The alchemy of CDO credit ratings

Collateralized loan obligations (CLOs) were one of the largest and fastest growing segments of the structured finance market, fueling the 2003-2007 boom in syndicated loans and leveraged buyouts. The credit crisis brought CLO issuance to a halt, and as a result the leveraged loan market dried up. Similar to other structured finance products, investors in CLOs rely heavily on credit rating provided by the rating agencies, yet little is known about CLO rating practices. This paper attempts to fill the gap. Using novel hand-collected data on 3912 tranches of collateralized loan obligations we document the rating practices of CLOs and analyze their structures.     

CLO trading and collateral manager bank affiliation

This paper investigates whether the institutional affiliation of a collateralized loan obligation (CLO) manager influences the manager's access to information and risk appetite. We find that CLO managers affiliated with banks start to sell off their positions in loans arranged by their bank well before the onset of default. In contrast, CLO managers affiliated with nonbanks do not lower their exposures to distressed loans. These findings are consistent with bank-affiliated CLO managers being more risk averse, but they could also derive from them having access to valuable information. On close inspection, we find that although bank-affiliated CLO managers are averse to holding any distressed loans, they are also more aggressive at divesting distressed loans arranged by their parent bank, suggesting that they benefit from an information wedge. Besides helping us understand CLO managers’ trading activities, our findings highlight a potential limit to banks’ ability to originate loans and distribute them via their affiliated CLOs.     

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 Miller's 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 Miller's 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.     

CLO Performance

We study the performance of collateralized loan obligations (CLOs) to understand the market imperfections giving rise to these vehicles and their corresponding economic costs. CLO equity tranches earn positive abnormal returns from the risk-adjusted price differential between leveraged loans and CLO debt tranches. Debt tranches offer higher returns than similarly rated corporate bonds, making them attractive to banks and insurers that face risk-based capital requirements. Temporal variation in equity performance highlights the resilience of CLOs to market volatility due to their closed-end structure, long-term funding, and embedded options to reinvest principal proceeds.     

Portfolio performance manipulation in collateralized loan obligations

We examine the discretionary activities that CLO managers engage in to pass monthly overcollateralization (OC) tests. These tests require a CLO's loan portfolio value, scaled by the CLO notes’ principal balance, to be above a certain threshold. Using CLOs’ granular disclosures, we develop model-free estimates for discretionary loan fair valuation and transaction-based proxies for strategic loan trading. We find a positive association between these discretionary activities and the probability of avoiding an OC test violation. This association varies predictably with junior noteholders’ influence and CLO market conditions. Strategic trading—but not discretionary fair valuation—relates to worse future CLO performance.     

FINANCIAL INNOVATIONS IN LEVERAGED COMMERCIAL LOAN MARKETS

In the last decade, three innovations in commercial loan-based securities and derivative have enabled institutional investors to access commercial loan markets on leveraged terms : collateralized loan obligations (CLOs); loan-based total return swaps; and leveraged loan-based structured notes (LLSNs). These innovations have been driven by a combination of structural changes in the banking industry, enhanced technology for securitizations, reformed banking regulations, and the advent of credit derivatives.
Besides providing new investment opportunities for institutional investors, these recent innovations in loan markets also promise to reinforce the existing trend in banking away from financial intermediation and toward information intermediation. Such a trend, the authors argue, is helping to ensure the long-run viability of commercial banks. By transforming loan assets in the ways described in this article, banks can generate fee income instead of interest income (thus limiting their capital requirements and interest rate and credit exposures) while still exploiting their comparative advantage in credit analysis and monitoring.     

The anatomy of corporate securitizations and contract design

Collateralized loan obligations (CLOs), intermediaries situated between investors and traditional banks, play an increasingly central role in the provision of credit to constrained corporations, holding as much as 75% of all new institutional leveraged loans. Despite their ascendancy in the risky corporate credit market, there has been little academic research on the CLO market. This paper provides a comprehensive overview of the design and structure of the CLO market, describing the general macroeconomic milieu that has facilitated the rapid growth of the market, the mechanics therein, as well as recent risks that have emerged. Understanding the anatomy and dynamics of CLOs is paramount for developing insights into the role of non-bank financial intermediaries in financial markets.     

Corporate Loan Securitization and the Standardization of Financial Covenants

We examine whether syndicated loans securitized through collateralized loan obligations (CLOs) have more standardized financial covenants. We proxy for the standardization of covenants using the textual similarity of their contractual definitions. We find that securitized loans are associated with higher covenant standardization than nonsecuritized institutional loans. In addition, we show that CLOs with more diverse or frequently rebalanced portfolios are more likely to purchase loans with standardized covenants, potentially because standardization alleviates information processing costs related to loan monitoring and screening. We also document that covenant standardization is associated with greater loan and CLO note rating agreement between credit rating agencies, further supporting the relation between lower information costs and covenant standardization. Overall, our study provides evidence that loan securitization is related to the design of standardized financial covenants.     

Are banks happy when managers go long? The information content of managers’ vested option holdings for loan pricing

While traditional finance theory holds that managers with option-laden incentive contracts may favor equity at the expense of debt, a risk-averse manager may be more likely to retain vested in-the-money options if the manager has private information that the firm's risk-adjusted performance will be better. It follows that vested option holdings should be positively associated with credit quality. In support of this, we find that vested option holdings have a strong negative association with loan pricing, especially for informationally sensitive loans, and also predict higher cash flows and credit ratings, a greater distance to default, and lower equity volatility.     

Disclosing to Informed Traders

We develop a model in which a firm's manager can voluntarily disclose to privately informed investors. In equilibrium, the manager only discloses sufficiently favorable news. If the manager is known to be informed but disclosure is costly, the probability of disclosure increases with market liquidity and the stock trades at a discount relative to expected cash flows. However, when investors are uncertain about whether the manager is informed, disclosure can decrease with market liquidity and the stock can trade at a premium relative to expected cash flows. Moreover, contrary to common intuition, public information can crowd in more voluntary disclosure.     

Portfolio pumping: An examination of investment manager quarter-end trading and impact on performance

Utilizing a database of daily institutional fund manager trades, we examine the contribution of strategic trading at quarter-end associated with potential ‘portfolio pumping’ or ‘ramping up’ of reported stock prices around quarter-ends. We provide the first direct evidence that active fund managers tend to purchase illiquid stocks on the last day of the quarter, in stocks in which they already hold overweight portfolio positions. Consistent with the way fund managers are evaluated, we found that the poor-performing managers display greater evidence of portfolio pumping. Both increased regulatory scrutiny and improvements to market microstructure design reduce the severity of stock price changes at quarter-ends.     

The influence of buy-side analysts on mutual fund trading

We present evidence on the trading and performance impact of buy-side analysts. Using data provided by a large global asset manager, we relate buy-side analysts’ recommendations to fund transactions on a daily basis. We show that buy-side analysts significantly influence trading decisions: Fund managers strongly follow recent recommendation revisions, even after controlling for other trading determinants. Positive abnormal returns to buy-side analysts’ revisions are also reflected in the performance of mutual fund trades: Trades triggered by buy-side recommendations have higher returns than other trades. Overall, the impact of buy-side analysts is more pronounced than that of sell-side analysts.     

The integration of bank syndicated loan and junk bond markets

This paper hypothesizes that the special role of banks as corporate quasi-insiders has been changing due to developments in informational, legal and institutional infrastructures of syndicated loan markets. We investigate the integration of intermediated and disintermediated financial markets through highly leveraged transaction (HLT) syndicated loans during the 1990s. We demonstrate that, with the emergence of traded HLT syndicated loans as an alternative high-yield asset to high-yield bonds, market integration has dramatically increased. Taking the late 1980s and 1990s together, different factors explain the movement of credit spreads of the two markets. HLT loan market’s spreads are strongly affected by bank liquidity. Bank liquidity’s effect on HLT loan spreads disappears after 1993. From 1994–1999, junk bond market liquidity factors affect bank loan pricing. We interpret these changes as evidence of the erosion of bank specialness.     

Words versus Deeds: Evidence from Post‐Call Manager Trades

We examine the impact of conference call tones on the direction and magnitude of subsequent manager trades. Our univariate results show that corporate insiders buy company shares following negative‐tone conference calls and sell shares following positive‐tone conference calls. This inverse call tone–trading pattern holds for both managers’ introductory sessions and subsequent question‐and‐answer (Q&A) sessions. Our multivariate results confirm the univariate call tone–trading patterns and show that contrarian manager trades are mostly driven by managerial selling activity. In contrast to the consistent and strong evidence of managers trading in the opposite direction of their call tones, we find no evidence of managers trading in the same direction of their call tones. We also examine the impact of analyst Q&A challenges on post‐call manager trades. Our findings suggest that managers learn from analyst feedback and adjust their post‐call trades accordingly.     

Callable or convertible debt? The role of debt overhang and covenants

We analyze what role debt overhang and covenants have in a manager’s choice between issuing callable or convertible debt when a firm needs to issue a substantial amount of debt. Callable bonds provide a higher coupon in exchange for a repurchase option. Convertible bonds offer bondholders the option to exchange debt to equity. Using a dynamic capital structure model with investment choice, we find that callable debt implies a larger debt overhang friction, and for highly leveraged firms convertible debt is preferred. Moreover, if outstanding bonds have net-worth covenants attached, callable bonds are more likely to be issued. Our empirical findings support the theory.     

Institutional stock trading on loan market information

One of the most important developments in the corporate loan market over the past decade has been the growing participation of institutional investors. As lenders, institutional investors routinely receive private information about borrowers. However, most of these investors also trade in public securities. This leads to a controversial question: Do institutional investors use private information acquired in the loan market to trade in public securities? This paper examines the stock trading of institutional investors whose portfolios also hold loans. Using the Securities and Exchange Commission filings of loan amendments, we identify institutional investors with access to private information disclosed during loan amendments. We then look at abnormal returns on subsequent stock trades. We find that institutional participants in loan renegotiations subsequently trade in the stock of the same company and outperform trades by other managers and trades in other stocks by approximately 5.4% in annualized terms.     

Government guarantees of loans to small businesses: Effects on banks’ risk-taking and non-guaranteed lending

We analyzed the loan guarantees that the Japanese government provided for banks’ loans to small and medium-sized enterprises (SMEs). We modeled and estimated how much and under what conditions loan guarantees affected banks’ risk-taking and banks’ non-guaranteed lending.In the presence of controls for bank capital and other factors that might affect supplies of bank credit, our estimates supported our model's implications that loan guarantees increased banks’ risk-taking.Consistent with our model, our estimates imply that, when banks initially had fewer guaranteed loans and then got more guaranteed loans, guaranteed loans were complements to, rather than substitutes for, non-guaranteed loans. As complements, loan guarantees could be “high-powered” in that they generated increases not only in guaranteed loans, but also increases in non-guaranteed loans that were a multiple of the increases in guaranteed loans. In addition, banks’ having more capital was associated with doing more non-guaranteed lending.     

THE NEW LEVERAGED LOAN SYNDICATION MARKET

Over the past ten years, commercial lending has been transformed from a one-off, bilateral "market" in which issuers maintained one or more separate banking relationships into a capital market in which one or more underwriters structure and price loans for syndication to groups of investors. This market-driven evolution has been most dramatic in the leveraged lending segment (defined as loans priced at LIBOR plus 150 basis points or more), where wide margins have attracted a large and growing field of underwriters, intermediaries, and investors.
Liquidity is the overriding theme in today's syndicated loan market, making the market a more user-friendly one for corporate borrowers and deal sponsors. As a result, a record number of corporate issuers are taking advantage of the syndicated loan market to finance strategic transactions or simply to reduce their borrowing costs. Deal sponsors, too, are tapping the market to finance leveraged buyouts, recapitalizations, and acquisitions at a pace not seen since the late 1980s. But, although acquisition pricing has reached cash flow multiples that recall those of the late '80s, equity contributions by sponsors are larger and credit structures are more conservative.
For banks and other investors, reduced loan pricing and more flexible credit structures have been balanced by much greater access to a large volume of diversified assets, as well as the ability to manage asset-specific and portfolio risk more effectively. As a result of more effective portfolio management strategies, lenders today are less vulnerable to credit problems with individual issuers or a given industry segment, and the bank market as a whole should be much less subject to disruption than it proved to be in the early 1990s.     

Do individual investors learn from their trading experience?

After analyzing retail investors’ stock trades for potential learning behavior, we present evidence that individual investors learn from their trading experience. Initially, we question whether investors’ previous forecasting ability (inferred from prior purchases’ subsequent risk-adjusted performance) affects their future trade profitability and activity. Indeed, as an investor's inferred ability increases, so does her ensuing trade profitability and intensity. Further, because additional investment experience allows more accurate ability inference, we posit that trading experience should help investors obtain better investment performance. Consistent with this hypothesis, not only do excess portfolio returns improve with account tenure, but we also find that trade quality (i.e., average raw and excess buy-minus-sell returns) significantly increases with experience (i.e., calendar time and account tenure). In sum, individual stock investors do learn, and they consequently adjust their behavior and thus effectively improve their investment performance.     

Securitization without adverse selection: The case of CLOs

In this paper, we investigate whether securitization was associated with risky lending in the corporate loan market by examining the performance of individual loans held by collateralized loan obligations. We employ two different data sets that identify loan holdings for a large set of CLOs and find that adverse selection problems in corporate loan securitizations are less severe than commonly believed. Using a battery of performance tests, we find that loans securitized before 2005 performed no worse than comparable unsecuritized loans originated by the same bank. Even loans originated by the bank that acts as the CLO underwriter do not show under-performance relative to the rest of the CLO portfolio. While some evidence exists of under-performance for securitized loans originated between 2005 and 2007, it is not consistent across samples, performance measures, and horizons. Overall, we argue that the securitization of corporate loans is fundamentally different from securitization of other assets classes because securitized loans are fractions of syndicated loans. Therefore, mechanisms used to align incentives in a lending syndicate are likely to reduce adverse selection in the choice of CLO collateral.