Question: Years prior to the 2007 meltdown in the market for

Years prior to the 2007 meltdown in the market for asset- backed securities saw a significant increase in “ covenant- lite” debt, under which debt contracts had few if any debt covenants. For example, a firm may issue such debt to finance a planned takeover. One estimate is that, in 2007, covenant- lite debt accounted for 35% of all debt issued in the United States.
Typically this debt was bought by financial institutions, such as banks. A bank would then combine this loan with other similar loans and slice the total up into tranches of similar credit quality. It would then sell these tranches to investors on a secondary loan market. The purchaser would receive his/ her share of the interest and principal payments paid by the firms whose debt is in that tranche. Thus, the investor could buy interest-bearing debt with the level of default risk he/ she desires, and pay accordingly. The effect, it was felt at the time, was to disperse credit risk through the economy. It was expected that even for a covenant- lite tranche of low quality there will be no more than a few defaulting firms, so that any credit losses are spread over all the investors in that tranche.
Furthermore, it was possible to increase the credit quality of a tranch by buying credit default swaps (CDSs). These are derivative instruments under which the issuer of the CDS, for a fee, agrees to compensate tranche investors for credit losses incurred by that tranche. If CDSs are bought to protect, say, 25% of the underlying debt in the tranche, the effect is to increase the credit quality of the tranche significantly. This further dispersed credit risk, since now at least part of the risk was borne by the CDS issuers.

a. If you were an investor in interest- bearing securities, would you be willing to invest a substantial amount of your capital in tranches secured by covenant- lite debt? Explain why or why not. Consider both your evaluation of expected return and risk in your decision.
b. Concerns are sometimes expressed that issuing covenant- lite debt creates a moral hazard problem for the firms issuing such debt. What is the problem?
c. The ability to increase the credit quality of high- risk debt by means of CDSs seems almost “magical.” However, based on experience from the 2007– 2008 market melt-downs, the increase in credit quality was not as great as expected. Why?

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