Leveraged liquidity: bear raids and junk loans in the new credit market.

• Author: Gabilondo, Jose

1. INTRODUCTION II. A LIQUIDITY ACCOUNT OF CORPORATE LEVERAGE MARKETS A. Borrowing and Firm Liquidity B. Secondary Market Liquidity and Its Links to Borrower Liquidity C. The Summer 2007 Market Break in Liquidity D. Saved by the Fed: Liquidity for All III. LEVERAGE AND LIQUIDITY LOOPS IN THE FINANCIAL SECTOR A. Minsky: The Ongoing Relevance of Liability Financing B. Market Structure Shifts Towards Ponzi Finance 1. Desensitization to Leverage 2. Floating-Rate Debt 3. Nonbank Lenders 4. Secondary Credit Markets C. The Revival of Financial Cycle Theory IV. CASE STUDY: LEVERAGED LOANS A. Instrument and Market Structure 1. Origination 2. Secondary Markets 3. Covenant Structure B. Regulatory Implications V. MODELING LEVERAGED LIQUIDITY A. From Models to Markets B. Internalizing Extreme Liquidity Events Into Risk Management (and Then Back to Models) VI. CONCLUSION I. INTRODUCTION

   By now, we have all noticed the turbulence in our credit market. Defaults on residential mortgages have climbed, prices for structured credit products have fallen, and banks have tightened lending standards. To counter some of this, the Federal Reserve (Fed) has been adding "liquidity" to the credit system by lending banks cash (or financial resources that act like cash) against collateral pledged by the banks. (1) Liquidity injections reassure nervous banks and, it is hoped, coax them into making loans of their own to consumers and businesses, that way jump-starting confidence in the economy. One such liquidity tool is the Fed's discount window, which lets a bank pledge its own loans to bank customers (or securities from the bank's own portfolio) in exchange for a cash loan from the Fed. (2) Think of it as the Fed's pawnshop for commercial banks facing short-term liquidity problems.

   During the discount window's near-century of operations, only depository institutions like commercial banks could use it, with the exception of some nonbank firms that got emergency loans in the Great Depression. (3) But in March 2008, the New York Federal Reserve Bank agreed to use discount window liquidity for the benefit of Bear Stearns (Bear), an investment bank, using JPMorgan Chase & Co. (JP Morgan), a depository institution that is a member of the Fed, as a financing conduit. (4) The loan was used to fund JP Morgan's acquisition of Bear, for which JP Morgan put in $1 billion and the Fed lent $29 billion through the discount window at terms that are much more borrower-friendly than typical discount window lending. (5) In the words of the New York Fed, the action was being taken "with the support of the [U.S.] Treasury Department, to bolster market liquidity and promote orderly market functioning." (6) JP Morgan finalized the acquisition of Bear in a stock-for-stock merger that became effective in May 2008. (7)

   Legal authority for the deal with Bear (aptly named since "bear" means downward price pressure) came from a section of the Federal Reserve Act that lets a majority of Fed governors extend emergency credit to individuals and firms in "unusual and exigent circumstances," as they had in the 1930s. (8) The use of Fed liquidity to keep an investment bank viable is significant, as noted by the senior Fed official in charge of the loan when testifying about it to the Senate Banking Committee. (9) No isolated transaction, the Bear deal is part of an evolving response on the part of regulators to a new credit market. Just two weeks after the deal, the U.S. Department of the Treasury proposed a new approach to financial market regulation-the Treasury Blueprint for a Modernized Financial Regulatory Structure (Treasury Blueprint). (10) By recommending that the Federal Reserve had a legitimate interest in providing emergency financing to institutions other than depository institutions, the Treasury Blueprint blessed the Bear deal and endorsed access to the discount window for financial firms other than banks. (11) This too is noteworthy.

   The Bear deal is a watershed in U.S. banking and finance because it marks the official recognition that new liquidity dynamics in our credit markets merit attention. Indeed, liquidity is the financial dimension of the hour. As the Chairman of the U.S. Securities and Exchange Commission (SEC) emphasized about Bear, it was "a loss of liquidity-not inadequate capital-[that] caused Bear's demise." (12) Liquidity "feeds fantasies that risk has evaporated.... Just as inflation shaped psychologies a generation ago, liquidity determines our behavior in a world of short-term performance." (13) Unfortunately, our understanding of liquidity has not kept pace with the credit market, hence much discussion of the issue is imprecise or incomplete. (14) These liquidity dynamics are here to stay, so the sooner regulators and traders face up to them, the better. Luckily, financial academics and regulators concerned with liquidity are working on new conceptual tools, including this Article. (15) To that end, I offer an analytic framework (accessible to the nonfinancial reader) for understanding the liquidity dynamics of the new credit market that led to the Bear deal. The Article has four major parts: a liquidity analysis of the corporate leverage market (Part 11), a theoretical framework for these dynamics (Part III), a case study that illustrates these dynamics (Part IV), and recommendations (Part V).

   Part II offers a state-of-the-art liquidity account of the corporate leverage market that introduces lay readers to the Article's concept base. I start by distinguishing between borrower and market liquidity. A liquid borrower is one that can meet its debt obligations as they come due. Here, liquidity is not the same as solvency since a borrower that is bankrupt can be liquid, insofar as it has cash on hand to meet maturing liabilities. Conversely, a solvent borrower can be illiquid if its current debts exceed its cash and credit, so-called "equitable insolvency." For example, Bear's ample capital could not stave off its liquidity crisis. 16 Moving from the liquidity of a firm to that of a market, an asset market is said to be liquid when an asset can be quickly disposed of at its expected value.

   With this distinction in place, 1 then assert three interrelated axioms about the links between a firm's borrowing, the firm's liquidity, and market liquidity, links that have become increasingly apparent thanks to secondary markets for credit products. First, a firm can enhance its own liquidity by drawing on the market liquidity of its assets in their secondary market. Second, turning from the left- to the right-hand side of a firm's balance sheet, frothy liquidity in the secondary market for a firm's liabilities may not be a proxy for the firm's liquidity or, even, the credit quality of the liability because a borrower can become less liquid as trading in its liabilities becomes more liquid. Third, insofar as a firm borrows to buy financial assets, that firm's decision to shore up its own liquidity by borrowing less (or a lender's decision to cut credit to the firm) can reduce the market liquidity of these financial assets, thereby increasing the liquidity risk of another firm that had counted on selling them. In other words, both borrower liquidity and market liquidity may themselves be "leveraged" insofar as either rests on layered borrowing, whose terms may presume unsustainable increases in asset values and trading volume. When the escalation stops, so too do the liquidities of firms and markets. And then the losses and introspection begin. So it is not only an "Age of Leverage" (17) but, rather, one of leveraged liquidity in which the mutually reinforcing dynamics between leverage and liquidity came into plain view. Not tulips, but periods of financial euphorias do share certain elements, including the tendency to reflect about volatility and loss after the fact and to revisit core assumptions about financial markets. (18)

   Part III expands on the concept of leveraged liquidity by applying economist Hyman Minsky's analysis of how borrowing leads to financial fragility that can resolve, eventually, into financial instability. (19) A post-Depression academic, Minsky has important things to teach us about our current credit market, including about not properly heeding the risks of financial innovation, a point made in a recent New Yorker article about him. (20) He wanted to strengthen capitalist economies, like ours, by stabilizing the economy--a goal echoed by many facing the current round of congressional inquiries into the economy. (21) A proper appreciation of leverage cycles and their liquidity dynamics has been somewhat obscured by a culture of "financial innovation" that benignly frames the risk from new financing arrangements in terms of "entrepreneurial imagination" and a "general fascination with novelty." (22) This cultural paradigm rests on the idea that financial innovation obeys the irreversible path of progress associated with the development of the natural sciences or new technology. (23) Minsky offers a critical account of such innovation that is timely and useful.

   An interpreter of John Maynard Keynes's arguments about liquidity and the centrality of the financial sector, Minsky contributed to the Post-Keynesian theory that flowered during the reconstruction of financial markets after World War 11. Trained at Harvard under economic historian Joseph Schumpeter, Minsky observed that "[i]t turns out that the fundamental instability of a capitalist economy is the tendency to explode--to enter into a boom or 'euphoric' state," followed by a bust. (24) Few would deny that we are now in a bust state, although whether or not we were in a boom state as prices rose was a contentious claim, especially for growth boosters and financial promoters. Although classified as a "radical" post-Keynesian, his insights seem mild (though valuable) and, frankly, hard to resist. Most mainstream economists, regulators, and policy makers avoid...