The BIS folks have just released a literature review about the transmission channels between the financial and real sectors of the economy. This is a pretty comprehensive literature review (which also means that it is a tad dry), but there are interesting bits in their identification of gaps in the literature.
One of the observations in the paper led me to consider a question: is cash-flow based lending or collateral-based lending more susceptible to systemic risk? Which of them serves as a stronger transmission channel for risk between the financial and real sectors? The answer might point the way to better regulation of the financial industry.
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At the UCLA Big-Bankruptcy Empirical Research conference last week, an interesting question was raised regarding debtor-in-possession ("DIP") financing. Why do DIP facilities offer such high returns even though the historical default rates are so low? A study by Moody's shows that, of 297 cases of DIP facilities extended to large public companies which defaulted between 1998 and 2008, there were only 2 defaults.
Even though the probability of default is low, an argument may be made that DIP facilities pose risks which are "low probability, high severity". After all, one of the defaults in the Moody's study resulted in a low recovery rate of between 20-30%. Given the scarcity of default data, a common technique used in the industry is the "distance from loss" method. The super-priority status enjoyed by DIP lenders in the bankruptcy waterfall usually implies a high "distance from loss" for the debt. Indeed, the $505 million DIP facility in the Borders bankruptcy appears to provide a good illustration as to the low-risk nature of this asset class, as it enjoys a huge debt cushion of more junior debt.
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As Stephen Lubben has remarked on this blog, the litigation filed by Lehman against JPMorgan regarding JPMorgan’s alleged role in Lehman’s demise is heating up. Late last week, JPMorgan filed a colorful amended counterclaim, citing how Lehman had described the collateral it had given JPMorgan as "goat poo" internally and other things besides. The issue of Lehman’s collateral underlying its funding arrangements is a highly interesting one, not least because it ought to provoke some thought about how far we have come in managing and regulating liquidity risk.
Clearly, Lehman, then the fourth-largest investment bank, was playing with fire in trying to fund its daily business activities by putting down “goat poo” as collateral, and not just that, putting the system at risk by doing so. Lehman’s access to liquidity in its last days was highly dependent on its access to secured credit, and when lenders belatedly asked for more and better collateral, fell days later.What have regulators done since then?
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