The Credit Crunch: Credit Provision and Distribution
01 May 2008
The global credit crunch which began in the summer of 2007 was prompted by a number of factors. One of these was a model of banking known as "originate and distribute". How did this come about?
Until relatively recently, the activities of banks in financing their customers could be divided into the provision of credit - the traditional commercial banking activities where the banks used their own money to lend to borrowers - and the arrangement and distribution of capital market transactions - investment banking activities where the banks underwrite the purchase of debt or equity securities by retail or institutional investors.These two distinct activities had the same result (the provision of financing to a customer), but the skills and techniques involved were very different.
The provision of credit required the banker to be an expert in analysing the creditworthiness of the customer or transaction being financed, since the bank would make its profit from the receipt of interest and fees and these would be eroded or wiped out if the financing was not repaid.
In capital markets transactions, the banker needed a deep understanding of whether a particular issue of securities was likely to be purchased by investors in the capital markets, because the bank would make its profit from the receipt of arrangement or underwriting fees and these would be wholly or partly lost if the bank was not able to sell the securities in the market at or above the price at which it had underwritten the securities.
In other words commercial banking was all about credit risk and investment banking was all about market risk.
Of course, this description is a very simplistic one and ignores the fact that to be able to sell a security one needs to understand something about the creditworthiness of the issuer, while sometimes the lending bank needs to understand the capacity of the market to buy securities (for example, when the credit being provided is in the form of a bridge to a securities issue). However, it is a useful distinction and one which for many years was embedded in statute (for example, in the US where the Glass-Steagall Act had the effect of separating securities underwriting from commercial banking) or in practice (in the pre-Big Bang era in the UK the commercial banking and investment banking sectors were largely separated).
In the last 40 years, these distinctions have started to blur - slowly at first as banks began to syndicate large loan facilities, but with increasingly frenetic speed of late as (following the repeal of Glass-Steagall) the distinction between commercial banking and investment banking began to fall away and banks began to view credit as being something which could be packaged up and sold to investors rather than retained on their balance sheets ("originate and distribute").
In doing this, bankers were encouraged both by the fee income generated by this underwriting activity and by the regulators who sought to control the banking sector by stipulating amounts of capital to be set against assets which remained on balance sheets.
A multitude of techniques was developed in order to achieve this - from the simple (sub-participations) to the complex (SIVs, CDOs, LCDS). Although there is nothing wrong in essence with any of these methods, some of the practices associated with them have contributed to the global credit crunch.
What were these practices?
• Insufficient due diligence - If you are lending money to a customer in circumstances where your profit depends upon the ability of the customer to pay interest and principal on the loan, then it is likely that you will carry out due diligence sufficient to satisfy yourself that the customer will be able to do so. If, on the other hand, you are primarily lending to the customer so that you can package up the loan with a number of other loans and sell the resulting package to a group of investors, then there must at least be a temptation to do only so much due diligence as is necessary to persuade those investors to buy the securities (since then your market risk has been covered). This appears to have been what has happened in relation to a number of mortgage loans to sub prime borrowers in the USA.
• Lack of independent credit analysis - If you are a bank making (and retaining on your balance sheet) large loans to a number of customers, you are likely to do your own credit analysis on those customers. If, on the other hand, you are an investor in securities which consist of literally thousands of loans packaged up and then sliced into security form, it may be impossible for you to carry out your own analysis and you may have to rely on analysis carried out by a third party - like a rating agency. Even though it may be clear that the rating agency is only giving an opinion on the likelihood of default (or of losses if a default occurs), you as an investor may (however wrongly) take the rating as a sign of the inherent value of the security.
• Focus on market risks - If you are a banker structuring a transaction where the main risk for your institution is a market risk rather than a credit risk, then you are likely to pay more attention to the terms protecting against that market risk (such as underwriting provisions, etc) rather than terms aimed at minimising credit risk. When it was discovered that investors in leveraged loans were not insisting upon the strict financial covenant packages which had traditionally protected against credit deterioration in leveraged finance, these terms swiftly disappeared from the documentation and so called "covenant lite" transactions became the vogue.
• Dependence on short-term funding - Commercial banking often consists of using short-term funding (deposits from customers) to fund long-term assets (loans to customers). However, the key to this model is making sure that the short-term funding will always be available. If it is withdrawn, then the model breaks down. Many of the structured credit transactions described above depended on the ready availability of short-term funding (like commercial paper issuance) which disappeared rapidly when confidence waned.
• Funding investors - If a bank is able to sell a security to an investor at 101% of its face value, it becomes all too easy to believe that it will always necessarily be worth at least that amount and to treat that security as if it were as good as cash. Banks began to lend money to investors in order to enable them to purchase the packaged securities which the banks had created in the first place. This increased demand for the securities in the short term, but was only a sustainable model so long as sufficient people had faith in the value of the securities.
When problems in the US sub prime mortgage market started to reveal the prevalence of some of these practices, the confidence of investors, banks and regulators in the value of these packaged securities started to wane and it quickly became apparent that without that confidence some of these packaged structures were not nearly as robust as they had seemed at first. Investors began to worry that insufficient due diligence might have been done on the underlying borrowers and loan assets. They started to lose faith in the ratings which many investors in transactions had used as a substitute for independent credit analysis. They also questioned why traditional credit protections were not included in these transactions. Short-term funding became either extremely expensive or impossible to source and banks which had funded investors to buy the packaged securities they created discovered that their collateral (often the securities themselves) was not worth as much as they had first thought.
The credit crunch is a classic example of a ‘bubble' market in which financiers and investors convince themselves that they have found something - a commodity, an industry, an idea - which is so mould breaking that investing in it is a certain way to make returns which far outstrip the profits which can be made from more traditional and prosaic investments. Examples of previous bubbles would be the "tulip mania" in the Netherlands in the 17th century and the dot com boom of the 1990s.
Following the bursting of such a bubble, there is usually a difficult period in which investors have to come to terms with the fact that their investments (tulip bulbs, high-tech shares, packages of sub prime mortgages) are not worth nearly as much as they first thought. However, eventually the market will settle down to a greater or lesser extent.
While the market adjusts to the bursting of the bubbles in sub-prime mortgages and leveraged loans which were fuelled by the "originate and distribute" model of banking, there are a number of lessons which seem to have been learned from the experience of the credit crunch.
One key element in bank finance transactions is that the lender(s) perform appropriate independent due diligence and credit analysis on the creditworthiness of the borrower and transaction.
Another lesson is that every loan which a bank makes has the potential to remain on that bank's balance sheet even when the loan is made with the intention of being packaged and sold to investors. Banks, therefore, need to be comfortable with the credit of the borrower and with the credit protection provided by the documentation even when they don't anticipate holding on to the loan. In any event, investors will be more likely to buy a packaged security if they feel that the lender has properly analysed and protected itself against the credit risk of the underlying loan transactions.
Sometimes a structure designed to ensure that assets are kept off a bank's balance sheet will not succeed either because short-term funding will not be available (eg, in the commercial paper market) or because the reputation of the bank demands that it cannot simply leave investors in its packaged securities to bear all the losses (eg, many of the SIV transactions have had to be "brought on balance sheet" (financially supported) by the sponsor bank).
Those running banks need to be able to take an overview of their business and understand exactly what risks are being run - even when the business appears very profitable in the short term - and whether revenue generation is solid and sustainable (eg, is it good, sustainable business to make a loan, package it into a security, and then finance an investor to buy that security using the security itself as collateral for the financing?). The question that should be asked is - if the short-term profitability of a business is too good to be true, is that because it is not really so profitable in the long term?
Most banking lawyers have been trained to analyse the ways that they can minimise or mitigate the credit risks of financing transactions (whether by way of contractual provisions or through structuring or by way of security). While the "originate and distribute" model was in the ascendancy, these skills have been less highly valued by clients and a reliance on precedent became more important than an ability to analyse credit protection (as long as there was a precedent for investors being happy to accept a particular provision, the provision was likely to be agreed even if it was not necessarily effective as a credit protection mechanism).
The advent of the credit crunch and the likelihood that credit protection will again be the prime purpose of credit documentation means that some of the traditional skills of banking lawyers will return to the fore. A number of the provisions which had become popular during the ‘bubble' are, therefore, less likely to be seen in credit documentation in the near future. In the leveraged finance arena these include covenant lite, interest toggle, non-amortising loans, unlimited equity cure provisions and PIK/PIYC features
Of course, the credit crunch has not turned back the clock on distribution methods completely and banks will still want to be able to manage their balance sheets by disposing of assets through securitisation and other packaging methods. However, at least for a while, these techniques will not be all-pervasive and many banks will return to their traditional roles as credit providers - with a consequent greater focus on credit analysis and credit protection for their lawyers.