Did Structured Credit Fuel the LBO Boom?

In our forthcoming Journal of Finance paper, Did Structured Credit Fuel the LBO Boom? we study how large shifts in the availability of credit affected the corporate use of leverage by examining LBO transactions that rely heavily on debt financing. We argue that developments that led to the growth of structured credit contributed to increased credit supply that at least partially fueled the recent LBO boom. Our evidence highlights important linkages between structured credit, the dual role of banks in the structured credit markets as loan originators and underwriters, and the corporate use of leverage.

We are not suggesting that structured markets were the only development fueling the recent LBO boom. There is evidence that other forces were also at work. Firms during this period held on to record levels of cash and many generated sizeable cash flows, factors prone to create agency conflicts. Recent work, such as Brav et. al. (2008) have shown the emergence of activist hedge funds that sought to correct some of these agency conflicts and other papers have studied the role of financial sponsors in lowering agency costs through going private transactions. However, we believe our results do emphasize that structured credit markets can have enormous impact on the availability and pricing of credit, which in turn affect the LBO market and potentially other forms of leveraged activities. Our results also demonstrate an important connection between the lending and underwriting activities of banks. While many papers have explored the role of commercial banks in underwriting activities, this literature has focused almost exclusively on underwriting in primary markets, such as bonds, IPOs and follow-on equity offerings. We demonstrate that underwriting activities in structured markets can also have meaningful consequences and have altered the role of banks as financial intermediators. This shift from the traditional originate-and-hold (or sell) model of lending to an originate-to-distribute lending model led to disintermediation of banks with greater access to credit, cheaper credit prices, and looser covenants.

Our results also suggest a potential explanation for one of the most puzzling aspects of the current financial crisis – why did large commercial banks invest heavily in CDO instruments that later proved to be a source of massive asset write-downs and losses? We suggest that the underwriting activities of commercial banks in structured credit markets might be part of the answer. Faced with attractive opportunities to profit from securities underwriting, and balance sheet constraints to fund large LBO loans, banks appear to have originated LBO loans with the intent to sell them to structured product vehicles. Regulatory initiatives towards risk-based capital management might have allowed them to pursue these activities in a manner that was friendly to their capital requirements.

The full paper is available for download here.