Financial Services Industry Modules
1) What are three of the major drivers in the development and growth of the Shadow Banking market?
1) A constant search for returns by investors in a low interest rate environment. 2) The demand for capital by lower rated companies. 3) The unregulated aspects of the market allow for more creativity and control on the part of investors. Credit agreements can be customized based on based on specific requirements, eg., maintenance versus incurrence covenants as warranted, etc.
Why did Collateralized Loan Obligation Funds (CLOs) perform as advertised during the Financial Crises of 2008-2009 while Collateralized Mortgage Bonds(CMBS) failed to perform as advertised?
"Garbage in, garbage out". The institutional loans that were put into CLOs were heavy due diligence and were of the credit quality that was verified by each of the parities involved in the transaction, including the PE firms, the underwriters of the debt and the rating agencies. The Mortgages that were put into the CMBS vehicles were not subject to adequate due diligence either by the rating agencies or the firms underwriting the transactions. As such, instead of having viable, credit worthy mortgage holders that could make debt payments, most of the houses being financed were either empty or had non-credit worthy mortgage holders that couldn't make the mortgage payments. As such, the majority of CMBS vehicles originated at that time defaulted.
What is the difference between a Broker and a Dealer? Why is it important that an Investment Bank act as a Dealer in the secondary market?
A Broker acts as an agent bringing a buyer and seller together to consummate a transaction. For this service the Broker collects a fee. At no time does the Broker have a principal position in the transaction. A Dealer acts as a principal. In other words, the Dealer buys the security from the seller and then looks to sell the security to a buyer. The Dealer earns a bid-ask spread, or the difference between what the Dealer bought and sold the security for. This is "making a market" in the security. It's important for an IB to act as a Dealer as this increases the number of transactions that can occur in the secondary market and increases the liquidity/price support for securities. For timing issues, pricing issues, geographical issues, etc., a Broker wouldn't oftentimes be able to bring a buyer and seller together. The Dealer uses its balance sheet as a short term warehouse for the security which allows it to overcome these issues. The price at which the Dealer bought the security also oftentimes acts as a natural floor price as the Dealer does not want to lose money on the trade and will work to sell the security at a higher price in order to lock in its profit.
Why would a start-up company issue a convertible bond? Why would a "fallen angel" issue a Convertible Bond?
A Convertible Bond can give a start up company equity credit today for equity to be issued in the future at the conversion price of the Convertible Bond. That does a couple of things. It does not immediately dilute current equity investors with an equity issuance which would cause the stock to trade down and increase costs. The conversion occurs at a higher price and therefore lowers the immediate cost of the "equity" that the company is issuing. It also puts a floor on the company's rating that can allow the company to issue concurrent debt at a lower cost as only issuing the debt could cause the company's rating to be downgraded, therefore increasing the bond's costs. A "fallen angel" would issue a Convertible Bond to help preserve its investment grade rating and thereby lower the cost of its capital structure.If the company falls below investment grade, its entire bond complex must trade into the high yield market that is a fraction of the size of the investment grade market.As such, any new bond issue would have competition from the company's existing bonds, all of which would trade down given the transition to the high yield market and would price accordingly (significantly higher
1) What is a Repurchase Agreement (Repo)? Why is it used so frequently by financial firms?
A Repurchase Agreement is where one party sells a security at a discount to another party. At the same time the first party contracts to buy the security back at a given time and price. This arrangement is in fact a secured loan as defined by GAAP. The difference between the buying and selling price represents interest on the loan. Financial firms are frequent users of repos to finance their daily operations as a large part of the balance sheet is made up of securities that they are holding as dealers in their flow trading operations. As such, these securities represent a huge source of secured collateral to be used to secure short term funding in the Repo market. The securities used are liquid and easily valued.
1) What is a Value at Risk (VAR) model? Why is so much emphasis placed by regulators on having financial firms develop VAR models and checking their voracity?
A VAR model measures the relative risk of the aggregate risk positions on an IB's balance sheet to an IB's capital under various economic, interest rate, credit, etc., scenarios. It is a measure of the potential loss that can occur to the IB based on its balance sheet's composition and whether there is sufficient capital available to cover that loss. Regulators are extremely focused on these models as there is no standard industry model (each one is customized by each IB). The regulators want to make sure that the model is sufficiently robust to accurately measure the risks to and the capability of the IB's balance sheet to survive those risks under various adverse conditions.
Describe each of the following and the document that governs each of their investment in a company? B) Bond investor
A bond investor is a third party provider or lender of debt capital. This capital is more highly ranked, ie., it has a stronger claim on the company's assets in case of liquidation, than an equity investor. Since the investor is not part of the company, it needs a legal document to govern the arrangement on which it is willing to provide the capital. For bond investors, which are securities as defined by the SEC, that documents is an Indenture. The rules on which the extension of credit is being provided are called covenants.
1What is a derivative?
A derivative is a contract the value of which is derived from another entity. An example would be an interest rate swap. The swap's value is derived from the value of referenced fixed/floating rate securities.
1) What is the difference between an equity and a debt (both bond and loan) investor? Why would a debt investor need covenants? Why wouldn't an equity investor need covenants? What is a covenant?
An equity investor has an ownership stake in the company. A debt investor is a third party provider of debt capital which by its terms requires that the capital be repaid. Covenants are the rules under which a company borrows money from either a bond or a loan investor, which are third party capital providers.
Describe each of the following and the document that governs each of their investment in a company? A) Equity investor
An equity investor invests in the company. It is a share of company ownership and as such is governed by the by-laws and articles of incorporation of the company.
1) What is an incurrence covenant? What is a maintenance covenant? Which one is more advantageous to the borrower and why?
An incurrence covenant sets a limitation on a company and is reported only when that limitation will be violated by an action. An example would be setting a leverage test of debt/ebitda of "X". As long as the company is within that covenant limit, the company does not have to report anything regarding the covenant to its lender. If it will incur something that will cause a violation of the covenant, the company will then have to report the violation. A maintenance covenant sets a limitation on a company that must be complied with at all times and is reported to the lender as such, usually on a quarterly basis by certification of the company. An example would be setting a leverage test of debt/ebitda of "X". The company would have to certify that they were in compliance with that covenant at all times through the reporting period. Any breach of the covenant during the period would have to be reported. Incurrence covenants are more advantageous to a borrower as they give the borrower significantly more flexibility during a down cycle to operate without being in breach of the covenant.
1) What are credit default swaps (CDS)? Why have CDS become so popular and what is the chief form of risk that they represent?
CDS are derivatives that are in essence, unregulated insurance products. CDS have become popular because they are a very inexpensive way to enhance a structured vehicle's bond issuances in the market. If a vehicle doesn't have quite enough portfolio diversification to achieve the targeted ratings of its various funding securities tranches, a CDS can be issued to achieve the targeted rating. This was the chief cause of the Financial Crisis of 2008/2009. CDS is also a very efficient way to hedge credit exposure to a particular counterparty. Because CDS is so popular, unregulated and broadly distributed in the market, it creates a huge source of systemic risk in the Financial System. It is the biggest risk endemic to the market and is very difficult to regulate.
1) What is the biggest driver of why derivatives have become so popular with issuers?
Derivatives' popularity has been driven by a substantial decrease in the cost of execution. Document standardization (ISDA's), netting and information access such as Bloomberg have all contributed to a dramatic reduction of costs across the market.
1) What is the difference between Flow Trading and Proprietary (Prop) Trading? Why would the Dodd Frank Law prohibit the latter?
Flow trading is acting as a Dealer and making a market in a security. Generally this is a short term position (as labeled on the IB's balance sheet) but given market conditions can be longer term. The important thing is the intent to hold the security short term. Proprietary trading is taking a position in a security with the firm's capital unrelated to making a market in the security. Prop trading tends to be medium/long term in nature, but is not required to be so. The important thig is what the intent of the investment is. Since some of the IB's capital is coming from FDIC, U.S. Government guarantee deposits, the government does not want to expose itself to the risk of a proprietary trade going bad. Remember that the government is backstopping the deposits, i.e., capital that is being used by the IB to engage in the prop trade. The view is that since the government is at risk, they have a say as to the types of trading that IB's can engage in.
What is a Hybrid Security? What is the characteristic that causes a Convertible Bond to have more/less equity credit from the Rating Agencies?
Hybrid Securities are securities that have components of Debt and Equity. Convertible Preferred Equity has a mandatory dividend payment that gives the security bond like characteristics. It is senior equity and is the preferred way in which Private Equity Firms make their equity investments. Convertible Bonds are bonds with an equity warrant attached. As such, and based on up front agreed parameters, Convertible Bonds have the right to convert into the common equity of a company at a pre agreed upon price. That right has a value that is incorporated in the pricing of a Convertible Bond. As such, a Convertible Bond's price is collectively determined by the Convertible Bond market, the Bond Market and the Equity Market. The more vested the conversion mechanic of a Convertible Bond into Equity is with an investor, the more equity credit the issuer gets for the bond from the Rating Agencies. The more vested the conversion mechanic of a Convertible Bond into Equity is with the issuer, the less equity credit the issuer gets for the bond from the Rating Agencies.
1) What does "investment grade" and "non-investment grade" mean? Why is this important? Why is the Federal Reserve concerned about a massive ratings downgrade of investment grade companies to non-investment grade?
Investment grade is a definition by the rating agencies of companies/debt that is defined as less risky or lower probability of default. The nomenclature is anything that is rated equal to or higher than BBB-/Baa3/BBB- by S&P, Moody's or Fitch, respectively. Non-investment grade is a definition by the rating agencies of companies/debt that is defined as riskier or a higher probability of default. The nomenclature is anything that is rated lower than BBB-/Baa3/BBB- by S&P, Moody's or Fitch, respectively. Because of the multi decade long low interest rate policy that the Fed has maintained, many, many low investment grade (IG) companies have issued long term bonds and are at risk of getting downgraded to below IG given the economic disruption caused by COVID. The IG market is multiples the size of the non-IG market. Since IG debt is owned by investors that can only own IG debt, if an issuer of that debt gets downgraded to below IG, those investors have to sell that debt at whatever price that they can get at that time. If you have a large supply of formerly IG debt coming to the non- IG market, which is a fraction of the IG market size, the price of that debt will decline precipitously and cause a market disruption and a freezing up of the market. This is what happened when COVID impacted the market and forced the Fed to provide emergency liquidity as a result.
1) Why do Private Equity Firms, otherwise known as Sponsors, prefer leveraged loans to HY bonds?
Leveraged loans have no call provisions and are cheaper to arrange than HY bonds (175bps gross spread for leveraged loans versus 250 bps gross spread for HY bonds). They sometimes have a repayment premium of 25-50 bps for up to a year to protect them against repricing should interest rates decline (remember these are floating rate instruments that directly reflect changes in interest rates). They are prepayable at par in a refinancing. HY Bonds, on the other hand, have make wholes and call provisions that protect the investor in case of a refinancing. This is because they are a fixed rate instrument and investors are exposed to changes in interest rates (remember bond math?) and this is what investors require to take that interest rate risk. Since a company's balance sheet which is owned by a PE firm is in a constant state of flux due to monetization's by the PE firm, leveraged loans are a much lower cost option than bonds. If the PE firm refinances the balance sheet, sells the company, needs an amendment, etc., all of those activities are cheaper to execute with loans versus bonds give the lack of these call provisions. The cost of those refinancing's comes directly out of LPs' investments in the PE fund and reduces the fund's returns. Loans are cheaper and have a smaller negative impact on the PE fund's returns. Hence the preference for loans by PE firms.
Describe each of the following and the document that governs each of their investment in a company? C) Loan investor
Like a bond investor, a loan investor is a third party provider of debt capital. Like a bond investor, this debt capital is more highly ranked, ie., it has a stronger claim on the company's assets in case of liquidation, than an equity investor. As with a bond investor, the provider of this capital needs a legal document to govern the arrangement on which it is willing to provide this capital. With loans, which are NOT securities as defined by the SEC, that document is a Loan Agreement. Like bonds, the rules on which the extension of credit is being provided by loan investors are called covenants.
1) Why would a distressed direct lender prefer maintenance covenants versus incurrence covenants in its loan documentation?
Maintenance covenants allow for direct ongoing control by the lender of the borrower. The borrower at all times has to prove that they are in compliance with the covenant. Incurrence covenants do not. As long as there is no default, there is no course of action an incurrence covenanted lender can pursue should a problem arise with the borrower that puts the lender's investment at risk. As such, a credit agreement with maintenance covenants allows a lender to lend to a riskier borrower while maintaining greater control of the borrower's actions, thereby lowering the lender's risk on a relative basis. All bi-lateral lending agreements to poorly rated borrowers have maintenance covenants as a result.
Excluding securitization as it relates to the disintermediation of bank loans, what is securitization? Why would a firm (bank or company) want to securitize an asset?
Securitization refers to the packaging of non-traded financial assets on the balance sheet of a firm into a form of securities (bonds) that can then be traded on the public markets. A firm would want to securitize assets as it frees up the balance sheet to engage in additional business. The assets to be securitized are sold to the securitization vehicle thereby increasing the cash portion of the balance sheet and reducing the need for equity to maintain the illiquid asset. It allows for a more frequent cycling of capital across the balance sheet of the firm executing the securitization.
1) Why would a company issue debt as a "Regulation D placement" versus issuing a public bond?
Reg D placements do not require any public disclosure to the rating agencies. As such all issuances are totally confidential which is important to certain companies. Likewise, if a company is in an industry that the rating agencies refuse to rate as investment grade the company may use Reg D to arbitrage between the rating of the rating agencies and the NAIC which will usually rate such companies IG. This also holds true if the methodology of the agencies is such that one agency's requirement for an IG rating precludes another agency from rating the company IG. Many countries do not have a non -IG public market and use the Reg D market as an alternative source of debt capital.
1) What are some of the conflicts associated with Risk Arbitrage trading? Why are financial firms so focused on managing those conflicts?
Risk Arbitrage is a form of prop trading that occurs on M&A deals. It is a bet that is generally made using the model that a target company's stock will rise while an acquiring company's stock will decline on the announcement of a transaction. (We've covered the reasons why previously in the Advisory Module). Risk Arbitrage involves shorting the acquirer's stock and going long the target company's stock, thereby locking in your spread. The risk with this trading strategy is that it ignores many of the political and regulatory issues that can negatively affect a deal. The biggest conflict with Risk Arbitrage is that by shorting the acquiring company's stock that your firm just advised, it shows that your firm is not supporting the M&A deal. The short position creates downward pressure on the acquirer's stock, potentially making the deal more expensive or unobtainable. This in turn, will put the acquirer's CEO at risk of being fired, which obviously causes stress between the company and your firm, which can cumulate in your firm being fired and you along with it. Going long the target's stock puts upward pressure on its price which makes the acquisition even more expensive for the acquirer. It can result in a similar outcome as described above. The regulators are incredibly focused on potential insider trading as it relates to M&A. Any risk arbitrage trade is heavily scrutinized by the regulators to make sure that there is not connection either directly or indirectly to insider information. If there is, the source of the information, either directly or indirectly is subject to severe penalties.
1) What is Rule 415 and why has it been so impactful to the investment grade bond market?
Rule 415 is an amendment to the '34 Securities Act implemented in the early 1980's to make the U.S. Capital Markets more competitive with offshore markets. Rule 415 allowed for "shelf registrations" thereby speeding up debt/equity issuances and lowering market risk for issuers. It allowed for competition between banks for bond business thereby lowering issuer costs as banks would extend cheap credit lines to entice an issuer to hire them for their bond business. It allowed for reverse inquiry from investors thereby empowering capital markets within the IB as those roles provided live market feedback to issuers. It also encouraged creative products that banks could offer issuers to incent them to give the banks additional bond business.
How do you securitize credit card receivables which have an average life of 18 months in a securitized vehicle with a long term (greater than 18 months maturity) capital structure?
The SPV has a revolving line of credit with the institution that is securitizing the credit card receivables. As the receivables mature within the SPV, the SPV uses the revolving facility to buy additional receivables to refill the SPV with assets. As such, a level of asset overcollateralization is always maintained within the SPV to maintain the appropriate ratings on its tranches of bonds outstanding.
What are the basic characteristics of a securitized vehicle? How does it work?
The illiquid assets to be securitized are sold to an SPV. The SPV pays for the assets by issuing bonds to the public markets. Different tranches of bonds are issued with different credit ratings. Each tranche of bond's credit ratings is determined by the SPV's relative overcollateralization of assets/credit enhancement relative to the specific bond tranche and that specific bond tranche's claim on the SPV assets. The bonds with the first claim on the assets get repaid entirely before any other bond gets repaid. That tranche get the highest credit rating. Subsequent bond tranches have a greater and greater subordinated repayment claim on the assets of the SPV and get respectively lower ratings as a result. These cascading claims against the assets of the SPV are called a waterfall. All bond tranches receive a proportional share of the interest from the SPV. Coverage and overcollateralization levels are determined by historical loss/claims data maintained by the rating agencies. If the level of overcollateralization is insufficient to achieve a targeted bond tranche rating, that bond rating can be enhanced by credit default swaps which are purchased by the SPV.
How could an investor who can only buy AAA rated securities buy into a Securitized Vehicle?
The investor can buy the AAA rated bond tranche from the SPV that is issuing the bonds.
1) What is the largest buyer of non-investment grade loans, otherwise known as leveraged loans? Describe or draw the mechanism of how it works?
The largest buyers of leveraged loans are Collateralized Loan Obligation Funds, or CLO's. CLO's are a structured vehicle and as such are put together with a similar structure to other structured vehicles such as Collateralized Mortgage Backed Securities (CMBS), Asset Backed Securities (ABS), etc. The vehicle purchases loans across a distribution of ratings and industries to achieve an acceptable overall probability of default based on 150 years of default data per industry/rating which is maintained by the Rating Agencies. Different tranches of fixed rate securities are then issued into the market and provide the capital to the CLO to purchase the loans. Those securities are rated based on their ranking as to loss should there be defaults in the vehicle. The first loss security is the equity and the last loss security is rated AAA. Tranches of BBB, securities are also issued based on their relative loss positions. To repeat, each rated security that is funding the CLO achieves its rating based on the probability of default for the loans in the CLO and the relative loss position of the security should there be defaults of the loans in the vehicle. Given a CLO's cost of capital, they are generally precluded from buying investment grade loans as the returns on those loans do not support the cost of funding for the CLO. There are some exceptions for low rated investment grade loans where even though the return is too low for the CLO, the improvement on the overall probability of default that the low rated IG loan gives to the CLO loan portfolio offsets that detriment. It creates more capacity for the CLO to buy lower rated loans with higher returns. This is because the probability of default is not linear to the rating of a loan. The probability of default increases at a faster rate than the relative decline in the r
1) What is the size of the leveraged loan market? What is the size of the HY bond market?
The leveraged loan market is approximately $1-2 Trillion and the HY bond market is approximately $3-3.5 Trillion.