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Gerry Schwartz, CEO of Onex Corp. Non-bank financial services firms such as Onex are rolling out new CLOs.J.P. Moczulski/The Canadian Press

One resurgent corner of the so-called shadow banking system is proving that not all the financial innovations that got much of the blame for the credit crisis were toxic after all.

The meltdown of 2008 seemed to spell the end for the alphabet soup of investment products – CDOs, non-bank ABCP, RMBS – that defined the shadow banking system, a world of lending that took place away from banks and funnelled money directly from investors to creditors.

The days of the crisis, and the years that followed, were the very definition of throwing the baby out with the bath water. Investors sold everything, especially anything with the taint of association with the business of structured credit or securitization. The idea that securitization was a reasonable method for spreading risk seemed to be dead, replaced by a belief that it was simply alchemy, a way to turn weak assets into ones that appeared strong.

In many cases, that was true: Collaterized debt obligations, for instance, were subprime mortgages repackaged as triple-A-rated bonds. However, collateralized loan obligations (CLOs) – packages of mostly high-yield corporate debt that are sliced up and sold – have been resilient, with few defaults. As a result, they are are once again drawing investor interest.

A healthy CLO business is great news for corporate borrowers, who will have another source of funds, and for managers, who can package loans and collect management fees. For investors, there will remain a lingering question of whether CLOs survived the crisis largely unscathed because they were inherently better conceived than other products such as CDOs, or whether the storm that swamps CLOs simply has yet to arrive. But with more conservative structures, investors are returning to the CLO market.

As that happens, non-bank financial services firms such as Canada's Onex Corp. are rolling out new CLOs to take advantage of the rebound. The second quarter was busiest for CLO sales since the market seized in 2007, according to the U.S. Securities Industry and Financial Markets Association. The amount raised in the last quarter almost equalled all of 2011. The third quarter looks strong as well, with issuance that includes Onex's second CLO, which raises $521-million.

Seth Mersky, an Onex managing director, argues that CLOs have something that CDOs based on mortgages do not: diversification. The idea that all the home loans from different cities in a CDO full of mortgages provided diversification proved wrong when the entire U.S. housing market sank with few exceptions. So far, there has been no widespread wave of defaults in corporations.

With CDOs, "what was really lacking was diversity," he said in an interview. "Even though it was lots of different mortgages, a diverse set of mortgagees, it was all real estate risk. In the end, it was almost entirely correlated. When it went bad, it all went bad at once. Corporate credit CLOs are significantly more uncorrelated."

The possibility remains that CLO survival may be less about a lack of correlation than the fact that corporations had stronger balance sheets than households, they were able to weather the credit freeze, and now they have been able to refinance with no trouble, thanks to a demand for yield. In other words, the idea that the assets in a CLO are not correlated may yet face a test.

And to be sure, during the worst of the crisis, CLOs were beaten up like other credit products, with yields relative to government securities exploding. But then the spreads came back in. And while other credit derivatives such as mortgage-backed securities were caught up in a wave of downgrades, most top-rated CLO paper stayed A-rated. Actual losses on the assets underlying CLOs have been tiny. That doesn't mean there hasn't been room to improve. Proponents point to tighter documentation and less aggressive structures, with far less leverage, in large part thanks to the experience with CDOs that made buyers and ratings agencies far pickier.

For Onex, CLOs are now part of the long-term plan. As a private equity firm, it uses high-yield loans to fund purchases of companies, so there is a belief that picking loans as a CLO manager is a natural offshoot.

"It's a business that we want to grow," Mr. Mersky said. "I would be very surprised if [Onex's CLO] No. 2 was the last one."

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