Banks throughout the world are increasingly utilizing a new asset securitization structure known as a "collateralized loan obligation", or "CLO", to meet their financial objectives. CLOs enable banks to sell portions of large portfolios of commercial loans (or in some cases, the credit risk associated with such loans) directly into the international capital markets, and offer banks a means of achieving a broad range of financial goals, including the reduction of regulatory capital requirements, off-balance sheet accounting treatment, access to an efficient funding source for lending or other activities, and increased liquidity. This article summarizes the benefits to banks of undertaking a CLO, discusses important rating agency and legal considerations affecting the structuring of a CLO, and describes the steps required to complete a CLO transaction.
What Is In An Acronym?
Simply stated, a "collateralized loan obligation", or "CLO", is a debt security collateralized by commercial loans. Perhaps more commonly, however, the term "CLO" is used to refer to the entire structured finance transaction in which multiple classes of debt or equity securities are issued by a special purpose vehicle (an "SPV") whose assets consist principally of commercial loans.
In its pure form, a CLO can be distinguished from its transactional cousins with similar-sounding names: a "CBO" or "collateralized bond obligation", in which the underlying assets consist of corporate bonds, and a "CMO", or "collateralized mortgage obligation", in which the underlying assets consist of mortgage loans.
While these types of transactions are distinct in concept, in practice particular deals frequently contain a mix of bonds and secured and unsecured commercial loans. Accordingly, some market participants have adopted the use of the more generic term "collateralized debt obligation", or "CDO", either to encompass the entire universe of CLOs, CBOs and CMOs, or to describe specific transactions with "hybrid" collateral, such as high-yield bonds and secured loans. While the use of this more expansive term may be desirable and ultimately prevail, the market generally continues to attach the terms "CLO", "CBO" and "CMO" to transactions involving hybrid collateral, with the choice of term depending on the predominant type of collateral.
The past two years have seen the dramatic emergence of an important new asset securitization structure—the bank-sponsored collateralized loan obligation, or "bank CLO." Beginning with the $5 billion R.O.S.E. Funding No. 1 Ltd. transaction sponsored by National Westminister Bank PLC in November 1996, a number of banks have used CLOs to dispose of sizable portions of their commercial loan portfolios. 2 According to one rating agency, sixteen bank CLO transactions, accounting for $34.1 billion of rated securities, were closed in 1997. 3 Most market observers expect the market to expand significantly in 1998 and beyond.
Bank CLOs enable banks to sell portions of large portfolios of commercial loans (or in some cases, the credit risk associated with such loans) directly into the international capital markets, and offer banks a means of achieving a broad range of financial objectives, including the reduction of regulatory capital requirements, off-balance sheet accounting treatment, access to an efficient funding source for lending or other activities, and increased liquidity. To date, most bank CLOs have been very large transactions—typically ranging from $1 billion to $6 billion—undertaken by very large international banks, including banks based in the United Kingdom, Japan, France, Belgium, Canada and the Netherlands. In late 1997, NationsBank entered the market with a $4.2 billion CLO, and thereby became the first (and, as of this writing, the only) U.S. bank to complete a significant CLO in recent years.
The very large size of bank CLOs to date reflects in part the rather significant up-front transaction costs involved in completing a CLO. As more and more of these transactions are done, the up-front expenses should decline as transaction participants and the market become more familiar and comfortable with the CLO "technology." While the need to minimize credit and other risks through diversification of the loan pool ultimately limits the degree to which small portfolios may be securitized, it may be expected that progressively smaller transactions will be achievable, and that the universe of banks that can profitably use the CLO technology will increase significantly.
This article summarizes the benefits to banks of undertaking a CLO, discusses important rating agency and legal considerations affecting the structuring of a CLO, and describes the steps required to complete a CLO transaction.
What Is A Bank CLO?
Before considering the benefits and costs of undertaking a CLO, it is useful to describe in a summary fashion the structure of a typical bank CLO 4. In a typical bank CLO transaction, the sponsoring bank transfers the subject loan portfolio in one or more steps to a bankruptcy-remote special purpose vehicle (an "SPV"), which in turn issues asset-backed securities consisting of one or more classes (sometimes referred to as "tranches") of rated debt securities, one or more unrated classes of debt securities that are generally treated as equity interests, and a residual equity interest. The tranches of a CLO typically have different interest rates and projected weighted average lives, and may have different credit ratings, to appeal to different types of investors. The SPV sells the rated debt securities and simultaneously uses the proceeds to purchase the loan portfolio from the sponsoring bank.5 A portfolio manager, usually the sponsoring bank or an affiliate thereof, is appointed to service and manage the loans on behalf of the SPV.
Most bank CLOs are sponsored as "cash flow" transactions in which the repayment, and ratings, of the CLO debt securities depends on the cash flow from the underlying loans. 6 Some bank CLOs are self-liquidating, and provide for all loan payments to be paid through to investors as principal and interest on the debt securities. Other bank CLO transactions provide for the reinvestment of loan payments in additional loans to be purchased from the sponsoring bank or other sources. After the initial reinvestment period, the CLO enters an "amortization period" when loan proceeds are used to pay down the principal of the CLO debt securities.
In a prototypical CLO, the underlying assets collateralizing the CLO's debt securities consist of whole commercial loans. In real-world transactions, the underlying assets almost always consist of a more diverse group of assets which may include, participation interests, structured notes, revolving credit facilities, trust certificates, letters of credit, bankers' acceptances, synthetic lease facilities, guarantee facilities, corporate bonds and asset-backed securities. In addition, some recent transactions include "credit-linked notes", which are notes the payment terms of which relate to, but are not necessarily identical to, the payment terms of specific loans owned by the sponsoring bank, but which are not included in the transaction. Credit-linked notes can be used as collateral in lieu of the related commercial loans where the actual loans cannot be assigned without the consent of the borrower or another loan participant, or can be used to create derivative instruments with terms that more closely match the payment characteristics desired by investors than those of the actual loans.
One or more forms of credit enhancement are almost always necessary in a CLO structure to obtain the desired credit ratings for the most highly rated debt securities issued by the CLO. The types of credit enhancement used by CLOs are essentially the same as those used in other asset- backed securities structures -- "internal" credit enhancement provided by the underlying assets themselves, such as subordination, excess spread and cash collateral accounts, and "external" credit enhancement provided by third parties, principally financial guaranty insurance issued by monoline insurers. Most bank CLOs to date have relied on internal credit enhancement.
Bank CLOs can further be divided into "linked" and "de-linked" structures. In a linked structure, the sponsoring bank provides some degree of implicit or explicit credit support to the transaction as a means of improving the credit rating of some or all of the tranches in the transaction—that is, the credit rating of the debt securities issued by the CLO is "linked" to that of the bank. While such credit linkage may improve the pricing of a transaction, the provision of credit support by the sponsoring bank may constitute "recourse" for risk-based capital purposes, thus increasing the capital cost of the transaction to the bank and, if the transaction is being undertaken to reduce the bank's risk-based capital requirements, frustrating or even negating the intended capital benefit. In contrast, in "de-linked" structures, the CLO issuer relies entirely on the underlying loan assets and any third-party credit enhancement for its credit ratings—that is, the credit rating of the debt securities issued by the CLO is independent of that of the bank.
Finally, CLO issuers often use a variety of hedging instruments, including interest rate swaps, currency swaps and derivatives, to hedge against fluctuations in interest rates, currency values and other risks. Such instruments may also be used to address cash flow "mismatches" between the payment characteristics of the CLO debt obligations and the underlying loans, such as differences in frequency of payments, payment dates, interest rate indices (sometimes referred to as "basis risk") and interest rate reset risk.
The following chart shows the structure of a simple CLO transaction:
Benefits To Banks Of CLOs
Banks have used CLOs to achieve a number of different financial objectives, including the following:
1.Reducing Risk-Based Capital Requirements. Under the risk-based capital standards adopted by the banking regulatory authorities in the G-10 countries pursuant to the so- called Basle Accord formulated in 1988 by the Basle Committee on Banking Supervision, 7 banks in most developed countries are required to maintain risk-based capital of 8% of the outstanding balance of most commercial loans. 8 The 8% capital requirement is generally the highest percentage of capital required to be held against any asset type. Considering that margins on commercial loans are usually relatively small, the high risk-based capital requirement makes holding commercial loans, especially those of investment grade quality, not a particularly profitable or efficient use of capital for most banks. Using a CLO to securitize and sell a portfolio of commercial loans can free up a significant amount of capital that can be used more profitably for other purposes, including holding higher yielding assets, holding lower risk-weighted assets, making acquisitions, paying dividends and repurchasing stock.
By way of example, a bank with a $1 billion portfolio of commercial loans is required to maintain risk-based capital of 8%, or $80 million, against that portfolio. If the bank is able to complete a CLO transaction in which it is able to sell all of the debt and equity securities of the CLO for cash on a break-even basis, the bank will free up $80 million of regulatory capital that can be used for other corporate purposes or to support the origination or purchase of another $1 billion portfolio of commercial loans, or the origination or purchase of $2 billion of 50% risk-weighted assets (such as residential mortgage loans), or $5 billion of 20% risk-weighted assets (such as FNMA or FHLMC securities).
It should be noted that the risk-based capital benefit of a CLO transaction may be reduced or altogether eliminated if the sponsoring bank or an affiliate retains all or a portion of the subordinated debt securities or equity securities of the CLO issuer, or otherwise guarantees or provides credit support to the transaction. Under the risk-based capital guidelines as in effect in the U.S., a bank that retains such a subordinated or equity security, or provides credit support for sold assets, is generally treated as if it had retained the credit risk of the entire portfolio of sold assets, unless the bank's retained interest is less than the capital requirement applicable to the sold assets, in which case, under the so-called "low level recourse" rule, 9 the bank must maintain capital on a dollar-for-dollar basis against the retained security or credit support liability. Thus, if the bank retains subordinated and/or equity securities of $80 million in the hypothetical $1 billion CLO, it will be required to maintain the same amount of risk-based capital as it would had it not done the CLO transaction at all. If, on the other hand, the bank retains subordinated and/or equity securities of $25 million, it will be required to maintain capital of $25 million, and will have freed up $55 million of risk-based capital in the transaction.
Obviously, the low level recourse rule provides a powerful incentive to banks to structure CLO transactions so that most, if not all, of the subordinated debt and equity interests of the CLO issue are sold or transferred to parties not affiliated with the bank. 10 As discussed below, the operation of the low level recourse rule must be considered in structuring any bank CLO transaction.
2.Increasing Liquidity and Lending Capacity. Banks can free up not only risk-based capital, but cash, by securitizing and selling a portfolio of commercial loans. The funds generated by a CLO can then be reinvested in additional commercial loans (which may be expected to result in origination fee income) or in other higher-yielding or lower-risk weighted assets or can be used for other corporate purposes. Depending upon market conditions, a CLO can be a very attractive source of funding for other bank lending activities.
3. Accessing More Favorable Capital Market Funding Rates. Banks with relatively low credit ratings can use CLOs to access higher-rated funding markets than would be available to them on a direct borrowing basis. Since many CLOs create one or more substantial tranches of AAA-rated securities, a bank with a rating of, say, "B" or "BB" can securitize a portfolio of loans with an implicit overall rating of "BBB", and create a "AAA" piece equal to perhaps 92% or 93% of the portfolio balance. Even if the smaller, lower-rated securities created in the CLO must be sold at a slight discount, the premium paid by the marketplace for the "AAA" piece can yield a "all-in" execution for a low-rated bank which is more favorable than the bank could achieve as a direct borrower.
4. Improving ROA and ROE. A bank may use a CLO to rapidly shrink its balance sheet if it uses all or a portion of the proceeds of the CLO issuance to reduce liabilities. A CLO's impact on a bank's balance sheet can be quite significant, especially when undertaken on the multi- billion dollar scale that has become the norm. Considering that commercial loan portfolios securitized in bank CLOs are often higher credit quality and therefore relatively low-yielding assets, the combined impact of reducing bank size and increasing the proportion of relatively higher-yielding assets on a bank's balance sheet can significantly improve a bank's return on assets, return on equity, and other financial ratios.
5. Reducing Exposure to Credit Concentrations. Banks in most jurisdictions are subject to "loans-to-one-borrower" or "lending limit" regulations that limit the amount of credit exposure a bank can have to a single borrower and its affiliates. 11
Moreover, as a matter of general safety and soundness, most banks attempt to limit their exposures to particular concentrations of credit risk, which may include concentrations of loans to particular borrowers, or to groups of borrowers in particular industries or geographic regions. A CLO may provide banks with an efficient means of transferring credit concentrations to investors who are not over-exposed to such concentrations. (By the same token, a bank may consider purchasing CLO debt securities to obtain access to particular credit segments in which they are under-exposed, or generally to further diversify their own portfolios.)
6. Managing Other Balance Sheet Characteristics. Banks use CLOs to manage various balance sheet characteristics in addition to credit risk, such as spread, liquidity and concentration of assets tied to a particular index, such as LIBOR. By securitizing assets having characteristics which are over-represented in the portfolio, and originating or purchasing assets which are under-represented, bank managers can fine-tune the financial profile of the balance sheet.
7. Preserving Customer Relationships. CLOs permit banks to transfer credit risk while preserving relationships with borrowers. A significant disadvantage to a bank of selling loans on a whole loan basis is that the purchaser of the loans (usually another bank) will then have an opportunity to establish a relationship with the borrower and thus usurp the selling bank's customer relationship and prospects for future business. In a CLO, the portfolio manager or loan servicer is typically the sponsoring bank itself or an affiliate, so that the borrower generally need not even be aware that the loan has been sold. Even if the borrower must be notified of the transfer (as may be required in some jurisdictions to effect a true sale of the loan to the CLO issuer), the transfer will not usually give the investors (or any other bank) a basis for establishing a relationship with the borrower. Most banks consider the ability to continue to deal with their customers to be a major advantage of a CLO over other possible methods of disposing of their loans.
8. Competitive Positioning for the New Financial Marketplace. One of the most compelling reasons for a bank to undertake a CLO is somewhat more subjective than the financial and regulatory objectives described above. It is widely observed that the commercial banking markets and the global capital markets are rapidly becoming integrated, fundamentally changing the mechanisms for funding business activities. Many of the world's premier investment banks have created formidable commercial lending units, and many of the world's largest commercial banks are actively involved in investment banking. In addition, as demonstrated by the pending Citicorp/Travelers combination, insurance companies are increasingly involved in both the commercial banking and investment banking arenas. Continuing regulatory reform in the United States and other countries is expected to foster the further melding of the commercial banking, investment banking and insurance businesses toward an integrated financial services industry. Equally as dramatically, the advent and evolution of the financial technology of securitization over the past 15 years or so have enabled banks and their customers to directly access the global capital markets through the asset-backed capital markets and the direct issuance of asset-backed securities.
A new, more efficient market for the funding of financial assets is clearly emerging.
In this new market, many banks are concluding that their expertise and strength lies in analyzing the credit of borrowers and structuring and originating loans, but not necessarily in holding the loans in portfolio. At the same time, there is an ever-increasing community of global investors— including mutual funds, large banks, pension funds, insurance companies and governments—that are eager to invest in structured securities backed by bank-originated financial assets.
Banks positioning themselves to be players in this emerging market may find it advantageous to establish a regular program of securitizing and selling their commercial loans through CLOs. The banks that pioneer the use of CLOs as an ongoing business strategy may be expected to have an advantage in establishing a market presence and reputation, and developing a diversified constituency of loyal investors that can be tapped in future transactions.
It should be acknowledged that many of the reasons set forth above for a bank to consider a CLO also apply to a traditional, straightforward sale of loans to another bank or investor. For example, traditional whole loan sales or participation sales can also be used to reduce risk-based capital requirements, increase liquidity, shrink balance sheets and reduce credit concentrations. However, CLOs provide many advantages over traditional loan sales, including access to a much broader investor base, the ability to package and dispose of a very large amount of assets in a single transaction, and the use of securitization technology—such as "tranching" on the basis of both maturity and credit risk—to meet the demands of particular investor groups and thus to increase the overall value of the portfolio. Moreover, several of the benefits listed above—namely, the ability of low-rated banks to access the upper reaches of the credit markets and the use of CLOs to establish an ongoing program of funding through the global capital markets—cannot be achieved through traditional loan sales.
Rating Agency Role
The major investment rating agencies 12 play a critical role in the structuring of CLOs, as the principal function of a CLO is to "convert" typically unrated commercial loans into highly rated debt securities that will be attractive to institutional investors. While each rating agency claims its own particular approach to analyzing CLO transactions, their approaches are very similar. In general, the rating agencies will evaluate the proposed structure, assess the expected default and loss performance of the loan portfolio, review the credit standing of third-party credit enhancers, hedge providers, portfolio managers and other transaction parties, and evaluate the various legal and bankruptcy risks posed by the transaction (discussed below).
The rating agencies have all published detailed guidance on their procedures for rating CLOs and CBOs, 13 which this article will not undertake to repeat. However, it is useful to highlight the principal rating agency concerns in rating CLOs.
1. Assessing Credit Risk of Underlying Commercial Loans. Obviously, a rating agency's assessment of the credit quality of the underlying commercial loans collateralizing a CLO transaction is a critical component of the rating determination. Historically, the difficulty of quantifying the credit quality of the commercial loans to be included in a CLO transaction has proved to be a major impediment to obtaining an acceptable rating for CLO transactions. In CBO transactions, which have structures that are virtually identical to those of CLOs, the underlying bonds collateralizing the CBO obligations usually have pre-existing credit ratings, which permit the rating agencies to analyze the proposed CBO structure by reference to the known ratings, thus simplifying considerably the credit analysis required to assign ratings to the transaction. In contrast, commercial loans are not generally rated by the rating agencies, and the task of assessing the credit quality of what may be a multi-billion dollar portfolio on a loan-by-loan basis can be quite daunting. Moreover, given the relatively high loan amounts and the differences in terms of commercial loans, the historical data maintained by banks with respect to delinquency and loss experience of their commercial loan portfolios are not generally considered by the rating agencies to be as reliable or predictable as such data may be for other, more fungible assets that are routinely securitized by banks, such as residential mortgage loans and credit card receivables.
This impediment to securitization of commercial loans has finally been removed in recent transactions because of new methodologies developed by the rating agencies to correlate their investment rating categories to a lender's internal credit rating system and/or loan underwriting criteria. Banks undertaking a CLO for the first time can expect to spend a considerable amount of time working with the rating agencies to establish this correlation. Nonetheless, this effort is far less time consuming than undertaking a loan-by-loan credit analysis of the borrowers in an entire portfolio and, once a correlation methodology has been established for a particular bank, the rating process on future transactions should be significantly simpler.
2. Diversity of Loan Portfolio. The rating agencies also take into account any concentration of loan characteristics that could affect the credit risk of the loan portfolio to be securitized. Concentrations of loans with the same or related borrowers, borrowers in the same or related industries, or borrowers in the same geographic area are viewed as increasing the risk of a portfolio, and usually result in rating agencies requiring additional credit enhancement. Generally speaking, the adverse impact of concentrations of loan types is decreased by diversification of the loan portfolio, which may be achieved by increasing the portfolio size and/or decreasing the average size of a loan. The desire to maximize the diversification of a CLO portfolio, and thus achieve favorable credit enhancement levels, may partially explain the large size of CLO transactions to date.
3. Due Diligence. The rating agencies and other participants in the transaction (particularly the underwriter or placement agent) will undertake extensive due diligence of the sponsoring bank, the portfolio manager (if not the sponsoring bank) and the loan portfolio. The due diligence of the sponsoring bank is likely to include an in-depth review of the bank's underwriting, origination and collection policies and practices, and its historical portfolio performance. This portion of the due diligence usually includes in-person interviews with bank officers and employees and a field inspection of the bank's facilities, as well as a review of policy guides and statistical information.
The rating agency may also undertake a limited review of sample loan files to identify documentation issues and to confirm that the information in the loan files matches the loan schedules and other data provided to the rating agency. Generally, the underwriter or placement agent and the issuer's counsel will require an even more in-depth review of the loan files to confirm, or even to generate, the detailed information that will be required to be included in the private placement memorandum and other disclosure materials regarding the transaction, to verify that the loans comply with established eligibility criteria and to review requirements for a transfer of an interest in the loan through assignment or participation. For a further discussion of the items likely to be reviewed in this detailed loan file review, see "Implementing a Bank CLO Transaction" below.
Copyright © 2000 Mayer, Brown & Platt. This Mayer, Brown & Platt publication provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.