An interesting speech by Jeremy Stein emphasizes the ingrained tendency of financial institutions to boost earnings by selling tail risk insurance in forms not covered by covered risk measures and regulation. Hence, financial innovation, changes in regulation, and macroeconomic changes often result in credit market overheating through implicit subordination in conjunction with excessive maturity transformation. At present such tendencies may materialize in the rising share of low-grade credit issuance, the rapid expansion of agency mortgage REITs, and the increasing maturity of securities in bank portfolios. For the future, the expansion of collateral swaps and other forms of collateral transformation deserves attention.

“Overheating in credit markets – origins, measurement, and policy responses”

Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve System

On the basic features of the institutions-based view of overheating:

“Many quantitative rules are vulnerable to agents who act to boost measured returns by selling insurance against unlikely events – that is, by writing deep out-of-the-money puts. An example is that if you hire an agent to manage your equity portfolio, and compensate the agent based on performance relative to the S&P 500, the agent can beat the benchmark simply by holding the S&P 500 and stealthily writing puts against it, since this put-writing both raises the mean and lowers the measured variance of the portfolio.”

“Since credit risk by its nature involves an element of put-writing, it is always going to be challenging in an agency context, especially to the extent that the risks associated with the put-writing can be structured to partially evade the relevant measurement scheme.”
“These agency problems may be exacerbated by competitive pressures among intermediaries and by the associated phenomenon of relative performance evaluation. A leading example here comes from the money market fund sector, where even small increases in a money fund’s yield relative to its competitors can attract large inflows of new assets under management. And if these yield differentials reflect not managerial skill but rather additional risk-taking, then competition among funds to attract assets will only make the underlying put-writing problem worse.”
“Three factors…can contribute to overheating:
  • Financial innovation…can create new ways for agents to write puts that are not captured by existing rules. The best explanation for the existence of second-generation securitizations like subprime CDOs is that they evolved in response to flaws in prevailing models and incentive schemes.
  • Changes in regulation…may also open up new loopholes, some of which may be exploited by variants on already existing instruments.
  • A change in the economic environment…[may] alter…risk-taking incentives. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to “reach for yield.” An insurance company that has offered guaranteed minimum rates of return on some of its products might find its solvency threatened by a long stretch of low rates and feel compelled to take on added risk. A similar logic applies to a bank whose net interest margins are under pressure because low rates erode the profitability of its deposit-taking franchise.”
Critical non-price warning signs
“In an institutions-driven world, where agents are trying to exploit various incentive schemes, it is less obvious that increased risk appetite is as well summarized by reduced credit spreads. Rather, agents may prefer to accept their lowered returns via various subtler non-price terms and subordination features that allow them to maintain a higher stated yield. Robin Greenwood and Sam Hanson (2012) show that if one is interested in forecasting excess returns on corporate bonds…[a] powerful predictive variable is…the high-yield share, defined as issuance by speculative-grade firms divided by total bond issuance. When the high-yield share is elevated, future returns on corporate credit tend to be low, holding fixed the credit spread.”
“It is not just bad credit decisions that create systemic problems, but bad credit decisions combined with excessive maturity transformation. A badly underwritten subprime loan is one thing, and a badly underwritten subprime loan that serves as the collateral for asset-backed commercial paper (ABCP) held by a money market fund is something else – and more dangerous… What we’d really like to know is this: What fraction of it is ultimately financed by short-term demandable claims held by investors who are likely to pull back quickly when things start to go bad? It is this short-term financing share that creates the potential for systemic spillovers in the form of deleveraging and market-wide fire sales of illiquid assets.”
Application to recent developments in credit markets

“The spread on nonfinancial junk bonds, currently at about 400 basis points, is just above the median of the pre-financial-crisis distribution, which would seem to imply that pricing is not particularly aggressive. On the other hand, the high-yield share for 2012 was above its historical average, suggesting – based on the results of Greenwood and Hanson – a somewhat more pessimistic picture of prospective credit returns…. The annualized rates of PIK bond issuance (payment-in-kind bonds used in leveraged buyouts) and of covenant-lite loan issuance in the fourth quarter of 2012 were comparable to highs from 2007. The past year also saw a new record in the use of loan proceeds for dividend recapitalizations, which represents a case in which bondholders move further to the back of the line.”

“[As to maturity transformation] dealer financing of corporate debt securities, much of which is done via short-term repurchase agreements (repos)…rose rapidly in the years prior to the crisis, then fell sharply, and remains well below its pre-crisis levels today…[However] if relatively illiquid junk bonds or leveraged loans are held by open-end investment vehicles such as mutual funds or by exchange-traded funds (ETFs), and if investors in these vehicles seek to withdraw at the first sign of trouble, then this demandable equity will have the same fire-sale-generating properties as short-term debt.”
“Agency mortgage real estate investment trusts (REITs) sector buy agency mortgage-backed securities (MBS), fund them largely in the short-term repo market in what is essentially a levered carry trade, and are required to pass through at least 90% of the net interest to their investors as dividends. REITs have grown rapidly in the past few years, from USD152 bn at year-end 2010 to USD398 billion at the end of the third quarter of 2012. This business model sensitive to conditions in both the MBS market and the repo market. If MBS yields decline, or the repo rate rises, the ability of mortgage REITs to generate current income based on the spread between the two is correspondingly reduced.”
“The maturity of securities in banks’ available-for-sale portfolios is near the upper end of its historical range. The added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully – especially since existing capital regulation does not explicitly address interest rate risk…The same pressure to boost income could be affecting behavior in other, less readily observable parts of their businesses.”
Influence on collateral transformation
“With a variety of new regulatory and institutional initiatives on the horizon that will likely increase the demand for pristine collateral – from the Basel III Liquidity Coverage Ratio, to centralized clearing, to heightened margin requirements for non-cleared swaps – there appears to be the potential for rapid growth in [collateral transformation].”
“[For example in] a collateral swap… an insurance company might approach a broker-dealer and engage in what is effectively a two-way repo transaction, whereby it gives the dealer its junk bonds as collateral, borrows the Treasury securities, and agrees to unwind the transaction at some point in the future. Now the insurance company can go ahead and pledge the borrowed Treasury securities as collateral for its derivatives trades.
The dealer… may have to engage in the mirror-image transaction with a third party that does [have the Treasury securities] – say, a pension fund. Thus, the dealer would, in a second leg, use the junk bonds as collateral to borrow Treasury securities from the pension fund. And why would the pension fund see this transaction as beneficial? Tying back to the theme of reaching for yield, perhaps it is looking to goose its reported returns with the securities-lending income without changing the holdings it reports on its balance sheet.”