Collateralized Loan Obligations: A Powerful New Portfolio Management Tool for Banks
by: Kenneth Kohler
Mayer Brown & Platt
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 structurethe 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 transactionstypically ranging from $1 billion to $6 billionundertaken 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
transactionthat 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 ratingsthat 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
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
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 governmentsthat
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 technologysuch as "tranching" on the basis of both
maturity and credit riskto meet the demands of particular investor groups and thus to increase the
overall value of the portfolio. Moreover, several of the benefits listed abovenamely, 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 marketscannot 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
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.
Banks contemplating a CLO transaction should be aware of several significant legal issues
that need to be considered in structuring a CLO. The rating agencies generally require satisfactory
legal opinions addressing these issues.
1. Bankruptcy/True Sale Issues. As is typical for asset-backed securities transactions,
the rating agencies will require that the CLO issuer be established as a bankruptcy-remote SPV. The
charter documents of the CLO issuer will limit its activities to acquiring loans to be used as
collateral, issuing debt and equity securities, entering into contracts with third party service providers
such as credit enhancers, and related ancillary activities.
As is the case in most asset-backed securities structures, the rating agencies will usually
require a legal opinion to the effect that there has been a "true sale" of the underlying loans from the
sponsoring bank to the SPV issuing the CLO debt securities and, if the sponsoring bank retains any
interest in the CLO issuer, a "nonconsolidation opinion" to the effect that, in the event of the
insolvency of the bank, the assets of CLO issuer will not be consolidated with those of the bank
under the "substantive consolidation" doctrine of applicable bankruptcy law. The point of these
opinions is to provide comfort that, in the event of the receivership or bankruptcy of the sponsoring
bank, the receiver, the bankruptcy trustee or the creditors of the bank will not be able to claim an
interest in the loan collateral and thereby defeat or interfere with its value as collateral for the CLO
In most jurisdictions, the question of whether loans have been "sold" in a manner that puts
them beyond the reach of creditors of the transferor is complex, and requires analysis of all of the
facts and circumstances of the transfer. The law firm issuing the true sale and nonconsolidation
opinions will examine and analyze all aspects of the structure and proposed operation of the CLO,
and typically will deliver a lengthy, "reasoned" opinion to the rating agencies. Most of the true sale
issues raised by a CLO structure are the same as those posed by asset securitization structures
generally, and do not require separate discussion here. 14 However, there are several "true sale"
related issues that are particularly associated with bank CLO structures and that should be considered
by any bank contemplating a CLO. These are discussed below:
A. Inclusion of Loan Participations. The loan portfolios of many banks include
participation interests in loans originated by themselves or others. In a typical participation, the bank
originating a loan will sell a "participation interest", representing a partial ownership interest in the
loan to another bank. Typically, the creation and sale of such a participation is done without the
agreement of the borrower to be bound by the arrangement, so the borrower remains in contractual
privity with only the originating bank. If a bank transferring a participation interest to a CLO issuer
or the originating bank (if different) becomes insolvent, there is a concern that, if the participation
interest were not truly sold to the CLO issuer, the participation would be deemed by a bankruptcy
trustee or receiver to be property of the selling or originating bank's estate, and amounts paid by the
borrower to the selling or originating bank would be captured in the insolvent bank's estate, and
therefore would be unavailable to support payments on the CLO's debt obligations.
There is no easy solution to this problem. Generally, the perceived risks posed by
participations are most easily dealt with in "linked" CLO transactions, in which the bank's credit
rating (and thus the likelihood of insolvency) is considered in the rating of the CLO debt obligations.
However, in an increasing number of de-linked transactions, including the recent NationsBank CLO,
the rating agencies have permitted the inclusion of so-called "100% participation interests" issued
by the selling bank in reliance on legal opinions to the effect that the CLO issuer, as holder of the
100% participation interests, had an enforceable ownership or security interest in the related whole
loans. 15 Banks considering the inclusion of loan participations in a CLO transaction should consult
the rating agencies and counsel early in the process to determine the extent to which the
participations may be included, and how their inclusion will affect the rating analysis.
B. Set-off Rights. Under long-standing common law and, in some jurisdictions,
statutory law, a borrower from a bank may have the right to "set-off" the amount of any deposits of
such borrower held by the bank against the amount of the loan. This principle is an example of the
doctrine of cancellation of mutual debts, which holds that when two parties owe money to each
other, one party may offset his obligation against the amount owed to him, so that only the net
amount is owed. While borrowers usually waive their set-off rights as part of standard loan
documentation, there is a concern that the waiver may not be effective in all circumstances.
Moreover, the FDIC, as receiver of U.S. banks, has been known to permit (and, indeed, encourage)
borrowers to offset deposits against their loans, effectively canceling outstanding deposits and
thereby reducing the FDIC's liability to repay depositors pursuant to federal deposit insurance. In
CLO transactions involving U.S. sponsoring banks, there is a concern that the FDIC has a strong
incentive to challenge the true sale characterization of loans or participations transferred to CLO
issuers in order to keep such loan assets available to create set-off rights against deposits.
The rating agencies may address these issues in two ways. First, as is the case with
participations, in "linked" structures the rating agencies may factor the risk of the sponsoring bank's
insolvency into the rating determination. In addition, with respect to both "linked" and "de-linked"
structures, the rating agencies may require the establishment of reserves as part of the CLO structure
to provide coverage for borrower and FDIC set-off risk.
C. Application of FIRREA to U.S. Banks. In the U.S., banks and savings
associations are generally excluded from the coverage of the federal bankruptcy laws. Rather,
depository institutions whose deposits are insured by the Federal Deposit Insurance Corporation (the
"FDIC") are subject to the receivership provisions of the Federal Deposit Insurance Act (the "FDI
Act"). The FDIC has issued a policy statement indicating that it will not seek to avoid an otherwise
legally enforceable and perfected security interest, provided that certain requirements are met. 16
Accordingly, when a U.S. bank or savings institution is the transferor of assets in an asset-backed
securities transaction, the rating agencies generally require, in lieu of a "standard" true sale opinion,
a so-called "FIRREA opinion" (named after the Financial Institutions Reform, Recovery and
Enforcement Act of 1989 ("FIRREA"), which amended the receivership provisions of the FDI Act)
to the effect that the SPV has a perfected security interest in the securitized assets and that, upon the
insolvency of the bank, the FDIC, as the receiver of the bank, would respect the security interest
therein granted to the SPV. Similarly, the nonconsolidation opinion required when the parent of the
CLO issues is an FDIC-insured bank is somewhat more complicated than is the case when the parent
is subject to the U.S. bankruptcy laws, and must take into account significant jurisdictional and
doctrinal issues regarding the extent of the FDIC's powers with respect to failed banks and their
D. State Law Receivership Issues. As previously noted, banks and savings
associations domiciled in the U.S. are generally excluded from the coverage of the general corporate
bankruptcy laws, but are subject to federal receivership laws administered by the FDIC. The banking
laws of most states of the U.S. also empower state banking authorities to seize and administer
insolvent or grossly mismanaged banks under the their jurisdiction; however, through a combination
of federal and state laws, the FDIC is virtually always appointed as the receiver for FDIC-insured
banks. State bank receivership laws may also be relevant for state banks since the FDIC, as
conservator or receiver of a state chartered bank, has the powers and duties conferred by applicable
State banking laws are of particular importance, however, when the bank entity transferring
assets to a CLO is located in the U.S. but is not subject to the FDIC's receivership provisions
principally, where the transferor is a U.S. branch or agency of a foreign bank. In these cases, the
powers of the state banking authorities must be scrutinized to determine whether additional steps
should be taken to ensure that the transferred loans will be treated as truly sold, will not be
substantively consolidated with the assets of the sponsoring bank or its affiliates, and will not
otherwise become subject to any extraordinary power of the state banking authorities. In some
statesincluding New York, whose state banking law gives the New York Superintendent of Banks
powers similar to the "automatic stay" of the U.S. Bankruptcy Codethese laws may require the use
of "two-step" or "two-tier" transfers of assets to effectively remove the transferred assets from the
jurisdiction of the state banking authorities. In such structures, the assets are first transferred in a
true sale from the selling bank to a separate bankruptcy-remote SPV, which then transfers the assets
to the CLO issuer.
2. Perfection Issues. As described above, rating agencies and investors are concerned
that transfers of the underlying commercial loans from the sponsoring bank or other loan sellers to
the CLO issuer constitute "true sales", such that the CLO issuer obtains the ownership interest in the
loans. A similar concern arises with respect to the transfer of the commercial loans from the CLO
issuer to the trustee for the CLO trust. In this case, the transfer of the loans is for security purposes
only, to provide collateral for CLO debt securities, and the legal objective is to ensure that the CLO
trustee will have a perfected security interest in the pledged commercial loans and any related
collateral. Both types of transfers (i.e., transfers of outright ownership interests and of security
interests) must be undertaken in a manner that ensures that the interest of transferee is "perfected,"
or generally protected from the claims of other purported owners or transferees of the collateral.
This requires the identification of the jurisdiction or jurisdictions whose law applies to the
perfection of the security interests. This determination is often a complicated issue in CLO
transactions, which typically involve many jurisdictions. Second, the determination requires an
analysis of the types of property that make up the commercial loan and related collateral. In fact,
these questions are inter-related, as the determination of the property type of the collateral will often
determine the jurisdiction whose law governs the perfection of the ownership interest or security
While a commercial loan is often perceived from a business standpoint as a single, discrete
item of property, from a commercial law standpoint a commercial loan may be characterized as a
bundle of related property rights and types, evidenced by a number of agreements and other
documents constituting a loan file. The most important loan document, of course, is the promissory
note or other agreement by which the borrower agrees to repay the loan. In most cases, this is in fact
a promissory note, which constitutes an "instrument" under Article 9 of the Uniform Commercial
Code (the "UCC") as in effect in most states of the United States. In some cases, however, the loan
may be evidenced by a contract or agreement which does not meet the technical definition of an
"instrument", in which case it will likely be viewed as a "general intangible". In the case of most
commercial loans, there are a number of ancillary documents and rights, such as security agreements,
assignments of leases and rents, guarantees, lock box agreements and the like, most of which are
likely to be characterized as general intangibles.
In the United States, perfection of a security interest in an "instrument" is generally
accomplished by transferring possession of the instrument to the secured party or its agent.
Accordingly, in a CLO transaction in which whole loans, rather than participation interests,
constitute the collateral, the underlying promissory notes are required to be physically delivered to
the CLO trustee or to a custodian acting on behalf of the trustee. In the United States, perfection of
the security interest in the ancillary rights categorized as "general intangibles" is accomplished by
filing a so-called "UCC-1 financing statement" with a governmental filing authority in the
jurisdiction in which the chief executive office of the debtor (in this case, the CLO issuer) is located.
If, as is often the case, the debtor has connections with more than one jurisdiction and there is
therefore a concern that the debtor may be deemed to have a chief executive office in more than one
state, UCC-1 filings are made in several jurisdictions. In the event non-U.S. law is determined to
govern these perfection issues, an analysis must be made of the applicable commercial law. In most
cases, the critical issue under non-U.S. law will be whether the borrower needs to be notified of, or
even consent to, the transfer of the security interest to the trustee.
Where loan participation interests, rather than whole commercial loans, are being securitized,
the issues become even more complex. In these cases, there will be a desire to obtain a perfected
security interest in the related participation agreement, which will most often be characterized as a
general intangible, but which may have a related "participation certificate" that could be
characterized as an instrument. The rating agencies will usually require an opinion that the CLO
trustee has a perfected security interest not only in the participation agreement, but also in the
underlying commercial loans. Not surprisingly, these perfection issues are the subject of extensive
legal opinions provided at the closing of the CLO transaction.
3. Risk-Based Capital Issues. As discussed above, a likely motivation for many banks
to pursue a CLO is to reduce their risk-based capital requirements. Generally speaking, a true sale
of a loan portfolio from a bank to a CLO issuer which is not a subsidiary of the bank will result in
the loans being removed from the bank's balance sheet for both financial reporting and regulatory
accounting purposes. In the case of a straightforward sale of assets with no continuing involvement
or responsibility on the part of the selling bank, the removal of the assets from a bank's balance sheet
will terminate any regulatory requirement that capital be maintained against such assets. Under the
risk-based capital rules in effect in most developed countries, however, a bank may be required to
maintain risk-based capital even against assets sold by the bank to a third party if the transferring
bank retains or accepts "recourse" with respect to the sold assets. 17
Accordingly, if a bank is undertaking a CLO transaction to reduce its risk-based capital
requirement, it must take care to structure the transaction in a manner that eliminates or at least
minimizes (in the case of U.S. banks subject to the low-level recourse rule) recourse to the bank.
Recourse issues typically arise in bank-sponsored securitization transactions when the sponsoring
bank either retains a subordinated interest in the sold loans or an equity interest in the issuer (whether
or not evidenced by a security) or provides credit enhancement to the transaction through a guarantee
or other credit support obligation.
In a typical CLO transaction, the equity interest in the CLO or an unrated subordinate debt
obligation issued by the CLO would be viewed as recourse if retained by the bank or a bank affiliate.
Thus, in planning a bank CLO transaction, the sponsoring bank will probably need to satisfy itself
that most, if not all, of any subordinated interest in the loan portfolio can be sold economically to
unrelated third parties. Structurally, this is usually accomplished by tranching the subordinate
interests into senior subordinated interests and a junior subordinated interest, with the senior interests
being sold to investors and the junior interest being retained by the bank or its affiliate.
4A Tax Issues. The most important objectives in a CLO transaction related to taxation
are (i) to avoid any potential tax impairment of the securitization vehicle itself (i.e., to prevent the
risk of any imposition of a vehicle-level tax, including any withholding tax, even though it might be
refundable) and (ii) to maximize tax neutrality (i.e., to minimize or eliminate any incremental tax
costs in implementing and maintaining the CLO structure by comparison to an "on-balance sheet"
financing). Tax neutrality requires minimization or elimination of (i) taxation of the transfer of the
collateral as a "sale" upon funding of the vehicle, (ii) adverse tax consequences with respect to
payments from the vehicle to investors or the sponsoring bank, (iii) adverse peripheral effects upon
the tax calculations of the overall non-securitization operations of the sponsoring bank, and
(iv) significant administrative burdens. Achievement of these objectives typically requires intense
analysis in the initial stages of structuring the transaction.
The most favorable tax structure depends on numerous variables, including (a) with
respect to the loan portfolio, the booking location, situs of the borrowers, and nature of the security
for the loans (e.g., real estate vs. non-real estate), (b) the nature and extent of the ramp-up or
reinvestment period, if any, (c) the legal status and residency of the sponsor (e.g., domestic bank vs.
branch of non-U.S. bank) and, to some extent, of the investors, (d) the relationship among (and
degree of subordination of) the securities to be issued by the CLO issuer, (e) whether or not the
sponsor can retain the residual (in the form of debt or otherwise) or must market it in whole or in part
to investors, and (f) the administrative flexibility of the sponsoring bank. Although there are foreign
marketing advantages for an offshore (typically Cayman Islands) CLO issuer and recent tax
legislation has made such an issuer more administrable, traditional constraints which have remained
unchanged may challenge the use of an offshore issuer in given circumstances. Alternative domestic
structures include a limited liability company ("LLC"), a "financial asset securitization investment
trust" ("FASIT") or, in limited circumstances, a "real estate mortgage investment conduit"
("REMIC") or real estate investment trust ("REIT"). All the circumstances must be considered in
the determination of the optimum tax structure.
5A Securities Law Issues. Bank CLO transactions raise a number of issues under U.S.
securities laws. 18 The principal U.S. securities law issues are discussed
Ai Securities Act of 1933. The U.S. Securities Act of 1933, as amended (the
"1933 Act"), generally requires the registration of public securities offerings with the U.S. Securities
and Exchange Commission (the "SEC"), and imposes disclosure obligations (and related statutory
liabilities for non-compliance) on issuers and underwriters. Most bank CLO offerings to date have
been structured to take advantage of exemptions from the registration requirements of the 1933 Act,
generally pursuant to the exemptions provided by Regulation D and Rule 144A (for certain private
placements) and Regulation S (for offshore offerings to non-U.S. persons). These non-public forms
of distribution have been used to reduce exposure to securities law liability, to avoid difficult SEC
disclosure requirements and to provide a basis for further exemptions under the Investment Company
Act of 1940, as amended (the "1940 Act"), discussed below.
Bi Investment Company Act of 1940. The 1940 Act generally applies to
"investment companies" that is, companies whose business is investing in securities, such as
mutual funds. Since loans fall within the definition of "securities" for many federal securities law
purposes, a CLO issuer could be viewed as an investment company subject to the 1940 Act if an
exemption were not available. Investment companies subject to the 1940 Act are subject to a
number of burdensome and costly restrictions regarding reporting requirements, limitations on
borrowings, corporate governance and other matters, and issuers of CLOs and other types of
asset-backed securities typically structure their transactions to fall within 1940 Act exemptions
whenever possible. At least three 1940 Act exemptions are frequently used in CLO transactions:
(i) Section 3(c)(1): This section, which was included in the 1940 Act as
originally enacted, excludes from the definition of "investment company" any company
"whose outstanding securities (other than short-term paper) are beneficially owned by not
more than 100 persons and which is not making and does not presently propose to make a
public offering of its securities." One advantage in certain contexts of Section 3(c)(1) over
the other exemptions described below is that there is no requirement that the investors have
a minimum financial capacity or level of investment experience. However, this advantage
is of little importance in the CLO market in its present state of development, since CLO
investors are almost always very substantial, financially sophisticated institutions. The
principal disadvantage of Section 3(c)(1), of course, is that it imposes a rather strict
limitation on the ability of investors to sell off partial positions and thus severely limits the
liquidity of the trading market for such securities. Moreover, the difficulty of tracking the
number of beneficial owners imposes a practical constraint on the usefulness of this
(ii) Section 3(c)(7): This section, which became effective in 1997,
excludes from the definition of investment company any company, "the outstanding
securities of which are owned exclusively by persons who, at the time of acquisition of such
securities, are qualified purchasers, and which is not making and does not at that time
propose to make a public offering of such securities." The term "qualified purchasers," in
turn, is defined to include individuals who own at least $5 million in investments, certain
companies that own at least $5 million in investments, certain trusts, and, subject to certain
exceptions, "qualified institutional buyers" ("QIBs") as defined in Rule 144A. While Section
3(c)(7) imposes financial capacity and sophistication requirements that are not present in
Section 3(c)(1), it represents a significant liberalization with respect to the potential size of
the investor group. Since the number of prospective investors is not limited under Section
3(c)(7), the use of Section 3(c)(7) may be expected to increase the liquidity of the market for
(iii) Rule 3a-7. Rule 3a-7 under the 1940 Act, adopted in 1992, excludes
from the definition of "investment company" any company that issues non-redeemable
investment grade, fixed income securities that entitle holders to receive payments that depend
primarily on the cash flow from a pool of financial assets. The Rule further permits, subject
to certain conditions, the sale of non-investment grade fixed income securities to certain
types of accredited investors as defined in Regulation D under the 1933 Act and the sale of
any securities to QIBs. Where the requirements of Rule 3a-7 are met, it is the most flexible
exemption with respect to the nature of the offering because it effectively permits public
offerings of at least the investment grade debt securities of a CLO. Moreover, even
non-investment grade fixed income securities may be sold to "accredited investors,"
generally a broader category than the more restrictive "qualified purchaser" category
permitted under Section 3(c)(7). This latter advantage provides greater flexibility in the
initial offering of the securities since the issuer does not need to comply with the onerous
private placement restrictions of the federal securities laws, and it also permits secondary
trading with fewer restrictions than under other possible exemptions.
Unfortunately, however, Rule 3a-7 also embodies a significant disadvantage
as compared to the other possible exemptions. Specifically, the Rule imposes several
restrictions on the ability of the portfolio manager to engage in trading activities with respect
to the CLO's assets, including most importantly a prohibition on acquiring or disposing of
assets for the primary purpose of recognizing gains or decreasing losses resulting from
market value changes. These trading restrictions limit the utility of the Rule 3a-7 exemption
in CLO transactions in which active management of the CLO's asset portfolio is
6A ERISA Issues. A thorough discussion of the application of the Employee Retirement
Income Security Act of 1974, as amended ("ERISA") to securitization transactions in general, and
to CLOs in particular, is beyond the scope of this article. 19 However, it should be noted that CLO
transactions may give rise to a number of possible "prohibited transactions" under ERISA if
securities are sold to plans because of the application of ERISA to the CLO issuer and its underlying
loans or other assets. Moreover, the U.S. Department of Labor has not issued any generally
applicable exemption for CLOs similar to the exemptions it has issued with respect to certain other
types of asset-backed securities. Accordingly, each CLO structure must be analyzed to determine
the applicability of ERISA and its exemptions to prospective investors. In general, debt securities
issued by a CLO issuer will not pose difficult ERISA issues so long as the debt is highly rated and
does not have substantial equity features. On the other hand, equity interests in a CLO issuer are not
entitled to any generally applicable ERISA exemption, and offerings of CLO equity securities
typically either prohibit or substantially limit investments by U.S. pension plans.
IMPLEMENTING A BANK CLO TRANSACTION
1A Professional Team Members. Structuring and completing a bank CLO is,
particularly in the case of the initial transaction undertaken by a sponsoring bank, a significant
undertaking requiring the attention of bank management and staff as well as numerous service
providers. Usually, the effort will be coordinated by the investment bank that proposes to act as
underwriter or placement agent in placing the CLO securities with investors (sometimes referred
to in this discussion as the "structuring agent"). The sponsoring bank's outside law firm will also
play a critical role in structuring and documenting the transaction and in ensuring that the legal
opinions required by the rating agencies and investors can be provided. Other service providers
necessary to complete a CLO may include a portfolio manager, credit enhancers, accountants, a
trustee, a custodian, a paying agent and a collateral agent.
2A Structuring and Documenting the CLO Transaction. The investment bank
designated as the structuring agent will usually assume the lead role in structuring the transaction.
It will analyze the projected cash flows from the pool of underlying loans, and attempt to "carve"
the aggregate cash flows into specific bond classes, or "tranches", that are designed to meet the then
current desires of prospective investors with respect to yield, weighted average life and credit quality,
among other characteristics. If one of the sponsoring bank's motivations is to reduce its risk-based
capital requirement, the structuring agent will have to take care to minimize the size of any
subordinated debt securities or equity interests to be retained by the bank or its affiliates. The
structuring agent will work closely with the rating agencies to ensure that the securities formulated
by the structuring agent will qualify for the desired ratings.
The transaction documentation for a bank CLO is conceptually the same as that for any other
asset-backed securitization, but in practice may be somewhat more extensive because of the
complexity of transferring large loan assets and the typical presence of multi-jurisdictional legal
issues. One important document will be the offering memorandum describing the CLO debt
securities and, if they are to be sold, the CLO issuer's equity securities. The offering memorandum
will include detailed information regarding the transaction structure and the underlying commercial
loans. This document may be prepared by either the sponsoring bank's counsel or the structuring
agent's counsel, but all principal parties will of necessity be heavily involved in its preparation and
review. A firm of independent accountants (which may be the sponsoring bank's regular outside
accountants or, if different, the accounting firm that undertook the loan file due diligence) will be
required to deliver a "comfort letter" confirming the statistical data that is shown in the offering
The transaction documents will also include the corporate documentation required to
establish the CLO issuer as an SPV, and the various asset transfer and servicing agreements required
to administer the CLO trust and securities. These will include an asset purchase or contribution
agreement by which the sponsoring bank will transfer the commercial loans to the CLO issuer, an
indenture governing the terms of the CLO debt securities, a servicing agreement, and numerous other
ancillary documents. Responsibility for drafting these documents will most likely be divided
between counsel for the sponsoring bank and the counsel for the structuring agent, but, as with the
offering memorandum, all of the principal parties will need to closely review and comment on the
draft documents. For the actual closing, numerous assignments, consents and other documents will
need to be prepared and executed to effectuate the actual transfer of loan assets to the CLO issuer.
As should be evident from much of the preceding discussion, the consummation of any CLO
transaction will require the delivery of a number of legal opinions regarding, among other things, the
structure of the transaction, the proper organization and legal status of the CLO issuer, trustee and
other related parties, the tax consequences of the transaction, the effectiveness of the various
transfers of commercial loans and related property, the perfection of security interests in the
commercial loans and related property, and compliance with applicable securities law. If, as is
almost always the case, the commercial loans were originated in or made to borrowers in different
jurisdictions and/or the securities are being offered in more than one jurisdiction, lawyers from
several or many jurisdictions will be involved in providing the required legal opinions.
While the delivery of the legal opinions is technically an event that occurs at closing, the
required legal opinions need to be considered from the earliest planning stages of the CLO
transaction, and the ability of the various lawyers involved to give the required opinions will often
drive structuring decisions and key provisions of the operative documents. Obviously, the
involvement of a number of different lawyers and law firms from the early stages of a transaction
can give rise to substantial expense. To minimize this expense, it is important that a CLO issuer or
sponsor involve lawyers who are familiar with securitization transactions generally and CLO
transactions in particular.
3A Due Diligence. A major difference between a CLO and a CBO is the level of due
diligence generally required with respect to the loan portfolio. While a CBO is typically
collateralized by bonds with easily verifiable payment and credit characteristics, a CLO is usually
collateralized by a large number of individual loans with non-uniform loan terms, each of which may
have been modified or have a history of legal problems or complications. As discussed above, the
rating agencies will either perform limited due diligence itself or rely on the more extensive due
diligence undertaken by other deal participants. Similarly, the structuring agent and the sponsoring
bank's counsel will want to ensure that all relevant facts about the loans are gathered, considered in
structuring the transaction, and adequately disclosed to prospective investors. The loan file due
diligence will generally be performed by a professional due diligence firm or the due diligence unit
of an accounting firm. The items to be reviewed will include the following:
Ai Confirmation of Payment Terms. The due diligence firm will review each file to
confirm that the payment amounts, payment dates, interest rates, maturity dates and other key
payment terms of each loan conform to the data in the computer records provided by the
sponsoring bank to the rating agencies and the structuring agent. Of course, these terms are
central to projecting the cash flows from the transaction which, in turn, drive many
Bi Funding Schedule. The due diligence firm will confirm that all funds have been
disbursed under each loan or, if they have not been disbursed, will so note so that provision
may be made to assure that any future funding obligations are satisfied.
Ci Prepayment Provisions. The due diligence firm will review each loan for any
relevant prepayment penalty, yield maintenance or other similar provision that could impact
cash flows and the likelihood of a loan pre-paying, so that such factors may be considered
in structuring the transaction and making disclosures to investors regarding the rate at which
loans are likely to be repaid.
Di Transfer Provisions. The due diligence firm will review the loan documents and
any loan participation agreements for restrictions on the ability of the selling bank to transfer
the related loan or participation interest that could impair the bank's ability to assign the loan
to the CLO issuer. The presence of such restrictions could give rise to a requirement of
obtaining the consent of the borrower or of other loan participants to the transfer or, at a
minimum, a disclosure to the prospective investors regarding the consequences of not
obtaining such consent.
Ei Environmental Issues. The due diligence firm will review the loan files for any
indication that the loan presents any environmental issues which could interfere with the
borrower's ability to repay the loan or create liability for the owner of the loan.
Fi Lender Liability. The due diligence firm will review the loan files for any evidence
that the sponsoring bank could be subject to a lender liability claim by the borrower which
could result in a right of offset by the borrower against the loan, or which could result in the
CLO issuer being drawn into litigation regarding the lender liability issue.
Gi Servicing Issues. The due diligence firm will review the file for any evidence of
improper servicing any other problems with the loan.
Considering the benefits that CLOs can provide to both sponsoring banks and investors, the
CLO market will almost certainly continue to grow and evolve. Banks that enter the market early
in this process may have a competitive advantage over those who wait.
This article presents a very general overview of bank CLOs. Actual transactions vary
considerably with respect to structure and asset types. Banks interested in pursuing CLOs should
contact an experienced investment bank or law firm for additional information on this important new
by: Kenneth Kohler,
Mayer, Brown & Platt
- Kenneth E. Kohler is a partner in the Los Angeles office of Mayer, Brown & Platt, a Chicago-based
multinational law firm. Mr. Kohler received his law degree from Yale Law School and his undergraduate degree from the University of California at Berkeley. His practice is concentrated in
the areas of asset-backed securities and mortgage-backed securities for bank, thrift and mortgage
banking clients. Return to article
- The author gratefully acknowledges the assistance of Jean S. Chin, Laura A. DeFelice, Mary C. Fontaine,
Thomas R. Hood, J. Paul Forrester, Thomas S. Kiriakos, Jason H. P. Kravitt, Leninne Occhino and George A.
Pecoulas, all partners of Mayer, Brown & Platt, and Jon Van Gorp, an associate of Mayer, Brown & Platt, in
preparing and reviewing this article.Return to article
- While the R.O.S.E. Funding transaction is generally cited as the first of the current generation of bank CLOs, the
history of such transactions can be traced to the seminal FRENDS B.V. securitization of portfolio LBO loans
sponsored by Continental Bank in 1988.Return to article
- Moody's Investors Service, Inc., "CBO/CLO 1997 Review/1998 Outlook: The Market Becomes a Fixture,"
January 30, 1998.Return to article
- CLOs are often classified as either "arbitrage CLOs" or "balance sheet CLOs." In an arbitrage CLO, the
sponsoring entity takes advantage of a favorable market opportunity to purchase a loan portfolio for the specific
purpose of undertaking a CLO generating a profit from the differential between the yield on the loans and the yield
on the CLO securities, as well as fees. In a balance sheet CLO, the sponsoring bank typically uses loans already on
its balance sheet, and undertakes the transaction principally to achieve one or more of the portfolio management
objectives discussed below under "Benefits to Banks of CLOs." Most bank CLOs to date have been balance sheet
CLOs and, unless the context suggests otherwise, the discussion in this article is focused on balance sheet CLOs.Return to article
- Although this is the typical structure, many recent CLOs have contemplated issuances of senior and subordinated
debt over time as the CLO vehicle "ramps up" and invests in the loan collateral, usually over a one-year period.Return to article
- In contrast, a minority of CBO transactions have been structured as "market value" transactions, in which the
repayment and rating of the debt securities is based on the value for which the collateral can be liquidated, and some
recent hybrid transactions have employed both "cash flow" and "market value" features.Return to article
- The Basle Committee on Banking Supervision is a committee of banking supervisory authorities which was
established by the central bank governors of the so-called "Group of Ten" countries in 1975. It consists of senior
representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States. It usually meets at
the Bank for International Settlements in Basle, Switzerland.Return to article
- Under the risk-based capital guidelines, banks and bank holding companies must maintain capital of 8% against
their risk-weighted assets. Most assets are weighted at 100%; however, certain classes of assets deemed less risky
than general assets, such as obligations issued or guaranteed by certain government or government-sponsored
entities, are weighted at 50%, 20% or 0% of their face amounts, depending upon their perceived riskiness.
Commercial loans are generally assigned a risk-weight of 100%, and therefore command the full 8% risk-based
capital requirement.Return to article
- Under this rule, established pursuant to 12 U.S.C. §4808, the risk-based capital requirement for recourse cannot
exceed the amount a bank is contractually obligated to fund.Return to article
- If the bank retains servicing responsibilities or is the collateral manager/portfolio adviser, the underwriter and/or
bondholders may require that it retain a certain minimum percentage of the subordinate debt as a performance
incentive.Return to article
- For example, U.S. national banks are subject to lending limits set forth in 12 U.S.C.§84 (1997).Return to article
- The principal rating agencies active in the U.S. and global markets are Duff & Phelps Credit Rating Co. ("DCR"),
Fitch IBCA, Inc. ("Fitch"), Moody's Investors Service, Inc. ("Moody's), and Standard & Poor's Ratings Services, a
division of McGraw-Hill Companies, Inc. ("Standard & Poor's).Return to article
- See, e.g., "Cash Flow CBO/CLO Transaction Rating Criteria: 1996 Update" (Standard & Poor's, Nov. 1996) and
"CBO/CLO Update: Market Innovations" (Standard & Poor's, Feb. 1998); "CBO/CLO 1997 Review/1998 Outlook:
The Market Becomes a Fixture" (Moody's, Jan. 1998); "CBO/CLO Rating Criteria" (Fitch, Mar. 1997); and "DCR
Criteria for Rating Cash Flow and Market Value CBOs/CLOs" (DCR, Sept. 1997). Return to article
- For an in-depth discussion of true sale and nonconsolidation issues, see Kravitt, Securitization of Financial
Assets (2d ed.), Chapter 5 (Aspen Law & Business, 1998).Return to article
- See, "Bank Collateralized Loan Obligations: An Overview" (Fitch, Dec. 18, 1997).Return to article
- Statement of Policy Regarding Treatment of Security Interests After Appointment of the Federal Deposit
Insurance Corporation as Conservator or Receiver, 58 Fed. Reg. 16833 (1993).Return to article
- In the U.S., the principal federal bank regulatory agenciesthe Office of the Comptroller of the Currency (the
"OCC"), the Board of Governors of the Federal Reserve System (the "FRB"), the FDIC and the Office of Thrift
Supervision (the "OTS")have each adopted similar, but not identical, risk-based capital rules. These rules were
developed by such banking agencies in concert, acting through an umbrella group, the Federal Financial Institutions
Examination Council (the "FFIEC"), which, in turn, modeled its approach on the Basle Accord described above.Return to article
- As many bank CLO offerings are global in scope, the securities registration and disclosure laws of many
jurisdictions may apply to any given offering. Counsel representing sponsoring banks CLOs will likely need to
consult with local law firms to ensure securities law compliance in all relevant jurisdictions.
For a thorough discussion of the ERISA issues applicable to asset-backed securities, see Kravitt, Securitization of
Financial Assets (2d ed.), Chapter 17 (Aspen Law & Business, 1998)
Return to article
Copyright (c) 1998 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.
back to top