HOFIS 35 - Collateralized Loan Obligations

Question 1

Definition of Collateralized Debt Obligation

Answer 1

Structured financial product that is backed by a diversified pool of debt obligations including:

• Corporate bonds
• Residential MBS
• Commercial MBS
• ABS

Question 2

How are cash flows of CDOs (CLOs) distributed?

Answer 2

Cash flows from underlying pool of a CDO (CLO) are distributed to debt and equity (i.e. tranches) issued by the CDO taking into account the relative seniority of the CDO’s liabilities

Question 3

Definition of collateralized loan obligations

Answer 3

A structured financial product that is backed by a portfolio of leveraged loans:

• Loans that banks made to corporations with speculative-grade ratings
• May gain exposure to specific loan by selling credit protection on the loan via a CDS

Question 4

Describe the capital structure of a CLO

Answer 4

In order of payment seniority in the CLO’s capital structure, these tranches are:

1. Senior debt
2. Mezzanine debt
3. Subordinated debt
4. Equity

Question 5

What is the driving force in creating a CLO structure?

Answer 5

To raise funds at the lowest possible cost:

• CLO’s equity holder, who is at the bottom of the chain of seniority, can get the most residual cashflow

Question 6

Describe two different motivations for the creation of a CLO

Answer 6

1. Balance sheet
   * Reduce the size of its balance sheet and reduce its regulatory and economic capital
2. Arbitrage

• Increase assets under management and management fees
• Asset manager assembles the initial portfolio of an arbitrage CLO

Question 7

Purpose of a CLO from the investro’s perpective

Answer 7

Partition and allocate the credit risk of a loan pool among investor groups that have different risk appetites

Question 8

What is the par coverage test of a CLO tranche?

Answer 8

Allows the diversion of cashflow (in cash-flow waterfalls) to the most senior tranche if the coverages tests for the tranches are not satisfied

Question 9

Formulas for Par Coverage Test in a CLO

Answer 9

Question 10

CLO’s two cash-flow waterfalls

Answer 10

• Collateral interest waterfall
• Collateral principal waterfall

Question 11

CLO Collateral Interest Waterfall

Answer 11

Dictates that interest payments made by the underlying loans get passed through to the CLO’s tranches in the following order:

1. Base fees and expenses to the trustee and asset manager
2. Interest expense of the Class A tranche
3. Principal repayments to Class A if Class A coverage tests fail
   
   • The collateral interest payments will be used to continue paying off Class A’s par value until Class A’s coverage tests pass
4. Steps 2 and 3 for Class B tranche
   
   1. If Class A has been paid in full and is retired, then the collateral interest payments will be used to retire Class B’s par value until Class B’s coverage tests pass
5. Repeat Steps 4 & 5 for any remaining debt tranches in the CLO structure
6. Any remaining collateral interest will be given to the equity tranche

Question 12

CLO Collateral Principal Waterfall

Answer 12

Dictates that the principal payments made by the underlying loans get passed through to the CLO’s tranches:

1. Amounts due from the interest waterfall that was not paid for by the collateral interest
2. Purchase of new collateral assets if we are in the CLO’s reinvestment period
3. Principal repayment of tranches in order of their priority
4. Payments to the equity tranche