[{"title":"page_481","lines":["(cid:120) A hedge fund manager buys CDO debt about which he doesn’t know much (with thousands of","underlying mortgages having been sliced and diced) or worry much (given the high debt ratings).","Concoctions like this are tolerated only in heady times. Clearly the results can be incendiary. We’re","waiting to see the final outcome – and perhaps to pick among the ashes.","One last thought: Let’s say slicing, dicing and selling onward do have the potential to reduce the","overall level of risk in the system, all other things being equal. Even if that were true, the other","things wouldn’t remain equal; market participants would adjust their behavior to the new","reality and in so doing return risk to its old level. On May 23, the Financial Times said this about","trying to reduce risk by selling onward and by obtaining credit insurance via derivatives:","This makes banks less vulnerable to individual defaults. But it could also be making","them feel so comfortable about lending risks that they are making more risky","loans. Outside investors such as hedge funds are gobbling them up, either because","they also think they are protected with credit derivatives or because they are","desperate to find somewhere to place their cash. This has triggered a collapse in the","standards used to conduct and fund deals. (Emphasis added)","Again, no matter how good fundamentals may be, humans exercising their greed and propensity to","err have the ability to screw things up. Perhaps Myron Scholes put it most succinctly (The Wall","Street Journal, March 6): “My belief is that because the system is now more stable, we’ll make","it less stable through more leverage, more risk taking.”","The L Word","U","Some of the most glaring innovation this time around has taken place in the area of leverage. It’s not","that leverage hasn’t been available and been used before: In the late 1980s, companies like RJR were","the subject of leveraged buyouts in which 95% of the purchase price was borrowed. Nowadays, debt","rarely constitutes much more than 80% of buyout capital structures, but the terms of the debt and the","ease of obtaining it are startlingly accommodating.","Unlike the historic norm, it’s routine today to issue CCC-rated bonds. It’s easy to borrow money for","the express purpose of distributing cash to equity holders, magnifying the company’s leverage. It’s","so easy to issue bonds with little or no creditor protection in the indenture that a label has been","coined for them: “covenant-lite.” And it’s possible to issue bonds whose interest payments can be","paid in more bonds at the option of the borrower.","The first requirement for an elevated opportunity in distressed debt is the unwise extension of","credit, which I define as the making of loans which borrowers will be unable to service if things","get a little worse. This happens when lenders fail to require a sufficient margin of safety.","Here the interrelatedness of cycles is quite evident. Good economic times bring rising profits.","Rising profits cause the default rate to subside. And the low default experience erases lenders’","reticence. Among other things, they become willing to lend money so that troubled companies can","8"]}]