II. Asset-backed securitisation--motivation and advantages of collateralised debt obligations (CDOs).

Author:Jobst, Andreas A.
Position:Collateralised Loan Obligations (CLOs
 
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The development of CDOs is closely associated with imperfections in capital markets, the management of credit risk exposure, the acquisition of an alternative method of asset funding and the illiquidity of asset claims held by banks due to an inherent absence of transparency. While securitisation is not an omnipotent antidote to remedy all these shortcomings and frictions in capital markets, it serves as a flexible vehicle to mitigate the efficiency reducing effect of these factors through a creative application of structured finance via a reduction in regulatory capital or an improvement of asset liquidity. Otherwise, the presence of perfect information would render obsolete the benefits gained from CDOs as the administrative cost of structuring and marketing such a securitisation transaction would have no counterbalancing benefit.

These benefits from the securitisation of bonds and bank loans have resulted in different forms of CDO structures in the bid to eradicate allocational inefficiencies emanating from certain properties of bonds and bank loans. An arbitrage CDO (see Exhibit 5) is a popular form of securitisation structure undertaken by investment banks to capture pricing differences between the acquisition cost of collateral assets in the secondary market and their aggregate valuation when bundled in a reference portfolio underlying the sale of the associated CDO structure. An arbitrage CDO will be undertaken once netting this marginal pricing difference by management fees yields profit. This arbitrage incentive applies to debt securities whose securitisation has either a cash flow or market-value structure. While an arbitrage CDO suggests mispricing in imperfect capital markets, a balance sheet CDO specifically aims to remove performing loans from the balance sheet in order to provide capital relief by reducing minimum capital requirements on credit risk exposure through a subsequent securitisation. Duffle and Garleanu (2001) point out that such securitisation might also increase the valuation of the assets through a possible increase of liquidity. If the collateral portfolio of this asset-backed securitisation is made up of corporate and/or sovereign loans, such a balance sheet CDO is called a collateralised loan obligation (CLO), i.e. the securitisation of corporate and sovereign loans (Eck, 1998; Kohler, 1998). Conversely, this means that we do not observe an arbitrage CDO structure in combination with an underlying reference portfolio made up of loans.

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Issuers administer most CLO transactions--as a subset of CDOs--in order to release risk-based capital and improve regulatory capital ratios rather than to make most efficient use of their capital. Such restructuring frequently allows the issuer to adjust the composition of the loan book, for example the granularity of debtors and credit risk concentrations. Unfortunately, large credit portfolios with a substantial degree of illiquidity defy an outright loan sale as banks incur substantial cost in negotiating technical details of internal credit risk assessments, barring any irritation in the client relationship due to changes in loan servicing.

In CLO transactions issuers combine a selection of loans of similar characteristics to create credit-enhanced claims (see section V) against the cash flow proceeds originating from this loan portfolio, which are sold as securities to investors. Since investors in a CLO transaction acquire a claim on the cash flow generated from a collateral pool, a loan securitisation provides a contractual repartition of the interest (transmission mechanism) generated from underlying loans, i.e. interest income and repayments of principal are allocated to prioritised tranches of securities. Credit losses from possible loan default are first assigned to the most junior claimants of the collateral portfolio before senior claimants are affected. Both interest and losses are allotted according...

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