Given the increasing propensity of financial journalists to cite the thriving debt markets as "a house of cards," (or at least to quote anonymous "Wall Street Bankers" as relaying the bad news) it is nice to see the Wall Street Journal's Dennis Berman asking "why, then, does it continue?" (subscription required) right along side that same paper's Serena Ng and Karen Richardson who point out (subscription required) how corporate actors are getting in on the game (even if they fail to mention the role of activist investors in the surge), and yet somehow manage to answer the question as well. What's the verdict?
People inside the big banks are eerily candid about the credit cycle creeping to an end. They also candidly admit they don't want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer. So they ply ahead.
The Going Private reader, being well versed in such matters, will recognize this as a "moral hazard" problem. As a Vice President, why not write the big loan today that will likely blow up in 48 months? Bonus time is only 9 months away, after all. Absent a claw-back provision for such bonuses, why worry? And, taking it a step further, if you are the managing director of a bank filled with Vice Presidents writing loans that may well blow up in 48 months, why not sell them to a CLO? (A nicely done, albeit slightly old, primer on CLOs of exactly the sort that will intrigue the Going Private reader and written by Andreas Jobst can be found here and is recommended).
The answer to the moral hazard "problem" is fairly simple. Introduce a structural compensation schema that rewards only enduring and stable loans. The mechanisms for this are well understood, as anyone who has gotten stock options with a "cliff" will happily tell you. But, given the ability to "lay off" the risk of these loan originations to a CLO, why be the first shop to start delaying bonus compensation for loan origination officers when you may well price yourself out of the market for top loan origination talent? What incentive do you have to avoid risky loans when the average time such an instrument remains on your books is six months or less? None, of course, if you have done the math and are comfortable with the aggregate exposure you are subject to with a six month window.
The Going Private reader, most likely being of the free market and capitalist ilk, will also likely wonder "where's the problem?" as CLOs tend to be sophisticated investors and certainly are (or should be) well aware of what they are buying and able to (even if they, by choice, do not bother) carefully manage the risks thereof.
Sure, there will be some blow-ups. And some blow-ups will be quite dramatic. But anyone who knows the CLO business will tell you that somewhere in there, perhaps in a basement cubicle of the CLO shop, there should be a little gnome computing efficiency frontiers for a blend of risky and not-so-risky loan portfolios, computing Sharpe ratios and generally minding the store so that frisky Vice Presidents of CLO groups, focused on maximizing their bonuses, don't get out of hand.
Will the Vice Presidents listen? Will the lure of high returns induce them to "push the limit" and, when someone has to be left holding the bag, will it be they? Will Managing Directors "bend" the rules to open the high-yield portfolios a little wider than is prudent?
The Going Private aficionado will reply, "who cares?" If the alternative to the occasional blow-up is a paternalistic, top-down economy designed to protect sophisticated investors from themselves then the Going Private reader will prefer the blow-ups (or retire from worldly affairs to the shelter of their Lake Como estate). Going Private readers believe in freedom, and consequences.
Plus, like wars, blow-ups are ever so fun to watch... from afar. (Just ask Paulson & Co.)
