In the Press… The Debt Machine

Joe Rennison, FT, Tuesday, January 29, 2019:

I always thought that the large-scale securitization of risky debts was among the least understood and most dangerous financial innovations, and thus I read with strong interest this balanced article on the “debt machine”.

Joe Rennison explains very well the mechanic involved in the securitization of corporate leveraged loans. On the one hand, it stresses that the risks may have increased in the leveraged loans market, and as a result in the CLOs market, due to less protecting covenants. CLOs may be partly responsible for this situation since they played a significant role to boost the strong demand for these leverage loans. Debtors are now able to obtain very attractive conditions. On the other hand, it makes a few reassuring points about the structure of the market which may limit the risk of a “big blow-up” (rating agencies seem to be more cautious than they were with the securitization of sub-prime loans prior to the 2008 crisis and investors in the riskiest tranches seem to be well-informed “strong hands”).

Thus, we understand that CLOs “debt machine” probably tends to weaken the solidity of the corporate sector and that the next recession may be painful for leveraged companies and their creditors. Yet, there are reasons to hope that this kind of securitization will not have the sort of devastating systemic impact that we observed in 2008 with CDOs based on mortgages.

This may be right. But systemic financial risks are not the only issues raised by the securitization of risky debts for regulators, investors and various commentators. A fundamental question is why securitization exists in the first place and whether it contributes over a full business cycle to a better financing of the real economy.

Without surprise, hedge fund and CLOs managers “think the presence of CLOs in the loan market is overwhelmingly a good thing”. In general, the main pro-arguments are along the following lines:

  • Investors are heterogeneous and many of them are very risk adverse.
  • There is not enough risk-free assets (T-bills) to satisfy the demand of these investors.
  • Securitization allows to increase the supply of risk-free assets (AAA) and leads to a better sharing of risks between various classes of investors.
  • Thus, securitization plays an important role to finance useful risky projects, for example the takeover of underperforming companies by private equity funds.

Obviously, there is something fundamentally right with this way of reasoning. The heterogeneity of investors is a fundamental characteristic of our economies, and the financial sector must find ways to accommodate this heterogeneity. Yet, there are potentially many ways to “share” risks and the question is why securitization of very risky debts is again winning the battle despite its many drawbacks.

Indeed, any financing circuit that increases the likelihood of bankruptcies at the corporate level cannot be optimal, as bankruptcies involve large dead-weight costs (not least the lawyers’ larges fees…). In general, risks are better shared directly at the corporate level through the issuance of debts of various seniorities and equity. The equity should be large enough to absorb most shocks and thus to avoid in most cases the bankruptcies’ dead weight costs. One can object that this traditional risk-sharing arrangement may not allow to issue as many AAA debts than the securitization of leveraged loans. This is not true. Firstly, less risky debts can still be securitized to produce more risk-free debts, without the vulnerability at the firm level introduced by highly leveraged loans. Secondly, the holders of the securities (debts of various seniorities, equity) can use them as collateral to produce some safe debt.

As a risk-sharing mechanism, the securitization of highly leveraged loans does not create miracles and induce some large explicit or implicit costs:

  • As already mentioned, with leveraged loans, bankruptcies can be more numerous in an economic downturn with large macroeconomic (depth of the recession) and microeconomic (fees of the lawyers…) costs.
  • As the risks for holders of these securities depend a lot on the correlation between the risk of default of various corporations, they become hard to value and quickly illiquid in period of economic stress. This was true for the subprime CDOs in 2008 and will probably be true for the CLOs in the future.
  • Large fees are collected by the institutions involved in the process (CLOs managers, hedge funds…).

So why the securitization of leveraged loans plays such an important role in the “debt machine”?

Financial innovation may sometimes be a very intelligent answer to a very real question (the best example are the ETFs able to bring liquidity to illiquid asset classes). But sometimes they reflect the genius of some innovators to draw, consciously or not, benefits from asymmetric information and bounded rationality. In other words, some financial innovation may create more losers than winners. Securitization of very risky corporates debts may be in this category.

There are probably two main “market failures” exploited by the large scale securitization process:

  • A “bounded rationality” failure. The AAA securities created by securitization of leveraged loans are very different in some key respects from other AAA securities. And these key differences are probably not correctly understood and reflected in their pricing. In a typical “normal” AAA security, a large part of the risk is specific to the issuer. In other words, a large part of the risk is diversifiable by holding a portfolio made of numerous securities. As demonstrated long ago by the CAPM model, securities with diversifiable risks (or “low beta” securities) don’t need to offer a high risk premium. The securitization process is a machine to sharply increase the beta of the produced securities. The highly rated tranches will lose in period of economic stress when numerous companies default and the stock market collapse. Thus, for the same risk of default or rating, a security born from the securitization process should offer a much higher risk premium than a security with more diversifiable risk. Indeed, securitized AAA securities offer a higher level of spread than other AAA securities. But the difference is probably nowhere near what is justified by the exposition of these securitized securities to extreme risks. In other words, the securitization process probably benefits from an analysis of risk too much based on probability of default (or ratings) and not sensitive enough to the correlation with other risks (or beta). Investors in highly rated securities issued from securitization are probably not compensated enough for the systemic risks they bear and, as a result, they probably subsidy the whole process.
  • An “agency” failure. Why investors very adverse to risks accept to buy with rather low spreads these securities that will underperform at the worst moment, i.e. in period of systemic stress? Is it only a “bounded rationality” failure, i.e. the lack of understanding of the CAPM model and the role played by betas? Probably not. A key aspect of finance is the importance played by agency problems. People who allocate the funds are rarely those who bear the risks. This may make very attractive for them to gamble on extreme and rare events. The securities exposed to these rare systemic risks will provide a risk premium that we’ll boost almost every year the return they get on the portfolio they manage. As a result, they will get promotions and bonuses. With luck, they will avoid a systemic accident during their whole career. If not, their risks are limited: the worst that can happen is that they may lose their job after many years of high compensations. In other words, due to the agency problem, there is probably a natural tendency of financial markets to misprice systemic risks. It is rather unfortunate that the “debt machine” is currently producing the sort of securities that may be dangerous for the economy and final investors, but attractive for the managers they trust.