CLO (Collateralized Loan Obligation) Market and Corporate Lending

• Published date: 01 August 2023
• Author: ANGELA GALLO,MIN PARK
• Date: 01 August 2023
• DOI: http://doi.org/10.1111/jmcb.12941

DOI: 10.1111/jmcb.12941

ANGELA GALLO

MIN PARK

CLO (Collateralized Loan Obligation) Market and

Corporate Lending

We investigate whether access to the collateralized loan obligation (CLO)

market as collateral managers or underwriters affects lenders’ ability to

overcome an idiosyncratic adverse shock in the corporate lending market.

In a triple difference-in-differences setting, we nd that lenders decrease

their origination of loans following a negative shock; however, those with

CLO access become more likely to arrange deals with securitizable facil-

ities (Term B). Moreover, they choose to arrange deals with smaller size

on-balance-sheet lending (Term A). The results suggest that securitization

is actively used by lenders to switch to off-balance-sheet lending and to re-

duce the risk retained on the balance sheet.

JEL codes: G21, G23, G24

Keywords: structured nance, collateralized loan obligations (CLOs),

syndicated loans

S     loan

obligation (CLO) structures is a key source of funding for the corporate lending

market. In contrast to other securitization markets, the CLO market has now fully

We thank the editor Bob DeYoung and one anonymous referee for comments and suggestions. Weare

also grateful to Max Bruche, Bonnie Buchanan (discussant), Barbara Casu, Giacinta Cestone, Sergey Cher-

nenko, Andrew Ellul, Daniel Ferreira, Vasso Ioannidou, David Marques-Ibanez (discussant), Giacomo

Nocera (discussant), Tommaso Oliviero, Alberto Pozzolo, Francesc Rodriguez-Tous, Anthony Saunders

(discussant), Grzegorz Trojanowski (discussant), and David Yermack. The paper also benetted from the

helpful comments received from the participants of the Exeter Business School Research Days 2016, In-

ternational Risk Management Conference 2017, 1st Workshop on Banking and Entrepreneurial Finance

at Universidad Pablo de Olavide, 2nd Conference on Contemporary Issues in Banking, FMA European

Conference 2018, EFMA Conference 2018, Manchester Annual Corporate Finance Conference 2018, and

27th Finance Forum, Madrid. All errors remain our own. Declarations of interest: none.

A G is a Senior Lecturer (Associate Professor) in Finance,Bayes Business School, United

Kingdom, London, 106 Bunhill Row, United Kingdom EC1Y 8TZ (E-mail: angela.gallo.1@city.ac.uk).

M P is a Lecturer (Assistant Professor) in Finance,University of Bristol, BS8 1PQ, Bristol, 15-19

Tyndalls ParkRoad, United Kingdom (E-mail: min.park@bristol.ac.uk).

Received July 20, 2020; and accepted in revised form March 15, 2022.

Journal of Money, Credit and Banking, Vol. 55, No. 5 (August 2023)

© 2022 The Authors. Journal of Money, Credit and Banking published by Wiley Periodicals

LLC on behalf of Ohio State University.

This is an open access article under the terms of the Creative Commons Attribution License,

which permits use, distribution and reproduction in any medium, provided the original work

is properly cited.

1078 :MONEY,CREDIT AND BANKING

recovered from the shock of the 2008 nancial crisis, reaching its highest level since

its peak at $256 billion in September 2008, becoming the dominant institutional

investor of syndicated loans. In 2018, CLO security issuance in the United States

amounted to $125 billion, with the total size of the CLO market estimated at $600

billion.1The well-established role of CLOs in the credit market is also conrmed by

the recent pandemic. After an initial sell-off in March 2020, the CLO market is re-

covering, supported by an even stronger demand for AAA-rated securities. Despite

this widespread use of CLOs and concerns about nancial stability, many aspects of

this market have received little attention so far.2

Similar to other securitizations, CLOs help banks securitize loans—typically, large

corporate loans—off their balance sheets into a special-purpose vehicle (SPV). De-

spite the traditional view that banks retain the majority of the loans they originate, the

adoption of the originate-to-distribute model is widespread, as an increasingly larger

share is originated to be sold or transferred to off-balance-sheet entities (see Bord and

Santos 2012, Buchak et al. 2018, Blickle et al. 2020, Irani et al. 2020). Recently, the

CLO market has become a preferred venue for distributing corporate loans that are

originated by banks, which suggests that access to this market may be valuable when

banks experience an adverse idiosyncratic shock. The literature on securitization has

generally demonstrated the positive effect of securitization on banks’ ability to lend

by ofoading risk from banks’ balance sheet and relaxing capital constraints.

However,there is still a lack of understanding of whether and how banks’ response

to an adverse idiosyncratic shock interacts with their ability to access the securiti-

zation market. Financial intermediaries adjust their lending activity in response to

shocks depending on key attributes of banks’ balance sheet characteristics, such as

equity (loss-absorbing capacity), leverage (acting as a constraint imposed by credi-

tors), and their funding sources (Shin 2009). Moreover, banks have lending capacity

constraints imposed by regulatory capital requirements, which limit the amount of

risk they can take on their balance sheets. Therefore, a shock to the equity represents

a challenge for banks that must remain compliant with minimum capital requirements

and/or should remain capitalized in line with their peers to avoid the related costs of

increased solvency risk (i.e., higher cost of nancing, more supervision, etc.). Ex-

tensive literature has provided support for banks’ reduced lending as a deleveraging

response to a negative exogenous shock on their capital (e.g., Bernanke and Lown

1991, Peek and Rosengren 1995). Similarly, more recent literature has shown the

impact of the Great Financial Crisis and of more stringent capital requirements on

1. Many of the most dramatic losses announced by large nancial intermediaries during 2007 and

2008 were linked to collateralized debt obligation (CDO); meanwhile, CLO-structured loans showedlower

loss rates and more stable ratings than comparable securitized products and corporate bonds. AAA- and

AA-rated CLO tranches have never experienced a default or loss of principal, not even during the nan-

cial crisis.

2. The contributions of most recent research have been focused on the internal dynamics of the CLO

structure, such as their trading, the use of nancial covenants, the effect of portfolio constraints, and per-

formance manipulation (Bozanic, Loumioti, and Vasvari2018, Loumioti and Vasvari 2019, Peristiani and

Santos 2019).

ANGELA GALLO AND MIN PARK :1079

lending (e.g., Gambacorta and Marques-Ibanez 2011, Chu, Zhang, and Zhao 2019,

for the implications in the syndicated loan market).

In this paper, we explore howbanks’ access to t he securitization markethelps them

to manage their capital requirements under a negative shock, focusing on the demise

of WorldCom in 2002—one of the largest bankruptcies in U.S. history—following

Lin and Paravisini (2012). We use WorldCom’s failure as an adverse shock to the

equity capital of WorldCom’s lenders that makes the capital constraints more binding

than before and thus reduces the amount of risk that can be taken unless accompanied

by an increase in equity capital. At the same time, we predict that, among the shocked

WorldCom lenders, those acting as underwriters or collateral managers of CLOs will

have direct access to securitization. This CLO access should allow them to deleverage

and relax the more binding capital constraints caused by the shock, leading them to

arrange deals with a more limited impact on their capital requirements, that is, deals

that contain securitizable facilities. Syndicated corporate deals typically contain one

or all of the following types of facilities with different features: revolving, Term A

and Term B. Revolving facilities are credit lines, meaning that a certain amount of

liquidity must be made available to corporate borrowers upon request. In contrast,

Term A and Term B facilities are standard long-term loans of xed amount and set

schedule. The key difference is that TermB are facilities structured specically for—

and sold to—institutional investors, such as CLO and structured nance vehicles,

whereas Term A is typically retained on the balance sheet.3Our main hypothesis is

that lenders with direct access to the CLO market will be more likely to arrange deals

that contain facilities that can be easily securitized (i.e., Term B) and also choose to

originate relatively smaller amortizing loan facilities (Term A) that will typically be

retained by the lender.

An alternative response would be to raise additional funds on the market via new

equity issuance instead of depending on the deleveraging strategy via securitization.

However,Lin and Paravisini (2012) showed that the market reactions to WorldCom’s

failure were severe, constituting a drop of approximately 10% in market-adjusted

returns relative to nonexposed banks. The magnitude of the market reaction is only

partial evidence of lenders’ direct exposure to the shock because it is inuenced by

many other factors that are not mutually exclusive, including reputational costs and

adjustments in monitoring technology (Lin and Paravisini 2012). Although various

tests are provided in the paper to assess the inuence of lenders’ exposure to the

WorldCom shock on their ability to lend, the stock reaction suggests that the market

conditions were not favorable for equity issuance by affected banks. Furthermore,

equity issuance also carries dilution issues (see Goetz, Laeven, and Levine 2021).

Another alternative to deleveraging via securitization on the lending side may be

loan sales, that is, selling existing and performing loans to third-party investors.How-

ever, loan sales to a third party are accompanied by several disadvantages relative to

3. If a deal contains only rst long-term facility, it is simply called a “TermLoan,” instead of “Term

A.”