Research Handbooks in Law and Economics series
Edited by Kenneth Ayotte and Henry E. Smith
Chapter 8: Covenant Lite Lending, Liquidity, and Standardization of Financial Contracts
Kenneth Ayotte and Patrick Bolton* 1 INTRODUCTION The last decade has witnessed many rapid changes in corporate financial practice. Perhaps most important among these is the expansion of securitization to corporate loans. Through securitization, corporate loans are originated and sold into investment vehicles that issue securities called Collateralized Loan Obligations (CLOs). A common justification for securitization is that it allows for otherwise illiquid corporate loans to be transformed into more liquid securities that can be easily traded in secondary markets.1 Though the channel through which this ‘liquidity creation’ occurs is not fully understood, a common explanation is that the process of pooling a large volume of loans allows third-party rating agencies, and the asset managers that assemble these pools, to create standardized securities that are easier to value than the individual, idiosyncratic loans that back the securities.2 This standardization occurs through several channels. First, credit rating agencies publish and use a standardized process to determine ratings for CLOs and the underlying assets in the loan pools.3 For example, assumptions regarding loan recovery in default, an input into the rating process, use standard formulae based on the priority ranking of the loan in the capital structure. Asset managers also provide standardization of the product offered to investors through the collateral restrictions in their organizational documents. These restrictions provide a list of characteristics to which the manager must adhere in assembling the loans in the pool. A noteworthy feature of this type of standardization is that it is open-ended: while the composition...
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