Blockchain is a CLO Lead Bank’s Best Friend
The subprime mortgage crisis in 2008 and 2009 tranquilized the investor spirit and created a healthy resistance to high-risk loans. Billions of US dollars worth of CDOs needed to be written off as sunk investments, sending long-established banks into oblivion. Collateralized loan obligations were bundled into this object of general aversion, though the subject of the basic unit of a CLO – the business owner – has in general a much different approach to taking out a loan than the average home buyer.
The average home buyer today has three main characteristics that may very well be the reason why she/he should not be taking out a loan that size. Each of these characteristics in themselves would be great for buying a home, but the three together make for a volatile mixture: Searching for Community. Looking for something “a level up.” Decision based on the gut feeling. When the desire for a “step up the ladder” in society is strong, it can cloud the judgement of a home buyer. Finding a place where they feel they belong, and having that “right feeling” about a house, could lead to embellishing themselves with a house they could never afford. Hence so many sour CDOs.
Business owners, on the other hand, generally have three different characteristics. They trust real assets. They plan and measure realistically. They are dedicated and passionate. For this reason a CLO, comprised of all sizes of business loans, has intrinsically a different value than a CDO. Yet their bundling and tranche structure sucked them into the batch of distrusted financial packages after 2009. As a result of that subprime mortgage crisis, the demand for lending money either in the form of mortgage bonds or CLOs almost came to a halt, with negligible issuance in 2008 and 2009.
Collateralized loan obligations in the US took an upward swing in 2012, reaching $55.2 billion, with new-issue CLO volume quadrupling from the previous year. Big names such as Barclays and RBS launched their first deals since before the credit crisis. Many lesser known banks began investing in CLOs too, reflecting the rebounding of market confidence in CLOs as an investment vehicle. CLO issuance soared since then, culminating in 2013 in the US in $81.9 billion, the most since 2006. In 2014 the US market saw $124.1 billion in issuance.
In 2015, due to new government regulations, CLO issuance slipped to a still-healthy $97.34 billion, though it slowed considerably at the tail end of the year, and all but shut down in the early months of 2016, as the leveraged loan market battled investor resistance to risk in general. Since then it has not returned to its previous heights.
However, now a lead bank, issuer of a CLO, can have confidence. With the introduction of blockchain technology, managing risk can be easier and compliance with risk-retention can facilitate the issuance of new products. The regulations instated in 2016 require managers to retain 5% of the entire size of the CLO. Since blockchain-based lending provides greater transparency, greater control over the movements of loans among banks, and greater security, a lead bank can confidently plan to retain a prescribed percentage of the risk because the risk becomes manageable. We will see a rise in new issuances of CLOs under the auspices of blockchain-savvy banks, making for a healthier economy of interdependence between businesses and banks. Blockchain will prove to be a CLO lead bank’s best friend.