A collateralized loan obligation (CLO) is a financial process to bring together loans to many different businesses into one package which is then resold to multiple lenders. The aim is to make the financial system more efficient by overcoming the mismatch between the different needs of individual borrowers and lenders. However, in some ways the CLO increases complexity and has been blamed for contributing to the banking crisis which emerged in 2007.
Strictly speaking, a collateralized loan obligation only involves commercial business loans. There are similar schemes which work the same way using bonds and mortgages, and some which combine two or more types of loans. The terms used for these schemes are often confused or used interchangeably. However, the basic system and the benefits and drawbacks are the same in all cases.
To understand why the collateralized loan obligation developed, you need to remember that some borrowers are considered more likely to repay than others. Some lenders are happy to make riskier loans because they can charge higher rates, while others prefer loans with lower rates because they are more certain of repayment.
The finance industry believed the loan market didn’t work as well as it could because individual lenders had to find individual borrowers who wanted the "right" type of loan. This could mean there was enough money available from all lenders to pay for all the loans borrowers needed, but the cash wasn’t getting where it was needed.
This led to the development of the collateralized loan obligation. In this system, many different existing loans, both risky and safe, are put together. Lenders then buy the rights to receive a share of the payments from all the borrowers. Each lender gets a different level of payment depending on how much risk they will accept.
If any of the borrowers involved in a collateralized loan obligation fails to repay their loan, the loss will be taken out of the share given to the lender who accepted the most risk. As more borrowers default, this lender could end up with nothing and then remaining losses would pass to the lender who took on the second highest level of risk, and so on.
The biggest problem with a collateralized loan obligation is that it increases complexity in the system and makes it much harder for large banks to keep track of how much risk they bear. In some cases, credit rating groups, which advise lenders on how risky an investment is, have labeled a collateralized loan obligation as very safe because some of the borrowers involved are considered very good risks; these ratings don’t take account of the loans to medium or high risk borrowers.
Some people argue this confusion has allowed too many very risky loans to be made to people who have since failed to repay them. The amount of money which hasn’t been repaid has been so high that in some cases even lenders who bought the "safest" shares of a collateralized loan obligation have found themselves losing money unexpectedly.