Christopher L. Culp

Contingent Capital vs. Contingent Reverse Convertibles for Banks and Insurance Companies

During the credit and liquidity crisis in 2007 and 2008, banks found themselves largely unable to raise significant new equity quickly from parties other than sovereign wealth funds and governments. Some banks have thus recently begun to consider contingent capital as a means of pre-arranging recapitalizations for future crises. Contingent capital is a type of put option that entitles a company to issue new securities on pre-negotiated terms, often following the occurrence of one or more risk-based triggering events. Copyright Copyright (c) 2009 Morgan Stanley.

Option-Based Credit Spreads

We present a novel empirical benchmark for analyzing credit risk using “pseudo firms�? that purchase traded assets financed with equity and zero-coupon bonds. By no-arbitrage, pseudo bonds are equivalent to Treasuries minus put options on pseudo-firm assets. Empirically, like corporate spreads, pseudo-bond spreads are large, countercyclical, and predict lower economic growth. Using this framework, we find that bond market illiquidity, investors’ over-estimation of default risks, and corporate frictions do not seem to explain excessive observed credit spreads, but, instead, a risk premium for tail and idiosyncratic asset risks is the primary determinant of corporate spreads.

Syndicated Leveraged Loans During and after the Crisis and the Role of the Shadow Banking System

In an article published in this journal in 1998, Nobel laureate Merton Miller argued that one of the best weapons available to national economies in their defense against the macroeconomic effects of banking crises is the availability of non-bank financial institutions and products — or what we now refer to as the “shadow banking system.” Although Miller may have exaggerated the independence of bank‐ and market‐based sources of financing, the author argues that events during and after the recent crisis have shown Millers claims about the importance of non‐bank investors in the provision of credit to be fundamentally correct. Critics of securitization and the shadow banking system tend to focus on the subprime mortgage story in which the sudden re‐pricing of credit risk and the resulting disappearance of investment demand for ABCP, private‐label mortgage-related ABS, and ABS CDOs created unexpected and significant downward price pressure on those asset types. But the leveraged loan market tells a very different story. In contrast to the near complete disappearance of private mortgage securitizations, the extraordinary recovery of the U.S. syndicated leveraged loan market demonstrates that the relation between commercial and shadow banking has proved to be a highly productive and resilient one — and very much a two‐way street. When leveraged loans and CLOs experienced problems from 2007 through 2009 due primarily to the widespread liquidity and credit market disruptions that affected essentially all structured credit products, institutional investors in leveraged loans disappeared and the leveraged loan primary market imploded. But when institutional participants recognized the value of the underlying asset — corporate loans — and regained confidence in shadow‐banking products, leveraged lending by banks recovered quickly and dramatically. This outcome is viewed as vindicating Professor Millers statement about the benefits of shadow markets and securitization — namely, the role of non‐bank investors in diversifying the risk of credit creation while at the same time improving the price discovery process in different markets. The recent history of the U.S. leveraged loan market demonstrates that shadow banking system participants play a critical role in meeting the total demand for such loans, and that the ebbs and flows from institutional leveraged loan markets are strongly connected with the health and integrity of the underlying leveraged bank loan market.

U.S. Structured Finance Markets: Recent Recovery,Post-Crisis Developments, and Ongoing Regulatory Uncertainties

In this article, the authors review the recent activity in U.S. structured finance markets and offer some comments on the changes in certain structured finance products resulting from the global credit crisis. They believe that these changes have helped foster an environment consistent with the return of economically legitimate uses of fundamentally sound structured financing techniques. The authors discuss specific changes in the market for collateralized loan obligations (CLOs) as an illustrative example. They also discuss the potential impact of various ongoing regulatory initiatives that may affect (perhaps significantly) the near- and long-term prospects for U.S. structured finance products and markets. The data currently indicate renewed investor interest in many of these products, and in the authors’ view, the post-crisis changes in the design and documentation of these products together with heightened investor awareness and better access to information suggest that such interest is not merely irrational yield-chasing. Yet, the ongoing regulatory uncertainty poses significant potential threat to the future of the U.S. structured finance market. Many of the possible dangers arising from pending or proposed regulations seem, moreover, to be unintended consequences of rules that were not specifically aimed at structured finance (e.g., the Volcker Rule). Unless regulators address those unintended consequences (and perhaps some intended ones), the prospects for the return of a vibrant and well-functioning structured finance market to facilitate legitimate risk transfer and asset funding may be much dimmer than recent market experiences otherwise suggest.

Financial Transaction Taxes: Benefits and Cost

Proponents of financial transaction taxes (“FTTs�?) claim that such taxes will raise revenue and discourage “destabilizing speculation.�? Opponents of FTTs claim that they are unlikely to achieve their stated goals and that FTTs will harm the performance of financial markets by reducing market depth and liquidity, increase market volatility, put downward pressure on asset prices, increase the costs of raising capital, and diminish the international competitiveness of the U.S. financial services industry. This paper evaluates the likely economic consequences of the establishment of FTTs in the United States based on the economic literature and empirical research on various FTTs that have been imposed throughout the world in recent decades. The research indicates that FTTs are unlikely to generate significant revenue and are likely to interfere with the performance of U.S. financial markets. Specifically: (i) the dual goals of FTTs to deter speculation and raise revenue are irreconcilably at odds with one another; (ii) FTTs raise the cost of financial transactions often by significant amounts; (iii) FTTs likely will have adverse impacts on asset prices and will engender commensurate increases in the costs of capital for many corporations; (iv) FTTs likely will divert trading to untaxed jurisdictions and financial markets; (v) FTTs would not necessarily reduce price volatility and, in some instances, can increase price volatility as a result of reduced liquidity; and (vi) FTTs are not expected to affect managerial decision making.

Have Pre-Crisis Levels of Risk Returned in U.S. Structured Products? Evidence from U.S. Subprime Auto ABS, CLOs, and Insurance-Linked Securities Markets

From 2011 through 2014, new issuance of U.S. structured products backed by subprime auto loans and leveraged corporate loans grew by 55% and 716%, respectively. The authors analyze the recent activity in these markets, as well as the activity and risks in the loan markets underlying auto asset-backed securities (ABS) and collateralized loan obligations (CLOs). Despite the empirical evidence of higher risks in auto and leveraged loan collateral, the analysis does not indicate a commensurate increase in risks to investors in the structured products based on those loans. For a comparison, they review market activity and risk indicia in U.S. insurance-linked securities, which, unlike auto ABS and CLOs, serve a pure risk-transfer purpose and do not result in any significant extension of credit by investors to sponsors. The authors also consider the likely impacts of the Volcker Rule and Credit Risk Retention rule on U.S. structured product markets, and they conclude that the regulations are likely to stifle market activity and discourage legitimate risk transfer.

Alternative Risk Transfer

Alternative risk transfer (ART) refers to the products and solutions that represent the convergence or integration of capital markets and traditional insurance. The increasingly diverse set of offerings in the ART world has broadened the range of solutions available to corporate risk managers for controlling undesired risks, increased competition amongst providers of risk transfer products and services, and heightened awareness by corporate treasurers about the fundamental relations between corporation finance and risk management. This chapter summarizes the dominant products and solutions that comprise the ART world today.

Shadow Banking, Risk Transfer, and Financial Stability

Shadow banking is the process by which banks raise funds from and transfer risks to entities outside the traditional commercial banking system. Many observers blamed the sudden expansion in 2007 of U.S. sub†prime mortgage market disruptions into a global financial crisis on a “liquidity run†that originated in the shadow banking system and spread to commercial banks. In response, national and international regulators have called for tighter and new regulations on shadow banking products and participants. Preferring the term “market†based finance†to the term “shadow banking,†the authors explore the primary financial instruments and participants that comprise the shadow banking system. The authors review the 2007–2009 period and explain how runs on shadow banks resulted in a liquidity crisis that spilled over to commercial banks, but also emphasize that the economic purpose of shadow banking is to enable commercial banks to raise funds from and transfer risks to non†bank institutions. In that sense, the shadow banking system is a shock absorber for risks that arise within the commercial banking system and are transferred to a more diverse pool of non†bank capital instead of remaining concentrated among commercial banks. The article also reviews post†crisis regulatory initiatives aimed at shadow banking and concludes that most such regulations could result in a less stable financial system to the extent that higher regulatory costs on shadow banks like insurance companies and asset managers could discourage them from participating in shadow banking. And the net effect of this regulation, by limiting the amount of market†based capital available for non†bank risk transfer, may well be to increase the concentrations of risk in the banking and overall financial system.

The Informational Content of CDS Spreads

We review the empirical academic literature on the informational content of credit default swap (“CDS”) spreads. Most of this literature posits and empirically documents that CDS spreads generally: (i) contain valuable information about the probability and severity of adverse credit events that the underlying reference entities may experience during the life of the CDS; (ii) reflect a risk premium that protection sellers demand to compensate them for reference entity-specific and systematic risks (both credit-related and non-credit-related); and (iii) are anticipatory and contain information regarding future announcements about the credit risk and financial condition of the underlying reference entity.

Loan-Only CDSs

We discuss the underlying market for broadly syndicated leveraged loans that characterize the deliverable loans on which most loan-only CDSs (“LCDSs”) are based. We then review the significant distinctions between single-name CDSs (typically based on bonds issued by reference entities) and LCDSs with loan-specific deliverable obligations. Such distinctions include reference entity credit events that trigger LCDSs, the timing of coupon payments on LCDSs, the specific obligations underlying LCDSs that are deliverable into LCDS-specific auctions or physical settlements, and the embedded cancellation options in LCDSs corresponding to prepayments on underlying broadly syndicated term loans.