The evolution of debt: covenants, the credit market, and corporate governance.

• Author: Whitehead, Charles K.

1. INTRODUCTION II. COVENANTS, MONITORING, AND LIQUIDITY III. THE EVOLUTION OF THE CREDIT MARKET IV. CORPORATE GOVERNANCE AND THE EVOLUTION OF DEBT A. Syndicate Structure and Lead Bank Incentives B. Covenant Levels and Monitoring C. Reputation D. Private Credit Liquidity V. SOME LESSONS FROM THE CREDIT CRISIS VI. CONCLUSION I. INTRODUCTION

   Debt and equity are like sibling rivals within the traditional agency cost framing of the firm. Shareholders, within that construct, may be inclined to resist new investment that principally benefits creditors, with the result that value-enhancing projects are delayed or abandoned. (1) Lenders, as well, risk the loss of wealth in the face of management opportunism that favors equity over debt.2 One response, ultimately at cost to the borrower, is increased covenants that restrict its actions and potentially furnish control rights to lenders. (3) Covenants and monitoring were presumed to be the least costly means to manage credit risk (4) in the absence of alternatives, such as portfolio risk management, that did not exist for debt at the time the agency cost construct was introduced. (5)

   Most corporate debt is private, (6) and most private lenders are banks. (7) Consistent with the role of debt within the traditional framing, (8) covenants act as early warning "trip wires" (9) that assist banks to manage credit risk, permitting them to reassess a borrower's managers when weakened financial conditions increase the risk of opportunism and mitigate loss by renegotiating loans in anticipation of, or following, a breach. (10) Banks are able to monitor a borrower's compliance at low cost, reinforcing the importance of loan covenants to corporate governance. (11) The trade-off for banks is the relative inability to transfer the loans they originate to others, further boosting their reliance on covenants and monitoring. (12)

   Balanced against those costs, a firm can improve its borrowing capacity and increase its share price through the debt capital available to fund new projects and the positive signal provided by new lending. (13) The resulting benefits can be tangible--a decline in the overall cost of capital as investors free-ride on the enhanced oversight provided by self-interested bank monitors. (14) Thus, the competing interests of debt and equity are balanced by the benefits of a capital structure that includes both. Like siblings, the result is a virtuous, if not always peaceful, equilibrium within the firm.

   But, clearly, change is afoot. As the capital market becomes more complete, (15) we may expect credit risk to be transferred and shared among market participants at lower cost than if borne separately. (16) The last two decades, in fact, witnessed an increase in private credit liquidity--as illustrated by the rise in syndicated loans (17) and credit derivatives (18)--fueled by change in the traditional bank-borrower relationship and the entry of new investors into the credit market. Banks began to manage credit risk through purchases and sales of loans and other credit exposure, generating higher returns on their loan portfolios, a portion of which could be passed on to borrowers through increased lending limits and lower interest rates. Weighed against those benefits were greater agency costs principally arising from the limited information about borrowers available in the market and the dispersed ownership traditionally associated with public debt, but increasingly a feature of private credit. (19)

   On balance, we would anticipate an increase in the ability of firms to incur debt--an outcome that, on its face, was consistent with the higher levels of borrowing that occurred in the mid-1990s and during the most recent private equity wave. (20) When the credit market soured, partly due to difficulty in valuing new credit instruments, the fallout was seemingly ubiquitous--with losses, beginning in the summer of 2007, ranging globally from government investment pools in Florida (21) to agricultural cooperatives in Japan. (22) Changes in the credit market likewise affected the supply of capital. A substantial drop in the price of leveraged loans reportedly resulted in a slowdown in secondary loan trading and, in turn, a bottleneck in new commercial lending. (23)

   Thus, a firm's decision to borrow must increasingly take into account change in the credit market beyond the traditional bank-borrower relationship that underlies the standard framing of the firm, a trend that I argue is likely to continue after the current credit crisis has passed. (24) That shift suggests an evolution in the factors that shape a firm's capital structure, from the agency cost construct, based on the sibling rivalry of debt and equity, to one that must now increasingly take account of the costs and benefits of an increasingly liquid private credit market. (25)

   Likewise, to the extent developments in the credit market affect how credit risk is managed, the traditional reliance on covenants and monitoring may also begin to evolve. Covenants and monitoring may no longer be the lowest cost means to manage credit risk, shaping their role, and the role of debt, within corporate governance. How will those changes be reflected?

   One argument is that the ability to transfer or diversify away credit risk--the "decoupling" of economic and control rights (26)--will limit the effectiveness of covenants and weaken debt governance by dampening a lender's incentive to monitor borrowers or act in the interest of others to whom loans or credit exposure have been transferred. Thus, changes in the private credit market--and the resulting commoditization of credit--reflect a tension between the potential benefits of transferring credit risk and the frictions that may result from growing liquidity. Counterparties who take on that credit risk, the analysis goes, may be better able to manage it at lower cost, but are unable to oversee borrowers as effectively, resulting in an increase in agency costs and an overall decline in governance. (27) Moreover, based on their special knowledge of each borrower's credit quality, banks may have an incentive to transfer lower quality assets to third parties--with a decline in lender oversight for those borrowers most in need of debt governance. (28) However, as I argue, that may not be the complete answer.

   Banks have a significant incentive to minimize the potential for moral hazard arising from the information asymmetries around borrowers for whom there is limited public information. Spanning that gap--by designing resale arrangements in order to address potential agency problems--may increase a bank's ability to transfer loans at lower cost, as well as to enhance profitability. (29) Thus, as the private credit market becomes more liquid, loans may be structured and lending relationships adjusted to mitigate agency costs. Retaining some portion of a borrower's credit risk, increasingly relying on reputation, and tightening covenant levels, for example, may offset the weakened oversight otherwise arising from the transfer of credit risk. (30) Rather than a decline, those changes may instead provide alternative means of corporate governance.

   One interesting possibility is prompted by growth of liquidity in the credit market itself. In a more complete market, actions that affect a firm's credit quality are reflected in changes in the price at which a firm's loans and other credit instruments trade. Those changes may affect a borrower's cost of capital--either in subsequent loans, including a change in the price and nonprice terms on which the loans are made, (31) or most recently, by tying the interest rate on loan facilities to the price of a borrower's credit default swaps. (32) The intuition is that, like public equity, private credit may begin to provide a discipline--through the feedback furnished by market participants--that complements the traditional protections provided by contract. (33)

   Greater capital market completeness also raises an intriguing question: Do the changes in debt, when coupled with the increased staying power of private equity, (34) foretell the possibility of a more basic shift in capital structure and corporate governance? For equity, a firm may increasingly choose to rely on private sources of risk capital, rather than on public share ownership. For debt, lenders may shift from their traditional dependence on covenants and monitoring in private loans to lower cost instruments that trade with increasing liquidity in an evolving credit market. Taken together, I suggest, we may begin to see the outline of an alternative capital and corporate governance structure whose evolution--from public to private capital, for equity; and private to increasingly public capital, for debt--reflects a new set of costs and benefits beyond those within the traditional framing. (35)

   The recent subprime loan crisis, however, has been blamed on the introduction of new credit instruments, calling into question the viability of a governance structure that relies, in part, on an increasingly liquid private credit market. To what extent did agency problems arising from the transfer of subprime loans to third-party purchasers limit, or even exceed, the benefits from financial innovation that fueled the rise in subprime liquidity? (36) And is there likely to be a similar cost-benefit outcome within the corporate credit market, portending a decline in private credit liquidity and the new role of private credit in corporate governance?

   Although agency problems in the securitization market have begun to receive national attention, concerns over those problems have troubled industry participants, investors, and academics for some time, (37) sparked, in the case of the subprime market, by its rapid and substantial growth. (38) Many of the problems stemmed from the incentives of loan brokers, who were paid to originate new loans but, following resale, bore none of the direct...