CLO Overview The role of a CLO manager is to buy commercial loans from originators (banks), pool the loans, and then structure the cash flows from the loans in the pool to create and sell securities (the CLOs) from these cash flows. The manager makes money in two ways. The first way is from fees from managing the pool. This includes loan servicing (collecting interest payments), reinvesting early amortizations, managing any delinquencies or work outs if the loans are defaulted upon, monitoring loan covenants, and reporting to the CLO investors. The CLO manager also makes money by investing in the equity tranche of the pool. The equity tranche is the riskiest piece of the structure, meaning equity investors collect proceeds only if the obligations of the more senior tranches are satisfied. The structuring of the pool into securities means prioritization of the interest and principal pay down cash flows into the tranches. The highest tranche with the most seniority is the Class A securities, followed by Class B, then the C and D classes. Equity is subordinate to the class D securities. The prioritization algorithm that directs the cash flows to the tranches is called the waterfall. Even though the underlying collateral is in the BB range, some of the securities can be as high as AAA because of the structural features of the CLO, i.e. the prioritization that creates significant over-collateralization to the higher tranches. The underlying loans pay the larger of [LIBOR or a floor] plus a spread. The loans are also callable. The CLO securities pay investors LIBOR plus a spread. Case Study HEM Asset Management, LP is a CLO (collateralized loan obligation) manager and has recently structured and sold securities for a new pool of $110 million in loan assets. The waterfall, the underlying loan detail, the spreads, the floor amount, expected recovery, the detail on fees and other valuable information is in the CDO.xls file. What is a Bank Loan.pdf has useful general information which HEM gives to its prospective clients who want to learn more about this relatively new asset class. One feature of a CLO is that in the first four years of the pool, early amortizations typically must be reinvested. After four years, any accelerated pay-down is typically returned to investors. Your Analysis What are the risks to the managers position in the pool, both as a manager earning fees and as an equity investor? How would you measure the risks, how might you mitigate the risks, and how would you summarize the risks to the owners of HEM Asset management? Is HEM adequately compensated for taking these risks? Consider 1) How much money the CLO manager expects to make on this pool 2) The risks to making this money 3) The time horizon 4) How you might measure these risk exposures 5) If the risk exposures are systematic or unsystematic 6) The correlation across the different risk exposures 7) What risk factors are those most important to measure and which risk factors are those you might be able to not worry too much about Analysis Outputs: 1) A scenario analysis that includes a baseline profit forecast over the life of the pool from both fees and equity returns and a profit forecast under particular what-if circumstances that you can clearly articulate and measure. The market baseline forecast should embody the markets views of what might happen to relevant economic variables. 2) A profit/loss distribution, using an historical data approach for the risk factors. Summarize key points on the distribution, such as the mean, the values near the mean (one std dev) and the extreme values (VaR at the e.g. 95% or 99% points on the distribution). Show the distribution for profits/losses at a particular point in time, such as the one year forecast. You may want to also consider showing the distribution for the present value of multi year profits, which is more complex. Intermediate milestones/deliverables will be set from now until the final exam date. What you should prepare between now and then: 1. Nature of the business, brief summary, and how the manager makes money from this deal. 2. Brief description of the risks that the manager faces with the deal. This part should not go into a lot of detail, but articulate precisely what the risk exposures are. You may want to include plausible, illustrative examples. 3. Statement about what the risk tolerance of the manager is likely to be. 4. Create baseline profits for manager, both from fees and returns on equity; do a one-year ahead projection, a two-year ahead projection, and do a total deal PV cash flow projection (i.e. project out until loans mature). 5. Given #2, find historical data on the risk drivers and evaluate what some of the key values are on the frequency distributionthe mean, the values near the mean, and the extreme values. Assess those values based on #3 and state what VaR levels you will be using. Instead of finding the profit/loss distribution (since this will be computationally intensive) and identifying the e.g. 0.01 (.99) percentile and other VaR points on this, using historical data, identify the VaR points of the risk drivers distributions and evaluate the managers losses associated with these points. 6. Perform a scenario analysis--Outline the values of the managers profits under various unlikely yet plausible values for the risk drivers youd like to evaluate. Then, evaluate the scenarios in terms of cash flows to the manager and display the results. 7. Are there any mitigants to the risks? Are they economical to implement? 8. Is the manager adequately compensated on its equity investment? Deliverables: 1) Group presentation on Dec 10th. 2) Submission due on the final exam date. A two page max write up to the board of directors that addresses the question: What are the risks and returns associated with managing CLOs and investing in the equity tranche? Your answer should be from the point of view of a risk manager, not a line manager. 3) Final exam questions will relate to the project. Presentation Guidelines and Grading Rubric Please be as brief as you can while still conveying all information that is needed. It will be easier to include everything you looked at and then edit down from there. The final deliverable can be Word or Powerpoint. The quality and clarity of your presentation is more important than formatting and color graphs etc. Key things to consider: CASVG for Clarity, Analysis (argument), Support of your argument, Voice (yours, not kluged together from various internet sources), and Grammar, including syntax, etc.