Creditflux Newsletter

CLOs are a side stream of the securitisation market – and they carry its pollution. Everything about these products reeks of structured finance. 

They have bizarre names like ABC CLO Series 2006-7a, which are designed to reassure fixed income investors that they are routine repackagings. They share the securitisation market’s fixation on ratings and on reducing complex credit risk to the short-hand of double and single Bs. And their creators spent most of the past 10 years on the fringes of big securitisation conferences in Orlando and Barcelona, sipping securitisation champagne.

In the early days, the fact that their products looked like securitisations was a boon to CBO and CLO originators, who needed to shift industrial quantities of debt, and who therefore needed big buyers, like insurance companies and treasury desks. Looking like an auto securitisation and having a name like a collateralised mortgage obligation helped to get deals nodded through investment committees.

But resembling a securitisation no longer carries the same advantages. In hindsight, CLOs should have been more distinctive. The senior managers of German insurance companies and Japanese banks do not sleep easy owning a product that has two out of three letters in common with a subprime-laden CDO. Who can blame them? It’s no surprise that, in the crisis, investors dumped their CLOs in droves.

Now, the CLO market faces a different problem. Regulators have decided that CLOs must be regulated like a securitisations. And that means addressing their big worry about securitisation, which stems from the sub-prime boom and bust: that it leads to feeble underwriting. To stop that, regulators in the US and Europe have decreed that banks that use securitisation should retain some risk.

CLO market practitioners may howl that their product doesn’t work like that. They can shout until they are hoarse that CLO assets are chosen by a manager whose interests are aligned with investors and not by some distant originate-and-distribute bank. But they shouldn’t be surprised if regulators ignore them. We all helped make the CLO look like a securitisation, and this problem is the natural consequence of that decision.

A CLO’s role is to take capital from investors seeking equity-like returns and from those seeking a safe, liquid home for their savings, and to pour these two tributaries into a river of corporate lending. There is a pressing need for this river in a world with a dysfunctional banking system. The structure has, after all, been tested in the most adverse conditions imaginable and passed with flying colours. And the phenomenal response from investors to the launch of Creditflux’s CLO Symposium in May suggests that there is resurgent investor appetite for these products.

But we should resist the complacent belief that CLOs are the only form of credit river we need. Other methods of channelling capital into credit are emerging. One is the return of business development companies in the US. There are also a growing number of lightly leveraged funds and managed accounts that target high yield bonds and loans.

Now is the time to think creatively of further ways to get the credit flowing, in ways that follow the spirit of the regulatory revolution now underway.

Our guest columnist Joe Pimbley suggests one novel idea, putting forward the concept of “covered CLOs” (see page 11). Perhaps speakers at the forthcoming symposium will come up with other bold products that could meet the needs of both investors and corporate borrowers.