Today it is hard to imagine a robust syndicated loan market without widespread distribution of major loans to an extensive investor base of banks, endowments, pensions, mutual funds, hedge funds and, especially, securitized vehicles like CLOs. It is equally difficult to imagine a healthy loan market without a system for rating loans and classifying them in terms of their default and recovery expectations, with links to the historical data that underpins those ratings and maps to the capital and reserve requirements of the banks and their regulators.
So it may seem like the "dark ages" of credit and lending to think back 20 years and reflect on a loan market without credit ratings, where the link between pricing and risk was tenuous. Many old-time "commercial" bankers (like the author) recall when banks used to hold their loans to maturity on their own books, and how credit analysis focused on a simple "yes/no" decision. Should we make the loan? Did the deal meet the bank's credit standards? There was little "portfolio management" in the decision. And pricing, especially, was an afterthought. Credit was all: is this deal a good one or a bad one?
In joining Standard & Poor's in 1992, I certainly had no notion of being a missionary to bring ratings to the commercial banking heathen. In fact, at that time the market considered ripe for picking by the rating agencies was the private placement market. The insurance regulator, the National Association of Insurance Commissioners, had just adopted a new credit scale that featured a huge reserve "cliff" between investment grade and non-investment grade borrowers, thus providing a potential inroad for ratings to help define which deals made the cut and which didn't.
So it was, that in pursuit of the goal of penetrating that market, I found myself in 1993 at an institutional private placement conference in New York. Loans had not yet generated enough interest among non-bank investors to support entire conferences devoted to them. But awareness had grown to the point where panel discussions on loans began to appear on the agenda of private placement conferences, usually sandwiched into the last half of the second day, where they competed for the audience's attention with the hotel bar and the early train home to Greenwich. As a result, there was not much of an audience left to witness the incident I will now relate, which figured so mightily in the development of loan ratings.
Loans at a Private Placement Conference
This particular panel on loans featured James B. (Jimmy) Lee, Jr. At the time Lee was running Chemical Bank's powerhouse syndicated lending group, from which he went on to head the bank's investment banking group, and ultimately rise to vice-chairman of JP Morgan Chase. While the panel's overall membership and presentation were pretty forgettable, Lee's answer to one of the questions from the audience was memorable, and catalytic in its impact on me, on S&P and on the loan rating business. Asked by a spectator, "How do you price your loans?" Jimmy didn't hesitate a nanosecond before answering, "We price 'em all the same - 400 basis points over LIBOR." The audience chuckled and that was it, on to the next panel.
But Lee's comment, partly in jest, but with a big grain of truth in it, gnawed at me for days afterwards. I knew syndicated loans were essentially a non-investment grade market that included double-Bs, single-Bs and even triple-Cs. At S&P we knew from decades of default statistics that single-B companies defaulted two to three times as often as double-B firms, and that default rates really jumped in triple-C territory. I also knew that in the bond and private placement worlds, the pricing "cliffs" between triple-B, double-B, single-B and triple-C were huge. So if Jimmy Lee's remark were even remotely true, then corporate treasurers and institutional investors were continually leaving money on the table or getting a windfall from one deal to another, depending on where each issuer fell on the credit spectrum.
Now you would think, armed with authoritative, actionable market intelligence like this, straight from the horse's mouth, that we at S&P would have jumped all over it. Unfortunately, S&P didn't have a rating that would work too well in evaluating secured loans to non-investment grade borrowers. Our traditional business had been rating corporate bonds, which were unsecured and issued mostly by investment grade companies. The whole analytical focus was on the risk of default. In other words, what is the risk of the issuer failing to pay interest or principal on time? Period. Since the likelihood of that occurring with investment grade issuers was minimal, there was almost never any collateral security to evaluate or much reason to analyze what would happen in a "post-default" environment. (The advent of high yield bonds changed that, but only a little. They were unsecured or even subordinated, so when defaults came, as they often did, there was little to recover.)
"No Rating" Is Better Than a Bad Rating
As long as a rating only addressed default risk, a rating on a bank loan was no help at all. It only emphasized the negative (that high yield companies were prone to default) but not the positive (when they did default, secured lenders got most of their money back.) But commercial bankers have always known how to make a risky credit "bankable" by tying the borrower up with protective covenants and collateral security. Although it represented a major change from past practice, S&P's criteria and methodology gurus eventually agreed with us that a "dual risk" approach - default risk and expected recovery - was necessary if we wanted to serve the bank loan market. It also helped that the bankers S&P went out and talked to re-affirmed to us over and over again that such a two-dimensional approach was absolutely necessary.
The rest is history. Rating syndicated loans became an integral part of S&P's corporate rating business, with volume some years even exceeding traditional corporate bond ratings. Now, twenty years later, we might well ask: How could anyone NOT analyze the structure, security and loss/recovery prospects of a company's various debt issues as separate elements of rating the total company? The answer may seem obvious today, but it certainly was not twenty years ago when Jimmy Lee took that question from the audience and helped spark a mini-revolution in the corporate rating business. I, for one, am very grateful that he did.
This article was written by
Bavaria introduced the Income Factory philosophy in his Seeking Alpha articles over the past ten years, drawing on his fifty years experience in credit, investing, journalism and international banking. His earlier book "Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism" exposes the excesses in the CEO pay arena. Both books are available on Amazon.
Bavaria began his career at the Bank of Boston, handling international credit workouts that included managing a fleet of ships, chasing a Vatican-owned bank in Switzerland, and leading the turnaround of troubled branches in Australia and Panama.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.