, the buyers of the bond keep the house. To create the CDOs, a bank forms a company and tasks it with the responsibility of buying those bonds that it has issued to securitize the previous house and other houses. Later the company secures all these bonds and issues new bonds that are backed by the earlier bonds. This is because the company cannot pay but instead keeps the bonds backed by the houses. In the creation of CDOs, the debt instruments are packaged and subdivided by the issuer into different classes that can be assimilated in various steps. Each step depicts a different order priority from the portfolio to which they are linked as well as different exposure to the default risk of the assets of the portfolio. These bonds are not only made with the debt of the houses, but also with many other types of assets.

Types of Collateralized Loan Obligation CLO

There are different CLOs according to the securitized asset:

• Collateralized bond (CBO)- Bonds
• Residential mortgage-backed securities (RMBS)- Home mortgages
• Commercial mortgage-backed securities (CMBS)- commercial mortgages
• Asset-backed securities (ABS) - which includes different assets such as credit cards.

Usually, a CDO with a structure appearing in the lower scheme where there are different steps is common. These steps or tranches include senior debt, mezzanine debt and stocks and every one of them respond differently depending on the step.

• Senior debt: These contain the best credit quality since they possess the least risk and are the safes. They are mostly given a triple-A rating
• Mezzanine debt: These have a higher risk compared to the previous one and thus pay a higher coupon than the previous.
• Actions: This contains the highest risk, and it is the first to incur losses. It is not rated.

The restructuring process involves buying the portfolio or collateral from the bank. Suppose this portfolio contains about 200 million dollars that have been structured in the three steps. It will be as follows:

• Senior debt that has a triple-A rating and promises an interest of 4% will have around 160 million dollars
• Mezzanine debt that has a double B rating and promising an interest of 7% will have about 30 million
• The shares that are not rated will have the remaining 10 million dollars.