Brattle Principal George Oldfield and Associate John Anthony co-authored an article for Law360 detailing the risk associated with the current market for collateralized loan obligations (“CLO”) and potential parallels with the subprime mortgage market leading up to the financial crisis.
The article, “Collateralized Loan Obligations: Subprime Déjà Vu?,” outlines the qualities of existing and newly issued CLO funds that may give rise to financial challenges and litigation in the event of an economic downturn. CLO funds invest in ‘leveraged loans’ which are syndicated loans that are below investment grade made by banks to highly leverage corporations. Through a complex series of transactions, these CLO notes are separated into various credit rating tranches and are issued to qualified institutional investors who, in turn, receive the corresponding interest and principal payments on the leveraged loans.
The authors detail recent changes in the structure and management of CLO funds which may have resulted in greater risk exposure to investors. For example, changes in skin-in-the-game rules and strong investor demand have afforded CLO fund managers more flexibility in investment strategy. CLO fund managers may have the capability to vary investment guidelines or collateral quality over time with little, or without, consent of the investor. This coincides with a weakening of CLO portfolio quality, demonstrated by record levels of CLO exposure to CCC loans, loans with the lowest quality credit rating. In addition, CLO funds have increased investments in covenant-lite loans which limit intervention in the case that a borrower’s financial performance declines, suggesting lower recoveries following default, and diminishing the protection to CLO fund investors. In the event of substantial loan defaults, the ability to make scheduled payments to CLO investors may be severely impaired.
According to the authors, while the default rate of leveraged loans has been historically low, the demand for higher yields by both investors and managers has driven riskier CLO fund management practices. These practices and the current structure of some CLO funds may prove excessively risky in light of a credit crunch resulting in circumstances prime for litigation.