Securitization: CLO and CDO

Securitization is a financial technique in which a pool of illiquid assets (loans, mortgages, accounts receivable) is transformed into marketable securities (Asset-Backed Securities, ABS). Securitization redistributes risk, provides liquidity to banks, and gives investors access to alternative assets. The U.S. structured products market exceeds $12 trillion.

CLO (Collateralized Loan Obligation) is the most actively developing segment of the modern structured products market. A CLO is created by a CLO manager, who: forms a diversified portfolio of 150-250 leveraged loans amounting to $400-600 million; attracts financing through the issuance of tranches of different seniority; actively manages the portfolio during the reinvestment period (4-5 years). CLO tranche structure: AAA (up to 60-65% of the structure, lowest coupon and risk), AA, A, BBB, BB (mezzanine), B (speculative), Equity (Junior/Subordinated Note, about 10% — takes the first losses, highest potential yield).

CDO (Collateralized Debt Obligation) is a broader class: the underlying asset may be bonds, CDS, or other ABS. ABS CDOs played a special role in the 2008 crisis: the underlying assets were subprime MBS (Mortgage-Backed Securities). Agencies mistakenly assigned AA/AAA ratings to senior tranches, based on models with underestimated default correlation. Synthetic CDOs were built not on real assets, but on CDS — this allowed the same credit risk to be "repackaged" many times over.

Waterfall — the mechanism for distributing cash flows in CLOs/CDOs: first, interest and principal are paid to senior tranches (AAA, AA, A), then to mezzanine (BBB, BB), and only last to equity. Equity receives the remainder after all senior holders are paid. Overcollateralization and Interest Coverage tests: if they are breached, cash flows are redirected to paying down senior tranches. This protects senior tranches from losses.

The modern CLO market. The amount of outstanding CLOs in the U.S. is more than $900 billion. CLOs are the largest holders of leveraged loans (about 60%). Banks and insurance companies are the main holders of AAA and AA tranches. Hedge funds and CLO managers hold equity and junior mezzanine.