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I am trying to understand, in its simplest form, how the collateralized loan obligations (CLO) work.

I refer to an article in The Atlantic for those who are interested in learning about CLOs.

The way I understand how it works is similar to the CDOs as they are both types of structured credit:

  1. There are firms who maxed out on their borrowing power and owe a lot already. They might need further financing for M&A activity or have a further investment need in positive net present value projects.

  2. When a syndicate of banks makes loans to these troubled banks, these loans are called "leveraged loans".

  3. The leveraged loans are packaged into CLOs where these are sliced up into different tranches for debt and equity investors usually conforming to a typical waterfall structure.

The CLO equity investors own the managed pool of bank loans while the CLO debt investors term-finance this pool.

So, when the CLO manager finances the purchase of the pool of bank loans, he or she must post collateral to ensure issuance to debt investors go smoothly. Otherwise, debt investors wouldn't jump on the bandwagon.

My Question: So, is the CLO collateral the actual leveraged loans in the pool? In other words, the coupon-producing leveraged loans in the pool themselves are posted as collateral to the debt investors? I am little confused as to how the collateral works for CLO.

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The loans are placed in a vehicle company (“special purpose vehicle” or SPV). This company issues various tranches of debt and purchases the loans from the marketplace. There is no specific posting of collateral by the manager as you describe. The manager is paid a fee to manage the pool of loans and may also own some equity (the most junior security issued by the SPV).

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How it works has been described clearly by dm63. I commend that answer.

I would like to add a few words about "collateral", what does it refer to?

Obviously the buyers of the debt tranches issued by the SPV would not do buy if they thought the SPV was just an empty worthless box. They agree to lend their money because the SPV owns some valuable income earning securities (the leverage loans). In this sense the LL can be said to be the "collateral" (or more simply the underlying assets) that back the debt tranches of the CLO. I must say I found this terminology confusing when I first encountered it. When I buy a corporate bond of Toyota I do not think of a huge car factory in Nagoya Japan and car showrooms all over the US as "collateral" for the bond (although in a sense it is: these are some of the things that give the bond its value, and will allow the company to pay me interest and principal).

If I had invented the idea I would have called them SBBL (Securities Backed By Loans) rather than Collateralized Loan Obligations. The Toyota Bonds could be Securities Backed by Automobile Manufacturing Assets. But it is too late to change the names now.

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    $\begingroup$ +1 Other 'collateral' is trust in the intersubjective reality named Toyota. :) And sanity of bankruptcy proceedings. $\endgroup$
    – ir7
    Jun 29 '20 at 15:58

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