Collateralized loan obligations may seem at first to be nothing but a throwback to private equity’s “golden era” of enormous leveraged buyouts.

Yet the market for this product, which has made a modest comeback since the financial crisis, is an important source of capital for many businesses. Now its revival is under threat, and that could have broader implications beyond deal makers.

A C.L.O. is typically a collection of large loans made by banks to corporations with higher amounts of leverage. The loans are bundled together into a securitization pool, and the pool is divided into multiple tranches. Interests in each tranche are then sold to institutional investors.

This market was booming before the financial crisis. According to Dealogic, $158 billion worth of C.L.O.’s were issued globally in 2006. Mega-buyouts like the $43.2 billion deal for TXU and the $28 billion First Data buyout were largely made possible by these financial instruments.

Then the financial crisis hit, and global issuance tumbled to $3.6 billion in 2009, according to Dealogic. Skittish investors fled in good part because of C.L.O.’s association with the big buyouts — and their leverage.

The retreat may have been overdone: C.L.O.’s are largely made up of loans that are at much lower risk of default than the more risky high-yield, or “junk,” bonds that also finance private equity buyouts.

Indeed, Moody’s Investors Service says that of the 630 C.L.O.’s outstanding in early 2011, only two defaulted and halted their cash payments. And they have made lemonade out of lemons: C.L.O.’s had a default rate of less than 1 percent even as the loans underlying them had a default rate of about 6.5 percent.

The market is recovering fitfully. Last year, Dealogic reported $11.8 billion in new issuances. Moody’s forecasts that the market will grow to $12 billion to $15 billion this year. So far this year, $1.3 billion worth of C.L.O.’s are in the pipeline, according to Thomson Reuters.

This is important because the market for new corporate loans to more leveraged companies has been kept alive by existing C.L.O.’s. The managers of these C.L.O.’s have been extending loans already in their portfolios or buying newly originated loans in the market.

This secondary market is starting to dry up. Many C.L.O.’s are approaching their legal maturity dates while others are running up against purchase limits set by their organizational documents. In the latter case, C.L.O.’s bundled before the financial crisis typically cannot have a total number of loans with maturities greater than eight to nine years on average. The reason is to prevent the manager from investing in loan issuances that outlast the planned life span of the instrument. But as C.L.O.’s age, they are bumping up against this limit.

So new C.L.O.’s are crucial to support the corporate loan market. Without them, banks will be hampered from originating credit since they will be unable to sell these loans off their balance sheet.

Read More: http://dealbook.nytimes.com/2012/01/31/a-debt-markets-slow-recovery-is-burdened-by-new-regulation/