The economywide danger of mishandled credit risk is highlighted in the recent paper by Daniel Alpert, Robert Hockett, and Nouriel Roubini, The Way Forward: Moving From the Post-Bubble, Post-Bust Economy to Renewed Growth and Competitiveness. The authors argue that fallout from the credit bubble of 2001-09 in the form of collapsed asset values underlying fixed debt commitments ("debt-deflation") is behind the ongoing process of deleveraging and economic turmoil.
Although credit bubbles have their origin in macroeconomic factors such as changes in global capital flows, there are decisions that can be made by lenders--at the firm level--that help to mitigate the onset of credit bubbles and the pain that occurs when they burst.
Lenders certainly have strong incentives to ride credit bubbles to the top by extending more and more credit. Nonetheless, because lenders are often the first to feel the pain from loan delinquencies and defaults, self-interest alone could encourage them to improve creditor governance by extending loans on terms that provide more protection when credit conditions begin to deteriorate. In fact, two recent publications highlight that, at least in the corporate context, lenders indeed negotiated greater protections in response to the bursting of the credit bubble and also more recently in response to the rising perception of macro risk in the second of half of 2011.
In a review of investment grade European corporate syndicated loans, Clifford Chance attorney Mark Campbell notes that immediately after the financial crisis increased credit protection came from three types of contract provisions. The first are those that protect against decreases in creditworthiness, including financial covenants and material adverse change clauses that may require a borrower to immediately pay back their loan or allow the lender to refuse to extend any more capital under an existing credit commitment. The second type are provisions that restrict the ability of the borrower to make significant changes to their business after a loan is made. The third are provisions that ensure a lender's claims are not subordinated to other lenders.
In addition, Alex Lee of Thomson Reuters notes that in the second half of 2011, U.S. lenders began to negotiate stricter reps and warranties in response to macroeconomic uncertainties. These reps most importantly include reps as to asset ownership and quality, material adverse changes, and borrower solvency. Importantly, better creditor governance may be the "money left on the table" that allows even risky borrowers to have access to capital and allays the fears of lenders. As noted by Lee:
Though controversial, these negotiation points appear to serve the function of bridging the gap between the harsh economic realities the borrowers face with the expectations banks have for high returns on their investments.
Credit risk even from macroeconomic changes is therefore something that lenders can be the first line of defense against. While no panacea for credit bubbles and collapses, strict yet commercially feasible lending may ultimately be able to reduce the occurence of debt-deflation and its consequences that Alpert, Hockett, and Roubini rightly note is so destructive. Of course, to more significantly reduce the risks of credit bubbles, better creditor governance must also extend to instruments that transfer credit risk.
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