This document discusses collateralized loan obligations (CLOs) and whether they pose risks to the financial system. It provides background on the 2008 financial crisis and post-crisis regulations. CLOs have grown significantly since the crisis while providing higher returns than other fixed income assets. However, there are concerns about deteriorating underwriting standards, increasing corporate debt levels, and shifts in the CLO investor base to less regulated entities. If an economic downturn occurred, losses on CLOs could have negative impacts on the financial system and real economy. Overall the document examines both sides of the CLO debate and whether they could potentially trigger the next crisis.

1. Are Collateralized
Loan Obligations
the ticking time
bomb that could
trigger the next
financial crisis?
By Kaan Sapanatan

2. Context
I. Newspaper Headlines
II. What has caused the financial crisis in 2008?
III. Post-Crisis measures taken to strengthen the Financial System
IV. Are all the risks mitigated or redirected?
V. What Are Collateralized Loan Obligations?
VI. Why are CLOs in the spotlight and what makes them so popular?
VII. Central Banks and IMF raising concerns?
VIII. This is how it works!
IX. Arguments for CLO’s and its inherent risk to the Economy
X. What is there to actually worry about? Part 1 - Underwriting Standards & Issuer Quality
XI. What is there to actually worry about? Part 2 - The size of the CLO Market & Type of Lenders
XII. What is there to actually worry about? Part 3 - Shift in Investor Base & Transparency Issues
XIII. What could go wrong?
XIV. Summary
XV. References
XVI. Disclaimer

4. What has caused the Financial Crisis in 2008?
 The 2008 crisis was the result of U.S. households
feasting on cheap credit to buy homes.
 The loans weren’t cheap because interest rates were
low—in fact they were higher compared to today—but
many mortgages were made with low introductory rates
for several years before resetting at much higher levels.
 That meant homeowners could refinance before the new
rates kicked in, thanks to the nonstop rise of home prices
as new buyers were constantly joining in the frenzy.  These Ponzi-like conditions created a giant
subprime-lending industry that persuaded millions
of people with bad credit or unstable incomes to
take on mortgages they couldn’t afford.
 When house prices stopped going up, it all
came crashing down.
 The harm caused by the housing bust was amplified
by the complicated securities that Wall Street
devised to package and repackage the loans, as
well as the derivatives bets made on them.
 Almost half of the costs were borne by European
institutions that had bought a lot of the securities.

5. Post-Crisis measures taken to strengthen the Financial System
The most important
change for banks has
been a sharp
increase in capital
requirements and
what qualifies as a
buffer against losses.
Banks Are Safer!
 The big banks have partially turned away from trading risky
structured products that few people can fathom and more
toward plain-vanilla banking functions such as lending to
companies and consumers.
 The relative shift has reduced the share of revenue garnered
from capital-markets trading at most of the biggest firms.
 The post-crisis capital regime and other regulations such as
the Volcker Rule, a key provision of the 2010 Dodd-Frank Act,
have contributed to this shift by discouraging risky trades.
Funding is more
stable. Half of the
short-term financing
that came from
overnight repurchase
agreements and other
shaky sources has
been replaced by
deposits—the stickiest
type, because they’re
backed by insurance.

6. Leverage Has Shifted from Households to Companies
The average debt-to-capital ratio of nonfinancial companies
in the S&P 500 Index had surged to 49 percent by the
end of June 2018 from 32 percent in 2006.
“The aggregate data probably understates the problem,”
said Phil Suttle, a former Bank of England economist.
“There are some companies flush with cash and very little
debt while others are up to their ears in it.”
Are all the risks mitigated or redirected?
 So perhaps it’s comforting that the biggest banks have lost their hold on
the riskiest type of lending in today’s market—leveraged loans.
 Hedge funds, smaller banks and broker-dealers with no banking
units filled the void.
 Jefferies Financial Group Inc., an independent brokerage whose market
share in leveraged loan underwriting was 0.07 percent in 2007, is now
among the top underwriters with 3 percent, according to Bloomberg data.
Well what is happening with all these leveraged loans…? Of course they are now being
packaged into collateralized loan obligations(CLO) and sold to investors. Sound familiar?
And this time its not the Banks that are lending

7. What Are Collateralized Loan Obligations?
A CLO is a type of structured credit
 A CLO is a portfolio of leveraged loans that is securitized and
managed as a fund. CLOs purchase a diverse pool of senior
secured bank loans made to businesses that are generally rated
below investment grade.
 First lien bank loans, which comprise the bulk of the underlying
collateral pool of a CLO, are secured by a debtor’s assets and rank
first in priority of payment in the capital structure in the event of
bankruptcy, ahead of unsecured debt.
 In addition to first lien bank loans, the underlying CLO portfolio may
include a small allowance for second lien and unsecured debt.
 CLOs use funds received from the issuance of
debt and equity to acquire a diverse portfolio of
senior secured bank loans.
 The debt issued by CLOs is divided into
separate tranches, each of which has a
different risk/return profile based on its priority
of claim on the cash flows produced by the
underlying loan pool.
 Whereby the senior secured bank loans from a
diverse range of borrowers—typically 100 to
225 issuers—are pooled in the CLO and
actively managed by the CLO manager.
 Economically, the CLO equity investor
owns the managed pool of bank loans and
the CLO debt investors finance that same
pool of loans.
 Currently the CLO structures are 12 to 15x
Levered. (Debt to Equity)

8. Why are CLO’s on the spotlight and what makes them so popular?
 Investors are finding shelter from Treasury volatility in
two of Wall Street’s hottest markets.
 Returns on U.S. leveraged loans and collateralized loan
obligations have outperformed other fixed-income asset
classes
 Despite recent volatility and increasingly loud voices
raising concerns about the rapid growth of these markets.
Leveraged loans have returned 4.29 percent
 Floating-rate debt such as CLOs and leveraged loans
have pulled in funds from investors as rates rise, and
borrowers have responded with massive swathes of
issuance in both markets.
 Investors are maybe more concerned with risks associated
with higher interest rates, and so demand for floating-rate
assets is expected to “remain white hot” over the next
quarter and into 2019, supporting both loans and CLOs
 Adding to their appeal, CLOs have outperformed other
fixed-income sectors each time 10-year Treasury yields
have risen more than 17 basis points according to an
analysis going back to 2012
 Adding a small allocation of CLOs to a portfolio may help
returns amid rate volatility flare-ups
 CLOs are outperforming corporate high-yield bonds.
 Returns for BB-rated CLO bonds are 5.57 percent so far this
year, and 8.74 percent for Single B-rated CLOs
 Compared to less than 2 percent for high-yield

9. Central Banks and IMF raising concerns?
 The International Monetary Fund has decided its
time to sound the alarm about leveraged loans.
 Ten years after the global financial crisis, investors
are once again showing increasingly risky
behavior as they search for sources of high yield
in response to a decade of low interest rates.
 The IMF added that “the most highly indebted
speculative grade firms” make up more of the
new issuance of leveraged loans than they did
before the financial crisis.
 “Having learned a painful lesson a decade ago
about unforeseen threats to the financial system,
policymakers should not overlook another
potential threat,” the IMF said.
 Also last month, the Bank of England said it was
also concerned about the increase in leveraged
lending, saying that global market is larger
than–and growing as quickly as–the US
subprime mortgage market was in 2006.
 In the last few weeks, former Federal Reserve
Chair Janet Yellen and former Federal Reserve
Board of Governors member Daniel Tarullo have
sounded the alarm on the rising issuance of
leveraged loans.
 Yellen said there had been a “huge deterioration” in
lending standards and was worried about
systemic risks associated with these loans.
 It’s particularly troubling because it’s happening at a
time when bank regulation is being relaxed. She said
these loans could bankrupt firms in an economic
downturn, making it worse.
 Bloomberg recently warned that the market has gone
too far now these risky assets are targeted at
individual retail investors.
 What’s more, there are concerns that existing
regulations don’t sufficiently protect against the
risks of leverage loans and CLOs, which are often
being built up by nonbank lenders.

10. This is how it works!
 Take Bomgar Corp., which
just lined up $439 million in loans.
 The deal marked the software
company’s third trip to the debt
markets this year.
 By one estimate, Bomgar’s
leverage could soon spike to 15
times its earnings.
 These kinds of transactions are
increasingly common in the U.S.’s
more than $2 trillion market for
leveraged loans and junk bonds, and
agencies including the Federal
Reserve can’t do much about it.
 That’s because some of the most
aggressive financing is being
done outside the traditional
banking sector.
 But in addition to heavily-regulated banks,
Bomgar’s lenders include Jefferies Financial
Group Inc. and Golub Capital BDC Inc. --
firms outside the Fed’s reach.
 An effort by federal agencies to strengthen
loan standards triggered some of the
market’s shift from banks to less-regulated
lenders, including Jefferies, KKR & Co. and
Nomura Holdings Inc.
 If Bomgar does run
into trouble, Jefferies
and Golub may not
take a hit.
 That’s because
leveraged loans are
usually either bought by
mutual funds and other
fund managers or
packaged into
securities that are sold
to investors. (CLO)
 The US appeals court ruled in
February that;
 CLO managers, the biggest
buyers of these risky corporate
loans, will no longer be required
to have "skin in the game".
 CLO managers are now
exempt from the post-crisis
rules that stipulated that they
have to hold some of the
loans that they were
packaging up to sell on.

11. Arguments for CLO’s and its inherent risk to the Economy
 The CLO market has grown to match the size of the
CDO market at its pre-crisis peak.
 Yet one major difference makes the CLOs of today less
scary:
 The loans that comprise them are backed by collateral,
and if one of the companies in the mix defaults, an investor
can find recourse through the sale of that collateral.
 Pre-crisis CDOs built on mortgage-backed securities
had no such backstops.
 In a year of rising interest rates, the loans’ floating rates
insulate investors from steep losses. As part of a
balanced portfolio, they certainly make some sense
along with more traditional fixed-income investments.
 The Loan Syndications and Trading Association, an
advocate group for leveraged loans, points out that
collateralized loan obligations rated AA-rated or
better have never defaulted, even during the crisis.
 The good times can’t last forever…
 And while people in the CLO business point out that
these assets fared pretty well during the last
recession, nobody knows how the investments will
perform when the next downturn comes.
 The market for leveraged loans is larger than the market
for junk bonds!
 And remembering that blowups in the junk bond market
— most notably in the late 1980s — have caused
problems before.

12. Underwriting standards and
credit quality have deteriorated.
 Strong investor demand has
resulted in a loosening of non-
price terms, which are more
difficult to monitor.
 For example, they allowed them
to borrow more after the closing
of the deal.
So far this year, issuance has reached an
annual rate of $745 billion globally.
More than half of this year’s total involves
money borrowed to fund mergers and
acquisitions and leveraged buyouts
(LBOs), pay dividends, and buy back
shares from investor—in other words,
for financial risk-taking rather than
plain-vanilla productive investment.
What is there to actually worry about? Part 1
Underwriting Standards & Issuer Quality
 Covenants require a borrower to pass financial tests,
usually on a quarterly basis.
 These tests can stipulate how much debt a company
can have or the earnings it needs to generate.
 But cov-lite loans now make up around 80 per
cent of new issuance in the booming leveraged
loan market, which surged past the $1 trillion
milestone in the US earlier this year.
 In an economic downturn, whatever type of investor
ends up holding the leveraged loans, the
collateralized loan obligations which include
leveraged loans, or the sellers of credit default
protection referencing CLOs, will have fewer credit
protections than what they need to sustain
losses.
 With rising leverage, weakening investor protections,
and eroding debt cushions, average recovery rates
for defaulted loans have fallen to 69 percent from
the pre-crisis average of 82 percent.
 A sharp rise in defaults could have a large
negative impact on the real economy given the
importance of leveraged loans as a source of
corporate funding.

13.  The collateralized debt obligations (CDO) issuance
and outstanding have decreased since the financial
crisis.
 In fact, CDOs outstanding have decreased by 27%
since the first quarter of 2008 until the last quarter
when data were available, the third quarter of 2018.
 However, whereas all kinds of collateralized debt
obligations have decreased substantially since the
beginning of 2008, collateralized loan obligations
(CLOs) outstanding have risen by 130% to $600
billion in the same time period.
 At the beginning of 2008, CLOs were 25 % of CDOs
outstanding; just a decade later, CLOs now
represent about 80% of all CDOs.
 CLO issuance is already significantly higher than
issuances in credit card ($30.9 bn) and student loan
($16.6 bn) asset backed securities, and even slightly
higher than auto loan ($97.4 bn) asset backed
securities.
 Just because leveraged loans get packaged into
CLOs does not make risk disappear
What is there to actually worry about? Part 2
The size of the CLO Market & Type of Lenders
 With risks shifting to shadow banks—hedge funds, insurance firms,
independent broker-dealers and other intermediaries that aren’t
deposit-takers—critics have questioned whether governments
will bail out non-bank institutions in the next crisis.
 There’s also the danger that the shadow players could bring
down the biggest banks.
 The banks could end up being on the hook if smaller shadow lenders
that have filled the void in risky markets end up failing.
 While the ties between the mainstream banking system and the
shadow one aren’t very transparent, increased lending by banks to
non-banks signals that some connections might have gotten stronger.

14. What is there to actually worry about? Part 3
Shift in Investor Base & Transparency Issues
A significant shift in the investor base is
another reason for worry.
 Institutions now hold about $1.1 trillion of
leveraged loans in the United States, almost
double the pre-crisis level.
 That compares with $1.2 trillion in high yield, or
junk bonds, outstanding.
 Such institutions include loan mutual funds,
insurance companies, pension funds, and
collateralized loan obligations (CLOs), which
package loans and then resell them to still other
investors.
 CLOs buy more than half of overall
leveraged loan issuance in the United States.
 Mutual funds that invest in leveraged loans have
grown from roughly $20 billion in assets in 2006
to about $200 billion this year, accounting for
over 20 percent of loans outstanding.
 Institutional ownership makes it harder for
banking regulators to address potential risk
to the financial system if things go wrong.
 Regulators in the United States
and Europe have taken steps in recent
years to reduce banks’ exposures and
to curb market excesses more broadly.
 This has triggered a migration of
leveraged lending to nonbanks.
 There is important evidence that
nonbanks increased bank borrowing
following the issuance of guidance,
possibly to finance their growing
leveraged lending.
 The guidance was effective at reducing
banks’ leveraged lending activity, but it is
less clear whether it accomplished its
broader goal of reducing the risk that
these loans pose for the stability of the
financial system.
 While banks have become safer since the
financial crisis, it is unclear whether
institutional investors retain a link to
the banking sector, which could inflict
losses at banks during market
disruptions.

15. What could go wrong?
 We can clearly see that the CLO market Pre-2008
is fairly different to what it is currently!
 The common defense of the leveraged loan market
is the current and historical low default rate.
 The low-interest rate and low volatility environment
added with loosened transparency and regulations
and the boost of light covenants creates a new
environment which hasn’t been on a test before.
 Moody’s Investors Service forecasts that investors
who were used to recovering 77 cents on the
dollar from first-lien loans to failed companies may
only get about 60 cents. For second-lien loans,
they may get 14 percent instead of the historical
43 percent recovery.
 In the crisis, companies "were trying to do anything
and everything" to meet the covenants and avoid
default, but a search for flexibility quickly
morphed into an opportunity to ditch safeguards.
 The cov-lite loan boom will "flatten and lengthen
the default cycle" as zombie companies
"struggle on for longer" without covenants to
trigger a much-needed intervention from lenders.
How much
of this is
understood
by
Investors?
 The documentation for CLOs is also complex —
sometimes more than 300 pages long, according to
a primer from Guggenheim Partners.
 Each CLO usually has more than 100 issuers bundled into
one product.
 That provides diversification, sure.
 But it’s also an opportunity for investors to
unknowingly become vulnerable to problematic loans.
 The bigger problem is the overall erosion of
documentation
 It has crept into the documentation that more and more
cash from the company can be dividended out to the
private equity firm when the lenders have not been repaid
 It is hard to know how 'senior secured' you are when
there isn't unsecured debt below you in the capital
structure. A larger share of companies have loans as their
only form of debt. if there’s nobody behind you, it doesn’t
matter if you’re first in line.”
 The dominance of covenant lite loans and you have a
perfect environment for low transparency and little
price discovery.

16. To Sum Up
Just like in the children’s game
of musical chairs, when the
music stops, someone is going
to fall on the floor pretty hard
 Since the Financial Crises in 2008, we are experiencing the longest bull rally in the financial markets which will eventually come to an end!
 However, the million dollar question is; whether it will end ugly like in 2008 or a mild end. The answer to this question lies whether you
believe there are systematic risks in our current system and if so how big are they?
 Debates on CLOs have been around for a couple of years, but first time in the last couple of months concerns have been raised by
powerful voices such as; IMF, Moody’s, Janet Yellen, Fitch, Bank of England.
 Despite the concerns, there is still a significantly growing appetite for CLOs. As mentioned in this report the nature of CLOs have changed
dramatically over the years. Mainly due to investor demand for leveraged loans, fueled by an appetite for floating-rate instruments,
accommodative markets, and a low default rate forecast
 Excessive borrowing is concentrated among companies, not millions of U.S. households and banks also are much better capitalized than
they were before the crisis.
 Compared to the heavily-regulated banks, most of the leverage loan lending is done by Non-Banks these days, which are less-regulated
lenders and outside the Fed’s reach.
 Going forward the attention should be focused on the leveraged loan market which is now larger than the high yield bond market, but
barely gets the attention it deserves
 Money is chasing looser and looser projects, and from one day to the next the spring uncoils
 What exactly do you do when you see tight credit spreads, low quality and significant issuance -- how do you slow that down gradually?
 So far, regulators appointed by President Donald Trump don’t seem focused on slowing things down.
When originators securitize low-quality loans and sell
them off as fast as they can, letting others deal with
the fallout and when enough bad loans default,
securities crash, it helps to spark the financial crisis.

17. References
1. https://www.bloomberg.com/graphics/2018-lehman-anniversary/
2. https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr815.pdf?la=en
3. https://blogs.imf.org/2018/11/15/sounding-the-alarm-on-leveraged-lending/?utm_medium=email&utm_source=govdelivery
4. https://www.bloomberg.com/news/articles/2018-09-27/wall-street-s-riskiest-loans-flash-dangers-as-watchdogs-muzzled
5. https://qz.com/1465460/the-risky-leveraged-loan-market-is-scaring-the-imf-janet-yellen-and-others/
6. https://blogs.imf.org/2018/11/15/sounding-the-alarm-on-leveraged-lending/?utm_medium=email&utm_source=govdelivery
7. https://www.warren.senate.gov/newsroom/press-releases/warren-presses-regulators-on-risks-in-leveraged-lending-market-
8. https://www.forbes.com/sites/petertchir/2018/10/23/why-leveraged-loans-are-a-better-signal-than-high-yield-bonds/#4fd32f427e86
9. https://www.forbes.com/sites/forbesrealestatecouncil/2018/11/15/investor-demand-is-increasing-for-shared-risk-in-securitized-cre-debt-products/#5e0352506a86
10. https://www.marketwatch.com/story/protections-on-risky-loans-are-close-to-their-worst-ever-levels-says-moodys-2018-10-25
11. https://www.washingtonexaminer.com/opinion/the-leveraged-loan-bubble-that-might-burst
12. https://www.euromoney.com/article/b1brb9c8ytgm3s/clos-underlie-loan-markets-pile-into-corporates
13. https://www.forbes.com/sites/mayrarodriguezvalladares/2018/10/26/leveragedloanmarketwarningshavebeenignoredforoveriveyears/#2fe3d4153df3
14. https://finance.yahoo.com/news/leveraged-loan-growth-sparks-concerns-next-financial-crisis-150121623.html
15. https://www.nytimes.com/2018/10/19/business/economy/clo-corporate-loans.html
16. https://www.bloomberg.com/news/articles/2018-09-30/how-leveraged-loans-are-and-aren-t-like-junk-bonds-quicktake
17. http://fortune.com/2014/04/10/collateralized-loan-obligations-our-next-financial-nightmare/
18. https://www.forbes.com/sites/mayrarodriguezvalladares/2018/09/23/financial-institutions-face-turbulent-journey-ahead/#65556afb3c55
19. https://therealdeal.com/2018/03/02/the-clo-a-financial-crisis-bogeyman-is-back/
20. https://www.mayerbrown.com/wall-streets-hot-clo-machine-freed-from-post-crisis-rules-02-09-2018/
21. https://www.bloomberg.com/news/articles/2018-02-09/clo-managers-exempt-from-risk-retention-regulations-court-rules
22. https://www.reuters.com/article/clo-q12018/us-clo-market-on-pace-for-record-year-idUSL1N1U61BZ
23. https://www.pinebridge.com/insights/investing/2018/01/clos-how-they-work
24. https://www.guggenheiminvestments.com/perspectives/portfolio-strategy/collateralized-loan-obligations-clo
25. https://www.bloomberg.com/opinion/articles/2018-07-10/clos-have-hit-a-peak-when-mom-and-pop-show-up
26. https://www.thinkadvisor.com/2018/07/09/collateralized-loan-obligations-are-a-new-to-inves/?slreturn=20181017061303
27. https://medium.com/@DerivValuation/are-collateralized-loan-obligations-the-new-debt-bombs-fef1c26e75b3
28. https://www.afr.com/markets/debt-markets/the-ticking-time-bomb-that-could-trigger-a-new-financial-crisis-20180903-h14vdo
29. http://www.fsb.org/wp-content/uploads/P050318-1.pdf

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