Using CLOs to Manage the Credit Risk of Corporate Loan Portfolios

Collateralized loan obligations (CLOs) are a key tool for managing the credit risk of corporate loan portfolios. Along with credit default swaps (CDSs), CLOs are the primary means of transferring credit risk from a bank loan portfolio to third-party investors without jeopardizing customer relationships. Furthermore, CLOs have the additional feature that they can be used to transfer the credit risk of borrowers that do not trade in the CDS market. The current crisis is expected to stress currently outstanding CLO transactions to degrees that may not have been anticipated when these transactions were originated. Those banks that have used CLOs to manage the concentration risk in their corporate loan portfolios will need to monitor the performance of these transactions closely to understand the effectiveness of the hedges that these transactions provide. After providing an overview of credit portfolio management practices and a brief description of CDSs and other standardized credit risk transfer products, this paper describes a framework for monitoring and communicating the hedge effectiveness of CLOs to support future decision making for managing concentration risk and approving new loans within banks