Collateralized loan obligations (CLOs) pool loans from various businesses and resell them to multiple lenders to make the financial system more efficient. However, CLOs add complexity and were blamed for contributing to the 2007 banking crisis. They involve commercial business loans, bonds, and mortgages, and lenders receive different payment levels based on risk. The system increases complexity and makes it difficult for banks to track risk, potentially leading to risky loans.
A collateralized loan obligation (CLO) is a financial process of pooling loans to many different businesses into one package that is then resold to multiple lenders. The goal is to make the financial system more efficient by overcoming the mismatch between the different needs of individual borrowers and lenders. Yet somehow the CLO adds to the complexity and is blamed for contributing to the banking crisis that erupted in 2007.
Strictly speaking, a collateralized loan obligation only involves commercial business loans. There are similar schemes that work the same way using bonds and mortgages, and some that combine two or more types of loans. The terms used for these schemes are often confused or used interchangeably. However, the basic system and the benefits and drawbacks are the same in all cases.
To understand why the collateralized loan obligation was developed, you need to remember that some borrowers are considered more likely to repay than others. Some lenders are happy to make riskier loans because they can charge higher rates, while others prefer lower-rate loans because they are more certain of paying.
The financial industry believed that the loan market did not work as well as it could because individual lenders had to find individual borrowers who wanted the “right” type of loan. This could mean that there was enough money available from all the lenders to pay off all the loans the borrowers needed, but the cash was not getting where it was needed.
This led to the development of the collateralized loan obligation. In this system, many different existing loans, both risky and safe, are pooled together. The lenders then buy the rights to receive a portion of the payments from all the borrowers. Each lender gets a different payment level based on the risk they will accept.
If any of the borrowers involved in a collateralized loan obligation defaults on the loan, the loss will be deducted from the portion awarded to the lender who accepted the greater risk. As more borrowers default, this lender could end up with nothing, and then any remaining losses would be passed on to the lender that assumed the second-highest level of risk, and so on.
The biggest problem with a collateralized loan obligation is that it increases the complexity of the system and makes it much more difficult for large banks to keep track of how much risk they are taking. In some cases, credit rating groups, which advise lenders on how risky an investment is, have rated the collateralized loan obligation as very safe because some of the borrowers involved are considered very good risks; These ratings do not take into account loans to medium or high risk borrowers.
Some people argue that this confusion has allowed too many very risky loans to be made to people who have since been unable to repay them. The amount of money that has not been repaid has been so high that, in some cases, even lenders who bought the “safest” shares of a collateralized loan obligation found themselves unexpectedly losing money.
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