Collateralized loan obligations (CLO)

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What are they?

A CLO is a type of asset backed security. It's underpinned by commercial loans made by banks. For example, banks that have lent $100m to company X will use the process of securitization to create bonds based on the future repayments due on that loan.

A CLO is fundamentally a kind of CDO. As with CDOs, banks seek to get the risk associated with CLOs off their balance sheets and set up special purpose entities (SPEs) to do this. The SPE will issue debt and equity with different risks of default that can be sold to investors with different appetites for risk.

What have they got to do with the financial crisis?

The CLO market isn't nearly as big as the CDO market, but it's still significant in terms of the credit crunch. This is because, as with CDOs, investors' appetite for CLOs has greatly diminished. This makes it more difficult for banks to package up their loans and sell them on (therefore making them less inclined to make similar big loans in future).

Questions have also been raised over the CLOs banks currently hold. In most cases, banks retained the least risky portion of the CLO debt themselves as this portion paid the lowest rate of return and was therefore of least interest to investors.

The Bank for International Settlements estimates that around $500bn of company debt used to fund takeovers during the boom times is due for repayment by 2010. If companies default on this debt, CLOs will be affected by writedowns in the same way as CDOs have been.

Last updated on 26 September 2008.

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