Back to Business with CLO 2.0

Guest Contributor: Mike MolaroImage, Managing Partner, NorthPoint Financial

Some of what were perceived to be the riskiest securities of the pre-financial crisis are back. The Collateralized Loan Obligation (CLO) market indicators are pointing to a profitable resurgence and growing inventory for these instruments.

CLOs are special purpose vehicles (SPVs) with securitization payments in the form of different tranches. CLOs allow private equity firms, hedge funds, and some banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing the risk associated with lending.

CLO issuance totaled $26.5 billion during just the first quarter of 20131.  In 2007, the perception was that the CLO market would default like global CDOs and MBS, however the returns actually remained stable. Now it appears that analysts’ predictions are coming true and CLOs are roaring back to prominence in the structured product space.

What are the differences between CLO 1.0 and today’s CLO 2.0?

Before 2007, CLO funds were a fundamental part of the financial matrix. The financial crisis swept away a raft of overleveraged funds and the rest were branded toxic. Investors became more sophisticated, as did the requirements on issuers.  While Wall Street and most financial firms were watching their asset backed investments head into a tailspin, there were members of the industry who got busy, working collectively to standardize the asset type with the terms in the indentures, and trading and settlement documents and processes.  What has emerged has been dubbed as CLO 2.0.

The complexities of tracking the class, size and expected ratings of a deal are not new, just a little easier.  S&P recently rolled out a weekly report to track CLO ratings in various stages2. Looking at information such as underlying loans, liability, exposure and pricing as well as deal size is still a challenge for firms who do not have dedicated resources.

Today, many large loan issuers and investors have started to dust off their CLO experience and are watching anxiously from the sidelines for the first half of 2013 and will likely reenter later this year.  One major difference between 2007 and 2013 is the average investor now has access to a true “data warehouse” and a system for compliance, portfolio management and reporting that can handle the nuances and data that revolve around the CLO market.

A new, important feature of CLO 2.0 is the “10 day testing” provision for completing a trading plan.  A trading plan enables managers to execute a series of trades over a 10-day period and run all compliance tests on the result of all the trades grouped together.  This additional flexibility allows managers to take advantage of a group of investment opportunities that they would miss if traded individually.  CLO 1.0 required that each trade be evaluated individually, as opposed to in the plan, leading to onerous and duplicative work to adhere to the indenture terms.

For managers to take advantage of the additional flexibility and investment opportunities afforded by a CLO trading plan, the manager must be able to model the hypothetical plan trades as a single “order.”  This requirement will dictate the selection of a robust Order Management/Compliance system.

In this new era, re-pricing rather than restructuring for the CLO is attractive due to the upgraded protection in the form of ratings stability, priority of payments on new notes and other provisions. The CLO equity holders are better protected and the administration of the CLO is significantly more economical.   The risk measurements on the CLO are more normalized and the playing field is a bit more level.

The CLO 2.0 has emerged a safer haven for most than its predecessor, now that the standards have been boosted.  That access has its upside.  There will likely be more players vying for greater returns and in turn will create greater liquidity.  The spotlight on CLOs may turn this once black knight into the opportunity that boosts portfolio returns.

1 – Wall Street & Technology May 2013

2 – S&P

About Maureen Lowe

President and Founder of Financial Technologies Forum, LLC. Editor-In-Chief of FTF News. Entrepreneur, Jersey Girl that recently returned to Jersey, Loves to Bake, Married to a Kiwi, First Time Mom
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