Q. So what’s a CLO, and how does it relate to CDOs and CMOs?
A. A CLO is a collateralized loan obligation– meaning, usually, business loans. It is a type of CDO– collateralized debt obligation, which is a more general term for securitized pools of various kinds of debts. Another kind of CDO is a CMO– the infamous collateralized mortgage obligations over which S&P is being sued by the DOJ and which were at the heart of the last crash.

Q. So, from all that, we gather that all of these things work more or less the same way, but pool together different sorts of debt instruments?
A. That’s right. They all take lots and lots of different kinds of debt obligations and put them into a pool, often a trust. Then the trust issues certificates to investors. Those certificates are of different “traunches”. The A traunche is the most secure, has the lowest coupon rate, and gets paid first. The B, is the next most secure, gets paid a little bit higher coupon, and gets paid second, etc.

Q. So what’s the secret sauce here? What makes these things so popular?
A. You’re breaking up the one-to-one relationship of an investor in the pool to any given security. The A Traunche gets paid first from whichever loans in the pool happen to generate cash flow that month. That’s why you can take a whole bunch of pretty bad loans and still create an investment grade trust certificate– in a large enough pool of bad loans, some will still pay: and all the first dollars go to the A trauche, so its chances of being paid are really quite good. The B trauche, less so… and on down the line.

Q. And then coming back to CLOs themselves, they’re becoming more popular again after going out of style post meltdown.
A. Yes. Note that the loans in a CLO tend to be a bit riskier that average– they’re usually “leveraged loans”, meaning higher coupon, unsecured loans, often ones used in an LBO transaction or some other extraordinary event. So they produce yield, something everybody’s desperate for now (as we discussed yesterday). And the securitized structure slices and dices the overall risks of the pool as capital providers want: lower risk and lower returns, or higher risk and much higher returns.