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I investigate how covenants, intrinsic to Collateralized Loan Obligation (CLO) indentures, provide a mechanism through which idiosyncratic shocks may be amplified, imposing negative externalities on other unrelated firms in CLO portfolios. To this aim, I exploit cross-sectional variation in CLO exposure to the Oil & Gas (O&G) industry, as well as the timing of the O&G bust in 2014 to study how non-O&G firms in CLO portfolios are affected. I find that when CLOs are subject to idiosyncratic shocks that push them closer to their covenant constraints, they fire-sell unrelated loans in the secondary loan market to alleviate these constraints. The ex-post, secondary market spread becomes the effective cost of capital for these innocent bystanders, as the expected rate of return across debt instruments is equalized in market equilibrium. In response, firms make financial and real adjustments. These adjustments are most pronounced for riskier firms held in CLO portfolios, whose loans are marked at market prices, as selling mark-to-market loans can generate greater slack in the covenant constraints. As the sample period for this study is 2012-2017, a relatively benign macroeconomic period, the effects may be significantly larger during times of stress such as Spring of 2020, at the outset of the COVID-19 pandemic.

Structured products like collateralized loan obligations (CLOs) tend to offer significantly higher yield spreads than corporate bonds (CBs) with the same rating. At the same time, empirical evidence does not indicate that this higher yield is reduced by higher default losses of CLOs. The evidence thus suggests that CLOs offer higher expected returns compared to CB with similar credit risk. This study aims to analyze whether this return difference is captured by asset pricing factors. We show that market risk is the predominant risk factor for both CBs and CLOs. CLO investors, however, additionally demand a premium for their risk exposure towards systemic risk. This premium is inversely related to the rating class of the CLO.

This article describes the structure of the trillion-dollar CMBS and CLO markets, and their current distressed states given the ongoing economic effects of the COVID-19 pandemic. It then outlines various disputes that may arise from this distress. For CMBS, these include control and valuation disputes; waterfall disputes; “busted deal” disputes; REIT, “repo” and margin call disputes; fraudulent selling and misrepresentation disputes; and repurchase claims. For CLOs, the potential disputes involve CLO managers, CLO arrangers, CLO investors and trustees, and CLO valuation issues. In each instance the article describes the parties involved, the legal issues that are likely to arise, and—where possible—the applicable law from prior litigation in respect of the same or similar issues. The article concludes that many of these disputes are likely to result in litigation again soon given the ongoing effects of the COVID-19 pandemic and current economic forecasts within the CMBS and CLO markets. TOPICS:CLOs, CDOs, and other structured credit, CMBS and commercial mortgage loans Key Findings • The world is facing a COVID-driven economic slowdown that many believe will expose flaws in the market for commercial mortgage-backed securities (“CMBS”) comparable to those seen in the residential mortgage-backed securities (“RMBS”) market in 2007/2008. • This broad, multi-sector, economic downturn is also likely to severely impact the hundreds of billions of dollars of Collateralized Loan Obligations (“CLOs”) that have been issued in recent years. Wide-ranging, cross-sector defaults are expected for the loans that collateralize CLOs, and extreme loss severity is expected when those defaults occur. • Both CMBS and CLO industry participants, and legal counsel involved or looking to become involved in the industries, should scrutinize potential disputes closely and prepare for potential litigation in the near future.

Privately-produced safe debt is designed so that there is no adverse selection in trade. This is because no agent finds it profitable to produce private information about the debt’s backing and all agents know this (i.e., it is information-insensitive). But in some macro states, it becomes profitable for some agents to produce private information, and then the debt faces adverse selection when traded (i.e., it becomes information-sensitive). We empirically study these adverse selection dynamics in a very important asset class, collateralized loan obligations, a large symbiotic appendage of the regulated banking system, which finances loans to below investment-grade firms.

There has been much recent discussion of the increasing risk of Collateralized Loan Obligations (CLOs) and their feeder collateral, leveraged loans (LLs). The models ratings agencies use rely on similarly flawed methods in place since the mid-2000s and the nature of the collateral coupled with dramatic recent increases in risk of the underlying loans and conflicts of interest suggest that CLO ratings should be capped at a level far below AAA. Just as in 2008, the market is engaging in a collective grand illusion without adequate scrutiny of the actual risk and meaning of a AAA rating. The risk goes far beyond CLOs and permeates the larger economy. There is frothiness and irrational exuberance permeating an “Iron Triangle” of private equity firms, CLOs, and pension funds. Systemic risk may be realized through significant job losses, rising pension fund deficits, credit losses for funds, insurance companies, and banks, and significant disruption to critical industries. The risk could be on the scale of the global financial crisis (GFC). The main systemic risks include 1) Employment: Private equity-owned companies employ nearly 9 million people; 2) Pension funds: Face potential losses on existing investments and perhaps more importantly may need to revise lower future return assumptions—these factors put millions of pensions at risk; 3) Investment losses: Banks, insurance companies, and funds are exposed to CLO and/or leveraged loans and face significant potential losses; and 4) Critical industry fallout: Many industries controlled by PE companies face widespread disruption should the funding vehicles of CLOs and leveraged loans freeze up. TOPICS:CLOs, CDOs, and other structured credit; financial crises and financial market history Key Findings • This article argues that Collateralized Loan Obligations (CLOs) do not justify AAA ratings and that there is significant systemic risk emanating from the “Iron Triangle” of CLOs, private equity (PE), and pension funds. • The AAA rating should be challenged across two broad fronts: the rating agency approach and the substantial increase in risk in the underlying leveraged loans in recent years. • Systemic risk: The Iron Triangle between CLOs, PE, and Pensions create significant systemic risk potentially on the scale of the Global Financial Crisis (GFC).

Machine learning and neural networks have recently become very popular in a large category of domains, partly thanks to their ability to solve complex problems by finding patterns in data, but also due to an increase in computing power and data availability. Successful applications of machine learning include for example image classification, natural language processing, and product recommendation. Despite the potential upside of machine learning applied to financial data there exists relatively few articles published while the ones that do exist exhibit that there exists a potential for the tools that it provides. This thesis utilizes neural networks to price collateralized loan obligations which is a type of bond that is backed by a large pool of corporate loans, rather than being issued by a single company or government like a regular bond. The large pool of corporate loans and structure of a collateralized loan obligation makes it a good candidate for this type of research as it involves regressing a large number of variables into a final single real-valued price of the bond where the relations are not necessarily linear. The thesis establishes a relatively simple model and builds upon this using a state-of-the-art ensemble method while also exploring a volatility scaled loss function. The findings of this thesis are that artificial neural networks can price collateralized loan obligations using only their structural and loan pool data with an accuracy close to that of a human. Ensemble methods outperform non-ensemble methods and boost performance by up to 28% when only considering mean squared error while scaling the loss function with the inverse of market volatility does not boost performance. The best performing model can price a collateralized loan obligation tranche rated AAA with an average absolute error of 0.88 and an equity tranche with an average mean absolute error of 4.67. Under de senaste åren har maskininlärning samt artificiella neurala nätverk blivit väldigt populära i många olika domäner. Detta är delvis tack vare deras förmåga att lösa komplexa problem genom att hitta mönster i data, men även tack vare en ökning i beräkningskraft samt att tillgängligheten av data har blivit bättre. Några exempel på områden där maskininlärning har applicerats med framgång är klassificering av bilder, språkteknologi samt produktrekommendationer. Trots att maskininlärning skulle kunna erbjuda en stor potentiell uppsida vid lyckad tillämpning på finansiella data finns relativt lite studier publicerade kring ämnet. De studier som däremot är publicerade visar på stora möjligheter inom området. Den här studien använder artificiella neurala nätverk för att prissätta ”collateralized loan obligations” (CLOs), som tyvärr inte har någon bra svensk översättning. En CLO utfärdar obligationer vars underliggande värde härstammar från en portfölj av företagslån, och är därmed ett finansiellt instrument. Strukturen av en CLO och dess underliggande lånportfölj ger upphov till en stor mängd data, vilket gör instrumentet till en bra kandidat för maskininlärning. Studien etablerar ett relativt enkelt neuralt nätverk som sedan används för ett jämföra med en ensemblemetod samt en modifierad loss funktion som tar höjd för volatilitet. Slutsatserna av den här studien är att neurala nätverk lyckas prissätta instrumenten näst intill lika bra som vad en människa skulle kunna göra med befintliga metoder som bygger på Monte Carlo simulering. Däremot är studiens metod inte lika beroende av antaganden som gör den befintliga metoden väldigt känslig. Vidare så bidrar ensemblemetoden som används till att minska det genomsnittliga felet i kvadrat med upp till 28%. Att ta höjd för volatilitet vid inlärning bidar inte till att minska felet.

Based on archival and survey data we show that the maturity of U.S. business loans has been continuously increasing since the mid-1930s when banks invented the term loan. Concurrently, bank innovation first involved the invention of credit analysis and covenant design. Later, bank innovation included the advent of loan sales, increased loan syndications, the opening of the leveraged loan market, and the securitization of loans in collateralized loan obligations. We estimate and calibrate a model of bank innovation to determine the quantitative contribution of bank innovation to economic growth. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

In this article, the authors investigate the drivers of CLO equity return and how to identify a good CLO manager. Pre-crisis collateralized loan obligation (CLO) structures proved to be very robust in the end. Today’s CLOs are structured more conservatively with generally more CLO debt subordination, cleaner asset pools, and less reinvestment flexibility. Looking at historical CLO equity performance, CLO 1.0 equity benefited from having cheap funding costs and opportunities to buy discounted loans during the financial crisis, ultimately achieving over 20% IRR. CLO 2.0 equity’s returns have been running lower so far in a benign credit market. The authors note that top-quartile US CLO equity always delivered low-to-mid-teens’ returns, regardless of market timing. It is also worth noting that CLO equity’s deal-level and manager-level performance dispersion is evident across different vintages and even more pronounced today than before the Global Financial Crisis as the number of US CLO managers grew from 100 managers pre-crisis to more than 130 today, with the outstanding US CLO market having more than doubled in size. TOPICS:CLOs, CDOs, and other structured credit, project finance, legal and regulatory issues for structured finance, financial crises and financial market history, manager selection Key Findings • Any style could lead to good or bad CLO performance. Active trading and portfolio management are the key to outperform and differentiate from peers for CLO managers. • It is hard to balance principal and interest returns of CLO equity, because minimizing portfolio losses often hurts running excess spreads. We can tell if CLO manager is more “equity-friendly” or “debt-friendly” by comparing various performance metrics. • Manager tiering will continue to be a common theme in the CLO market during the next downturn and the subsequent recovery period.

The Loan Syndications and Trading Association victory over federal regulators released managers of open market collateralized loan obligation (CLO) transactions from the requirement to comply with the US risk retention rules. This removed one of the most substantial economic hurdles to managing CLOs sold to investors in the United States and Asia. In their quest for a broader investor base, however, CLO managers are more frequently looking to Europe. At the same time, CLO managers continue to raise capital to fund the equity that supports their CLOs. Because CLOs sold to European institutional investors need to comply with the EU Securitisation Regulation, several important factors must be considered when structuring investment vehicles used by CLO managers to fund their CLO equity. This article examines some of the key legal, tax, and regulatory issues that CLO managers face when raising capital that will be used to fund the equity in EU-compliant CLOs. TOPICS:CLOs, CDOs, and other structured credit, project finance, legal and regulatory issues for structured finance, financial crises and financial market history, manager selection Key Findings • US CLO managers are increasingly looking to issue CLOs that may be sold to certain types of regulated European investors. At the same time, they continue to raise capital to fund the equity in their CLOs. • There have been several recent developments affecting the manner in which CLO managers are able to raise captive equity. These include, among others, the elimination of the US risk retention rules for “open market CLOs” and the adoption of the European Securitisation Regulation, which provides some clarity around some of the regulatory considerations related to investment vehicles through which such capital is deployed. • When structuring these investment vehicles, US CLO managers should be aware of the current state of the market on a variety of legal, regulatory, and tax issues.

Two major regulatory changes will significantly affect collateralized loan obligations (CLOs): the phasing out of support for LIBOR in 2021 and the European Union Securitization Regulations, which came into effect in January 2019. These changes will affect borrowers of capital, investment managers who securitize loans, investors in CLOs, and activity of trustees in this market. As markets prepare to transition away from LIBOR, the Fed’s Alternative Reference Rates Committee has established the Secured Overnight Funding Rate (SOFR) as its recommended benchmark interest rate. A collateral manager’s transition to using SOFR may require the assistance of a trustee to navigate the change. The EU Securitization Regulation imposes new standards of transparency, risk retention, and due diligence for issuers of and investors in securitizations. The new regulation will affect issuers of securitizations in any jurisdictions that market their products to investors in the EU. With a changing market, collateral managers and trustees should be prepared with language and systems in place to manage the transitions they may face. Ensuring that all parties are informed and prepared will abate market uncertainty and provide continuity. TOPICS:CLOs, CDOs, and other structured credit, legal and regulatory issues for structured finance, financial crises and financial market history Key Findings • As markets prepare for a transition away from using LIBOR as the benchmark interest rate, the Fed’s Alternative Reference Rates Committee has established the Secured Overnight Funding Rate as its recommended alternative. A collateral manager’s transition to using SOFR could be challenging and may require the cooperation of a trustee in navigating the change. • The EU Securitization Regulation, which came into effect in January 2019, imposes new standards of transparency, risk retention, and due diligence for issuers of and investors in securitizations. The new regulation will affect issuers of securitizations in any jurisdictions that market their products to investors in the EU. • With a changing market for CLOs, collateral managers and trustees should be prepared with language and systems in place to manage the transitions they may face proactively. Ensuring that all parties are informed and prepared will help to abate market uncertainty and provide continuity.

The Cayman Islands is well known to be the jurisdiction of choice for structured finance transactions due to its robust legislation and judicial framework, its creditor friendly nature, its familiarity to market participants (in particular, rating agencies), and the list goes on. What is less obvious, and arguably more intriguing, is the increased reliance on basic features of Cayman Islands corporate law to facilitate innovative structuring, particularly at the warehouse stage of a collateralized loan obligation transaction, and create greater efficiencies in transaction execution. The existence of these features is not novel; however, their increased adoption is. In this article, the authors explore the most commonly utilized features and the ways in which they support transaction innovation. TOPICS:CLOs, CDOs, and other structured credit; legal and regulatory issues for structured finance Key Findings • The flexibility of the Cayman Islands corporate regime allows for bespoke structuring. • There is an ever-increasing reliance on basic corporate law features to support transaction innovation. • Cayman as a jurisdiction is commercially responsive, facilitating efficient transaction execution through a robust statutory framework and evolving market practices.

The authors discuss basic structural and process considerations relating to the execution of a commercial real estate collateralized loan obligation (CRE CLO) transaction, focusing on several key differences between CRE CLOs and more-standard CLOs, with a particular emphasis on the tax analysis. The authors explore the tax challenges of the REMIC and grantor trust structures, as well of the advantages and disadvantages of utilizing a qualified REIT subsidiary (QRS) structure or having the issuer domiciled outside of the United States in a traditional offshore CLO/CDO structure. In recent years, CRE CLOs have provided CRE CLO sponsors an important financing alternative for transitional properties, one that is nonrecourse to the CRE CLO sponsor, and generally offers better match-term funding, and largely eliminates mark-to-market risks for the CRE CLO sponsor. CRE CLOs use much of the terminology and technology of middle market CLOs and achieve like goals for sponsors by achieving balance sheet leverage, but the nature of the collateral and the tax structure underlying the CRE CLO are fundamentally different from other CLOs. A potential CRE CLO sponsor should be aware that asset level disclosure in the CRE CLO market is far more granular than that for middle market CLOs. A potential CRE CLO sponsor should consider that significant company resources will be devoted to vetting the disclosure for a period of several months. TOPICS:CLOs, CDOs, and other structured credit, legal and regulatory issues for structured finance Key Findings • In recent years, CRE CLOs have provided CRE CLO sponsors an important financing alternative for transitional properties, one that is nonrecourse to the CRE CLO sponsor, generally offers better match-term funding, and largely eliminates mark-to-market risks for the CRE CLO sponsor. • CRE CLOs use much of the terminology and technology of middle market CLOs and achieve like goals for sponsors by achieving balance sheet leverage, but the nature of the collateral and the tax structure underlying the CRE CLO are fundamentally different from other CLOs. • A potential CRE CLO sponsor should be aware that the level of asset level disclosure in the CRE CLO market is far more granular than in the middle market CLO market. Given the transitional nature of the underlying properties, which require more due diligence by investors, together with short loan terms, investors demand significantly more disclosure than a middle market CLO offering. A potential CRE CLO sponsor should consider that significant company resources will be devoted to vetting the disclosure for a period of several months.

This article examines the macroeconomic factors that have led the US broadly syndicated loan and collateralized loan obligation (CLO) markets to be the largest in the world then looks at how the markets evolved to the current state and explores some of the current themes facing both markets. European leveraged loans and CLOs are the second largest market, followed by US middle market loans and CLOs. Each of these markets has different challenges facing them, but there are also similarities in structures, market participants, and market forces that can benefit from shared experiences. Finally, there is the potential for a CLO market to cross over to Asia to focus on Asian credit issuance. The US broadly syndicated loan and CLO markets can serve as a benchmark for the future development of global loan and CLO markets. TOPICS:CLOs, CDOs, and other structured credit, global markets, developed markets, emerging markets Key Findings • Growth in the US leveraged loan market has been supported by sustained, but moderate, GDP growth over the past decade and monetary policy both domestically and intentionally has encourage investment in the US. • Prevalent features of the current leveraged loan market, like robust secondary market trading and covenant-lite loan structures resulting from evolution of the leveraged loan market evolving and convergence with the high yield bond market. • US capital markets continue to evolve with CLOs and private credit providing more sources of liquidity for corporate issuers.

The US bond market had over $42.39 trillion of outstanding debt at the end of the third quarter of 2018, eclipsing the US stock market’s approximately $30 trillion in market capitalization. The sheer size of the bond market provides ample opportunities, as well as risks, for institutional investors. Some of these risks escape investors’ radar because of the nature of fixed income securities: low transparency, illiquidity, and over-the-counter (OTC) trading. In this article, the authors present our concerns regarding five secular changes wrought by the over-regulation of the marketplace after the financial crisis of 2008 and investors’ persistent thirst for yield. Further, although painful lessons were gleaned after the punishing 2008 financial crisis, the authors present empirical evidence that suggests that many sectors, such as auto loans and collateralized loan obligations, that were largely unscathed by this crisis may be at risk in the next downturn. This article is based on original data sources and academic research. The authors are in continuing dialogue with other experts that may further the research, and welcome interested parties to get in contact. TOPICS:Financial crises and financial market history, statistical methods Key Findings • Lack of market-making and other regulatory changes that will impede price discovery in the next downturn. • Masking of the deterioration of underlying collateral and rearview mirror analysis. • New versions of the old games played by the rating agencies. • Explosion in number of Asset-Liability mismatched structures. • Regulatory changes in compliance of financial institutions.

This note describes how the Federal Reserve’s Financial Accounts of the United States account for Collateralized Loan Obligations (CLOs) and discusses two new data series on CLOs that are introduced in the September 2019 publication of the Financial Accounts.

We study the effect of collateralized lending and securitization on the global supply of securitized assets, welfare, and international net and gross capital flows in a two country general equilibrium model with idiosyncratic investment risk. The financial sectors in the two countries, Home and Foreign, differ by the collateral requirement for investment loans, with Home requiring lower margins. In autarky, Home endogenously supplies more assets and enables more risk sharing. Upon financial integration, capital flows from Foreign to Home, leading to lower interest rates and an increase in the global supply of assets. Foreign enjoys substantial welfare gains through better risk sharing and portfolio reallocation, while the welfare experience for Home is ambiguous. Gross capital flows arise when agents face aggregate shocks to the expected payoff to investment projects, but can collapse when shocks concern the variance of returns.

Option pricing theory explains why collateralized loan obligation (CLO) equity holders should prefer riskier CLO collateral asset portfolios with greater cashflow volatility. The degree to which CLO equity holders are better off with riskier portfolios depends on how well CLO equity is performing or, in option terms, whether CLO equity is in-the-money, at-the-money, or out-of-the-money.

“Obligor overlap” refers to different collateralized loan obligations (CLOs) having the same loan obligors in their collateral asset portfolios. In this article, we show why obligor overlap is bad for equity tranche investors and good for debt tranche investors. In this respect, CLO industry practice favors the interests of CLO debt investors, as most CLOs have a high degree of obligor overlap with each other. In fact, CLO equity investors would have to look hard to find CLOs that own loans from very different sets of obligors. To reduce obligor overlap, CLO equity investors will have to insist that CLO managers change their collateral management practices.

It was once conventional wisdom that lenders routinely influenced corporate managers’ decision making. Covenants constrained borrower risk taking and compelled specific affirmative obligations to protect lenders. Recent policy discussion, however, laments loan markets’ turn to various forms of high-risk lending. So-called leveraged loans — relatively risky, below-investment-grade loans — more than doubled in outstanding dollar terms, growing from about $550 billion in 2010 to $1.2 trillion by 2019. These risky loans have taken up a larger and larger share of the loan markets over time. More leveraged loans are also “covenant-lite,” issued without traditional financial maintenance covenants. And regulators worry about “add-backs” — borrowers’ growing practice of making upward adjustments to projected earnings that tend to weaken leverage constraints. Moreover, bank regulatory changes have incentivized “originate-to-distribute” loan syndications that enable non-bank lenders to hold and trade leveraged loans too risky for banks to keep. Syndicated lending now involves greater and greater participation by nonbank or “institutional” lenders like hedge funds, CLOs (collateralized loan obligations), and mutual funds. Commentators worry about the new species of risky loans, with their dearth of traditional covenants and the fewer instances of lender intervention, which may portend instability in debt markets. At the same time, weakened covenant protections may lead to weakened corporate governance. In this Article, I respond to these fears, arguing that they may be overblown. The increasing share of leveraged and covenant-lite loans may not necessarily evidence undisciplined debt issuance. Many seemingly troublesome loans are issued as subparts of deals that include loans with traditional covenants and cross-default provisions, which effectively constrain borrower behavior. Though add-backs may increase firm leverage, they may also improve the informativeness of earnings-based financial covenants. In addition, while the incidence of loan covenant violations has dropped dramatically across U.S. public firms, recent research suggests that covenants have become more efficient. In effect, covenants are doing more with less. Financial covenants have generally become less restrictive and more discriminating in differentiating distress from non-distress situations.

Regulation and capital constraints may force banks and collateralized loan obligations (CLOs) to sell deteriorating loans, potentially hampering renegotiation and amplifying the initial negative shock to the borrower. We show that banks and CLOs sell downgraded loans to mutual funds and hedge funds. The reallocation of loan shares favors the syndicate's concentration, increasing lenders' incentives to renegotiate. However, syndicates remain less concentrated when potential buyers experience financial constraints and subsequently loans are less likely to be amended and more likely to be downgraded even further. Our findings indicate that existing regulations may amplify shocks to credit quality during periods of generalized distress in the financial system.

We show that insurance companies have almost nonupled their investments in collateralized loan obligations (CLOs) in the post-crisis period, reaching total holdings of $125 billion in 2019. The growth in CLOs’ investments has far outpaced that of loans and corporate bonds, and was characterized by a strong preference for mezzanine tranches rated investment grade over triple-A rated tranches. We document that these phenomena reflect a search for yield behavior. Conditional on capital charges, insurance companies invest more heavily in bonds and CLO tranches with higher yields. Preferences for CLO tranches derived from tranches’ higher yields relative to bonds with the same rating, and increased following the 2010 capital regulatory reform, resulting in insurance companies holding more than 40 percent of mezzanine tranches outstanding in 2019. In the process, insurance companies created the demand for the risky tranches that are critical to the CLO issuance.

Even before the coronavirus plunged the world's financial markets, analysts and regulators had been describing the $1.2 to 1.5 trillion leveraged loan market as a ticking time bomb likely to play a role in causing the next financial crisis. Many have been denouncing problematic fundamentals in the current leveraged loan market and comparing them to those that caused the 2007 subprime mortgage crisis to spread into a full-blown financial crisis towards the second half of 2008. Two legal innovations in the world of corporate finance are the main anticipated culprits of a future financial meltdown: covenant-lite (or “cov-lite”) loans and Collateralized Loan Obligations (CLOs). Our paper argues that concerns of a systemic breakdown in the financial system as a result of cov-lite loans and CLOs may be overstated. To do this, we first draw from a seminal working paper by researchers at the Federal Reserve of Philadelphia that demonstrate that cov-lite loans are almost universally part of a syndication structure that binds borrowers to compliance with financial covenants. Secondly, the paper succinctly explains CLOs and compares them with similar structured finance and securitization products, such as Collateralized Debt Obligations (CDOs), CDO-squared and CDO-cubed, as well as with derivatives, such as synthetic CDOs and Credit Default Swaps (CDSs), all of which played a role in obscuring financial market fundamentals in the lead-up to the great financial crisis. Third, the paper briefly analyzes the latest stress test results and financial stability reports by regulators in charge of monitoring systemic risk in the banking and wider financial systems. Finally, the paper explores EBITDA add-backs, a product of contract law and accounting that have played an increasing role in large Leveraged Buyout (LBO) deals and could distort a lender's credit monitoring functions, but concludes that they are currently ignored in the ratings analysis of leveraged loans and CLOs.

We show that the largest U.S. life insurers entered corporate loan markets as banks refocused on commercial banking from 2009, against a backdrop of unconventional monetary policies and tighter bank regulations. Through complex on- and off-balance sheet arrangements, these insurers, many of whom are controlled by private equity firms, are acquiring and deploying vast amounts of insurance liabilities to fill the void left by banks. Using the COVID-19 pandemic, we show that life insurers have become more vulnerable to an aggregate shock to the corporate sector and disproportionately benefited from the Fed response to the pandemic.

We build a benchmark for AAA-rated tranches of Collateralized Loan Obligations (CLOs) using Business Development Companies (BDCs), which hold a diversified portfolio of loans as CLOs do. However, BDCs are publicly listed, and their share price, equity volatility and borrowing cost are observable. Furthermore, BDCs' debt is not rated as AAA. Applying a structural model to BDCs, we extract market-implied correlation in their loan portfolio, compare spreads on CLO tranches and BDC-implied benchmark, and find that observed large credit spreads on CLO senior tranches after the financial crisis are a fair reflection of the systematic risk of correlated loan defaults.

Traditional liquidity measures can provide a false impression of the liquidity and stability of financial market trading. Using data on auctions (bids wanted in competition; BWICs) from the collateralized loan obligation (CLO) market, we show that a standard measure of liquidity, the effective bid-ask spread, dramatically underestimates the true cost of immediacy because it does not account for failed attempts to trade. The true cost of immediacy is substantially higher than the observed costs for successful BWICs. This cost gap is higher in lower-rated CLOs and stressful market conditions when failure rates exceed 50%. Across our 2012-2020 sample period for trades in senior CLOs, the observed cost is four basis points (bps) while the true cost of immediacy is 13bps. In stressful periods, such as the COVID-19 pandemic, for junior tranches the observed cost of trading increases from an average of 12bps to 25bps while the true cost of immediacy increases from less than 3% to almost 15%.

Using detailed loan holding data of Collateralized Loan Obligations (CLOs), we document empirical evidence for systemic risk due to leverage constraints on CLOs. Constrained CLOs fire sell loans downgraded to CCC or below, and thus loans widely held by constrained CLOs experience temporarily lower prices. This instability is exacerbated over time. As the CLO market grows, each CLO's effort to diversify its portfolio leads to similarity in loan holdings among CLOs, such that their leverage constraint binds simultaneously. CLOs' overlapping loan holdings transform idiosyncratic credit risk of large borrowers to systemic risk in the leveraged loan market.

Financial institutions constitute an increasingly important cornerstone of capital markets, yet research at the intersection of asset management contracts and asset pricing is sparse. In this paper, I study the externalities of Collateralized Loan Obligation (CLO) contracts on asset prices. The trading behavior of CLO managers generates price pressure for distressed loans around bankruptcy defaults, introducing fire sale risk. This behavior is driven mainly by covenant considerations. CLOs operating closest to their capital constraints experience significantly lower cumulative returns relative to unconstrained CLOs. Hence, this work demonstrates how CLO covenants interact with managerial incentives in the provision of credit.

The Covid-19 health crisis has dramatically affected just about every aspect of the economy, including the transition from a record long benign credit cycle to a stressed one, with still uncertain dimensions This paper seeks to assess the credit climate from just before the unexpected global health crisis catalyst to its immediate and extended impact We analyze the performance of several key indicators of the nature of credit cycles: default and recovery rates on high-yield bonds, and the number of large firm bankruptcies that we expect over the next twelve months and beyond;yield spreads and distress ratios;and liquidity Our focus is primarily on the nonfi-nancial corporate debt market in the United States, which reached a record percent-age of gross domestic product at the end of 2019 as firms increased their debt to take advantage of record low interest rates, and investor appetite grew for higher promised yields on risky fixed-income assets We also examine the leveraged loan and collater-alized loan obligation markets, as well as the increasingly large and important BBB tranche of the corporate bond market Specifically, we discuss the latter’s vulnerabil-ity to downgrades over the expected downturn in the real economy and this vulnera-bility’s potential impact on expected default rates by “crowding out” low-quality debt of other firms (some of which we believe are “zombies”) Using Z-scores for a sample of BBB companies between 2007 and 2019, we analyze this largest component of the corporate bond market to provide some evidence on the controversial debate as to whether there has been ratings inflation or, perhaps, persistent overvaluation of the nonfinancial corporate debt market since the last financial crisis © 2020 Infopro Digital Risk (IP) Limited

This paper provides a dissection of the Collateralized Loan Obligation (CLO) market and examines the significance of covenants in facilitating the provision of credit. Since the Great Financial Crisis of 2008, the leveraged loan market has witnessed unprecedented growth. CLOs play an increasingly central role in the provision of credit to corporations, holding as much as 75% of all new institutional leveraged loans, as reported in 2019. The rise of the leveraged loan and CLO markets have attracted the attention of central banks which have been concerned with both the growth of the market and the opaque nature of interconnections between intermediaries, leveraged borrowers, and investors. Despite their increasing importance, little is understood about CLO intermediaries. In this paper, I describe the agency frictions inherent in the CLO market, and discuss how optimal contracts are derived with covenants that curtail such frictions. In addition, I describe the general macroeconomic milieu that has facilitated the rapid growth of the CLO market as well as recent changes that have developed. Understanding the structural aspects and dynamics of CLOs intermediaries, situated between investors and loan syndicates, is paramount for analysis of the innards of the market, the role of covenants, and developing insights into the shadow banking sector as well as other securitizations.

The economic downturn caused by the Covid-19 pandemic accentuates extant concerns about the leveraged loan market. Using a novel dataset, we show that leveraged loan spreads have declined for nonbank-facilities since the introduction of the Interagency Guidance on Leveraged Lending (IGLL) and the ensuing “frequently asked questions for implementing the March 2013 guidance”. The decline in leveraged loan spreads is significant for highly leveraged borrowers, especially when involving term loans. We further demonstrate that risk shifting issues associated with the high level of Collateralized Loan Obligations issuance strongly explain the decline of nonbank leveraged loan spreads. In addition, a higher degree of information asymmetry, driven by an increase in covenant-lite loan issuance and weaker investor protection, are strongly associated with the narrowed leverage risk premium.

We examine whether syndicated loans securitized through Collateralized Loan Obligations (CLOs) have more standardized financial covenants. We proxy for the standardization of covenants using the textual similarity of their contractual definitions. We find that securitized loans are associated with higher covenant standardization than non-securitized institutional loans. In addition, we show that CLOs with more diverse or frequently rebalanced portfolios are more likely to purchase loans with standardized covenants, potentially because standardization alleviates information processing costs related to loan monitoring and screening. We also document that covenant standardization is associated with greater loan and CLO note rating agreement between credit rating agencies, further supporting the relation between lower information costs and covenant standardization. Overall, our study provides evidence that loan securitization is related to the design of standardized financial covenants.

This paper studies the vulnerability arising from the corporate loan holdings of collateralized loan obligations (CLOs) using a network reconstruction method and stress tests. Because of the portfolio diversification requirement imposed on the management of CLOs, some corporate loans are held by multiple CLOs. This commonality of corporate loans among CLO portfolios suggests the possibility that the diversification of risk in each CLO is not as high as it may appear from the perspective of the entire market. Stress tests show that portfolio diversification of securitization as observed in the CLO loan holdings is not necessarily effective in enhancing system-wide robustness against the idiosyncratic defaults of the underlying assets.

During the 2010s, collateralized loan obligations rapidly became a trillion-dollar industry, mirroring the growth profile and peak value of its cousin—collateralized debt obligations—in the 2000s. Yet, despite similarities in product form and growth trajectory, surprisingly little is known about how these markets evolved spatially and relationally. This paper fills that knowledge gap by asking two questions: how did each network adapt to achieve scale at speed across different jurisdictions; and to what extent does the spatial and relational organization of today's collateralized loan obligation structuration network, mirror that of collateralized debt obligations pre-crisis? To answer those questions, we draw on the global financial networks approach, developing our own concept of the networked product to explore the agentic qualities of collateralized debt obligations and collateralized loan obligations—specifically how their technical and regulatory “needs” shape the roles and jurisdictions enrolled in a global financial network. We use social network analysis to map and analyze the evolving spatial and relational organization that nurtured this growth, drawing on data harvested from offering circulars. We find that collateralized debt obligations spread from the US to Europe through a process of transduplication—that similar role-based network relations were reproduced from one regulatory regime to another. We also find a strong correlation between pre-crisis collateralized debt obligation- and post-crisis collateralized loan obligation-global financial networks in both US$- and €-denominations, with often the same network participants involved in each. We conclude by reflecting on the prosaic way financial markets for ostensibly complex products reproduce and the capacity for network stabilities to produce market instabilities., During the 2010s, collateralized loan obligations rapidly became a trillion-dollar industry, mirroring the growth profile and peak value of its cousin - collateralized debt obligations - in the 2000s. Yet, despite similarities in product form and growth trajectory, surprisingly little is known about how these markets evolved spatially and relationally. This paper fills that knowledge gap by asking two questions: how did each network adapt to achieve scale at speed across different jurisdictions; and to what extent does the spatial and relational organization of today's collateralized loan obligation structuration network, mirror that of collateralized debt obligations pre-crisis? To answer those questions, we draw on the global financial networks approach, developing our own concept of the networked product to explore the agentic qualities of collateralized debt obligations and collateralized loan obligations—specifically how their technical and regulatory “needs” shape the roles and jurisdictions enrolled in a global financial network. We use social network analysis to map and analyze the evolving spatial and relational organization that nurtured this growth, drawing on data harvested from offering circulars. We find that collateralized debt obligations sprad from the US to Europe through a process of transduplication - that role-based network relations were reproduced from one regulatory regime to another. We also find a strong correlation between pre-crisis collateralized debt obligation- and post-crisis collateralized loan obligation-global financial networks in both US$- and €-denominations, with often the same network participants involved in each. We conclude by reflecting on the prosaic way financial markets for ostensibly complex products reproduce and the capacity for network stabilities to produce market instabilities.

Collateralized debt obligations (CDOs) are structured products that are issued by a special purpose vehicle with the objective of improving the issuer’s balance sheet, increasing access to illiquid securities, and/or generating a higher yield than would be offered in a traditional fixed income security. This chapter provides an overview of CDOs including a discussion on the history, structure, uses, and impact on investors and the broader financial system. CDOs can be further classified by the type of security held as collateral, such as collateralized bond obligations (CBOs), which typically hold high yield debt, and collateralized loan obligations (CLOs), which hold bank loans. These financial structured products gain notoriety for their role in the financial crisis of 2007–2008 and have since declined in popularity. Despite the negative perception that CDOs carry, securitization continues to play an important function in the financial system and offers benefits to issuers and consumers as long as both parties use the end product responsibly.

This paper investigates whether the type of institutional affiliation of a collateralized loan obligation (CLO) manager influences the manager’s access to information and risk appetite. We base our investigation on CLO managers’ trading of distressed loans. Our findings reveal that CLO managers affiliated with banks start to sell off their positions in loans arranged by their bank well before the onset of default and continue to do so even after default. In contrast, CLO managers affiliated with nonbanks do not lower their credit exposures to distressed loans. These findings are consistent with bank-affiliated CLO managers having access to private information but also being more concerned to mitigate the reputational risk exposure of their banking organization. On close inspection, we find that reputational concerns are a significant factor in the decision to divest defaulted loans. Although the value of private information after default is moot, we find that bank-affiliated CLO managers are significantly more averse to holding their own arranged problem loans than holding distressed loans arranged by unaffiliated banks. Besides helping us understand CLO managers’ trading activities, our findings also highlight a potential limit to banks’ ability to originate loans and distribute them via their affiliated CLOs.

Structured products like collateralized loan obligations (CLOs) tend to offer significantly higher yield spreads than corporate bonds with the same rating. At the same time, empirical evidence does not indicate that this higher yield is reduced by higher default losses of CLOs. The evidence thus suggests that CLOs offer higher expected returns compared to corporate bonds with similar credit risk. This study aims to analyze whether this return difference is captured by asset pricing factors. We show that market risk is the predominant risk factor for both corporate bonds and CLOs. CLO investors, however, additionally demand a premium for their risk exposure towards systemic risk. This premium is inversely related to the rating class of the CLO.

The US bond market had over $42.39 trillion of outstanding debt at the end of the third quarter of 2018, eclipsing the US stock market’s approximately $30 trillion in market capitalization. The sheer size of the bond market provides ample opportunities, as well as risks, for institutional investors. Some of these risks escape investors’ radar because of the nature of fixed-income securities: low transparency, illiquidity, and over-the-counter (OTC) trading. In this paper, we present our concerns regarding five secular changes brought up by the over-regulation of the marketplace after the financial crisis of 2008 and investors’ persistent thirst for yield. Further, while painful lessons were gleaned after the punishing 2008 financial crisis, we present empirical evidence that suggests that many sectors, such as the auto loans and collateralized loan obligations, that were largely unscathed by this crisis may be at risk in the next downturn. This paper is based on original data sources and academic research. The authors are in continuing dialogue with other experts that may further the research, and welcome interested parties to get in contact.

Securitization by collateralized loan obligations (CLOs) is a key source of capital for the corporate loan market. We investigate whether access to CLO market has implications for lenders' ability to overcome an idiosyncratic shock. We find that WorldCom's lenders with a direct access to the CLO market increased the origination of facilities that are securitizable (Term B) by 11% compared to the other WorldCom lenders when they are shocked by WorldCom’s collapse. Together with the evidence of an increase in CLO issuance after the shock, our results suggest that securitization is actively used for lenders' risk management. The results hold in various robustness tests, including a triple-differences approach.

We investigate the relation between portfolio constraints (tests) that Collateralized Loan Obligations (CLOs) have to pass monthly, CLO managers’ loan trading choices and CLO equity returns. We find that stringent portfolio constraints are positively associated with the influence of CLO junior noteholders and tight CLO market conditions. We document that CLOs with restrictive tests have higher portfolio turnover, rebalancing and diversification, and hold loans for shorter periods, suggesting that managers of constrained CLOs actively administer loan portfolios to alleviate credit losses and costly test violations. We further show that managers of constrained CLOs respond to borrower news differently by trading loans to avoid reporting credit losses and to comply with the CLO tests rather than to generate profits from trading. Last, we examine the economic effects of restrictive portfolio tests and find that these constraints are associated with lower CLO equity returns. Our evidence supports the argument that portfolio constraints lead to divergent trading choices and ultimately to different levels of CLO performance.

Risk is building in the leveraged loan and collateralized loan obligation (“CLO”) markets. These two markets are connected: leveraged loans are being repackaged into CLOs just as mortgages and mortgage-backed securities were used to create collateralized debt obligations (“CDOs”), the financial products at the heart of the financial crisis 11 years ago. There are important differences but also troubling parallels between the leveraged loan/CLO markets and the earlier mortgage/CDO markets. One alarming similarity is the decline in leveraged loan underwriting standards: the market is now dominated by “covenant-lite loans.” Covenant-lite loans permit greater leverage by borrowers and remove an early warning system for lenders. Purchases of CLOs by banks and other regulated financial institutions made in order to game crucial regulatory capital requirements (“regulatory capital arbitrage”) remain a significant concern . Like mortgages and CDOs, leveraged loans and CLOs form a pipeline or system. Disruptions at either end of the system can cause financial havoc on the other end and then ricochet back. This is akin to a coiled spring or “crisis accordion.” Losses or disruptions in the leveraged loan/CLO markets, even if they do not approach the levels of mortgages/CDOs in the global financial crisis could still be significant, e.g., amplifying a recession. We should be humble about our ability to predict the upper bound of financial market disruptions or crises. Some tranches of CLO securities appear not to trade actively. Many CLO securities trade on opaque markets lacking transparent prices. A lack of trading of CLO securities undermines the economic rationale of these securities, as well as their safety and favorable regulatory treatment. A lack of transparent prices means that neither the marketplace nor regulators can rely on prices to police risk-taking in the CLO market. Regulators must monitor and analyze data on leveraged loans and CLO markets. The OFR needs cooperation from other financial regulators in assessing risk in these markets. Lack of data sharing among financial regulators remains a crucial weakness. The OFR needs an independent source of funding. Regulators need minimum standards in their examinations with respect to assessing bank exposure to leveraged loans. I also recommend: - Stress testing of financial markets, not just individual institutions; - Requiring financial regulators to conduct war games to prepare for market disruptions; - Underscoring that the burden is on financial institutions to prove that leveraged loans and CLOs are safe rather than on regulators to prove that they are unsafe. If data gathering reveals significant systemic risk in leveraged lending/CLO markets, regulators should use a mix of tools, including limiting bank investments in CLOs, enhanced and countercyclical capital requirements, and the Volcker Rule “covered funds” provisions.

In this paper, we empirically explore the effect of the complexity of a security’s design on hypotheses relating to credit rating shopping and rating catering in the collateralized loan obligation (CLO) market in the period before and after the global financial crisis in 2007. We find that complexity of a CLO’s design is an important factor in explaining the likelihood that market participants display behaviors consistent with either rating shopping or rating catering. In the period prior to 2007, we observe for more complex CLOs a higher incidence of dual-rated tranches, which are more likely to have been catered by credit rating agencies to match each other. Conversely, in the period after 2007, for CLOs, it is more likely that issuers shopped for ratings, in particular opting for a single credit rating by Moody’s, not by S&P. Furthermore, contrary to what market participants might expect, investors do not value dual ratings more than single ratings in the determination of the offering yield at issuance. Looking at the explanatory power of credit ratings for a dual rated CLO, the degree to which investors increase their reliance on credit ratings depends to a large extent on the disclosure of an S&P rating, not Moody’s. This suggests that investors recognize credit rating risk by agency in pricing CLOs. In sum, the policy implication is that, to effectively regulate CLOs, the regulatory environment ought to differentiate between complex and non-complex CLOs.

In this paper, we empirically explore the effect of the complexity of a security’s design on hypotheses relating to credit rating shopping and rating catering in the collateralized loan obligation (CLO) market in the period before and after the global financial crisis in 2007. We find that complexity of a CLO’s design is an important factor in explaining the likelihood that market participants display behaviors consistent with either rating shopping or rating catering. In the period prior to 2007, we observe for more complex CLOs a higher incidence of dual-rated tranches, which are more likely to have been catered by credit rating agencies to match each other. Conversely, in the period after 2007, for CLOs, it is more likely that issuers shopped for ratings, in particular opting for a single credit rating by Moody’s, not by S&P. Furthermore, contrary to what market participants might expect, investors do not value dual ratings more than single ratings in the determination of the offering yield at issuance. Looking at the explanatory power of credit ratings for a dual rated CLO, the degree to which investors increase their reliance on credit ratings depends to a large extent on the disclosure of an S&P rating, not Moody’s. This suggests that investors recognize credit rating risk by agency in pricing CLOs. In sum, the policy implication is that, to effectively regulate CLOs, the regulatory environment ought to differentiate between complex and non-complex CLOs.

Collateralized loan obligation transactions (CLOs) in the United States have proved a resilient investment product, having survived the financial crisis virtually unscathed. Since 2011, there has been a revival in the United States of offerings of CLOs. But U.S. CLOs have gone through many changes since the financial crisis both in direct response to the aftermath of the financial crisis and in response to new regulations. This article examines the changes in CLO structures and documentation since the financial crisis—general improvements in CLO indentures, adjustments in response to the Volcker Rule, as well as changes to comply with risk retention regulations.