I. Introduction.

Author:Jobst, Andreas A.
Position:Collateralised Loan Obligations (CLOs

In the lexicon of previous decades financial intermediation occurred when banks and non-bank financial institutions, such as insurance companies, accepted funds from depositors or other investors and channelled these funds at some margin to businesses and households by means of lending. Originators of loans used to hold such loans on the books until these asset claims matured, rolled over or terminated once debtors went insolvent. The corresponding credit risk was the prime focus of banks and non-banks, which applied forecasting models to estimate the probability of incurring bad debt, whereas interest rate risk could be managed by ensuring that the contractual interest rate on the loan varied with the cost of funds.

Over the last two decades, however, non-bank financial service providers, such as investment banks, captive finance companies and insurance firms have posed a formidable challenge as contenders in the intermediation process, employing the same technological advances as banks. Since the 1980s important technological changes have been taking place in the "old-fashioned" business of financial intermediation. Chief among the innovations introduced at major banks has been securitisation, which--in a general sense--reflects the substitution of credit finance by capital market-based finance. Generally, securitisation represents a structured finance transaction, where receivables from a designated asset portfolio are sold as contingent claims on cash flows from repayment in the bid to increase the issuer's liquidity position and to support a broadening of lending business (refinancing) without increasing the capital base (funding motive). Aside from being a funding instrument, securitisation also serves (i) to reduce both economic cost of capital and regulatory minimum capital requirements as a balance sheet restructuring tool (regulatory and economic motive), (ii) to diversify asset exposures (especially interest rate risk and currency risk) as issuers repackage receivables into securitisable asset pools (collateral) underlying the so-called asset-backed securitisation (ABS) transactions (hedging motive).

Much attention has especially been devoted to asset-backed securitisation (ABS), i.e. the mechanism by which individual, illiquid financial assets are converted into tradable capital market debt instruments (The Bond Market Association, 2001). Asset-backed securitisation (ABS)--usually backed by a portfolio of a large number of homogenous receivables in terms of seasoning, nominal value and remaining maturity (sec Appendix 3 for a specific break-down of the securitisation process and its characteristics)--is an asset funding tool for financial institutions as a surrogate of deposit-based refinancing as well as a modern form of corporate finance as a substitute for classical credit. Particularly banks have embraced a new form of ABS, the collateralised loan obligation (CLO), as a means to curb credit risk by outright selling portions of a large loan portfolios to investors. In the conventional type of such transactions a portfolio of pre-selected loans is transferred from the balance sheet of the originator to a special purpose vehicle (SPV) (1), which refinances itself by issuing securities on this reference portfolio to capital markets at a margin (Burghardt, 2001) (2). Typically institutional investors are the prime investor group for such transactions. Besides the obvious benefit of improved credit risk management, CLOs enable issuers to achieve a broad range of financial goals, which include the off-balance sheet treatment of securitised loans, reduced minimum regulatory capital requirements and access to alternative sources for asset funding of lending activities and liquidity support.

The move towards such capital market-based investment funding is reducible to various causes. (3) First, recent financial crises have led to a general shortage of investment funds and heightened competition for low-risk borrowers. Second, the deregulation and liberalisation of international financial markets as well as technological advances have elevated market efficiency to a level amenable to two strands of asset securitisation. On the one hand, the issuing of debt securities by banks and...

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