A bottom-up, reduced form credit risk model approach for the determination of collateralised loan obligation capital

Abstract

This paper uses a bottom-up, reduced form credit risk model with hazard rate estimated default probabilities to compute various collateralised loan obligation (CLO) tranches' loss probabilities and capital factors. It is shown that with respect to the loss probabilities, credit rated CLO tranches are less risky than comparably rated corporate bonds. In addition, a similar argument can be made that corporate debt loss rates will be on average larger than equally rated CLO tranche loss rates. And, it is shown that the National Association of Insurance Commissioners (NAIC) capital factors are typically larger than value-at-risk based capital factors. The policy implication is that NAIC capital factors distort investment incentives by requiring too much capital for CLOs relative to equally rated corporate debt.