What Is a Collateralized Loan Obligation?

A collateralized loan obligation (CLO) is a type of special purpose vehicle that splits the risk of making a loan among a number of financial parties. The lender divides the loan into tranches, which are small slices of the overall loan. The tranches are then sold to investors and companies as a type of security. These companies have priorities on the debt based on the size or order of their respective tranches. If the loan goes into default, the businesses who have purchased the tranches lose money, while the lender loses nothing.

Structure of a CLO

A CLO is one of many types of collateralized debts sold as assets on the secondary loan market. The basic structure is the same across the multiple variations of these debts, including collateralized mortgage obligations. The lender initially assumes a high degree of risk by writing the loan. As investors step in and purchase parts of the loan, the lender assumes a lower and lower risk. Eventually, if the entire loan is purchased through tranches, the lender has no remaining risk in the loan. However, each individual or business who holds a tranche has a part of the risk.

CLOs and Systemic Risk

CLOs gained a bad reputation after the market crash of 2007. The process of divvying up loans, rather than reducing risk, simply spread the risk further throughout the market. Today, the term "systemic risk" is well-known as a way to describe the domino effect that can take place when one loan goes bad. Each of the investors in the loan loses money. On a large mortgage portfolio when a number of loans default at once, the investors in the portfolio can suffer a crippling loss. This is precisely what happened in 2007. Defaults began to occur at a very high ratio, and shortly thereafter, institutional investors across the board saw unprecedented losses to their portfolios. 

Curbing Systemic Risk

In response to the CLO and systemic risk crisis of 2007, new financial regulations govern the divvying up of loans into smaller portions. Namely, a number of financial institutions are prohibited from investing in CLO portfolios. Further, lenders must make disclosures about the risk of a loan prior to offering tranches in the loan for sale. For example, a sub-prime loan should not be offered as a low-risk investment when the lender feels there is a relatively high chance the loan will move into default. 

CLOs and the Borrower

If your loan was sold off as a CLO, you will have no real impact as a borrower. You will make payments to the initial lender. It is the lender's responsibility to pay the investors. The only challenge may come if the lender goes out of business. In this case, the loans the lender is collecting will be purchased by a new finance company. This company will have the responsibility of paying owners of any tranches when you make payments on your loan. If there is a delay before a new owner purchases the loan, the investors will lose money, but the borrower is not responsible for paying them directly.

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