Picture a vicious cycle of financial backscratching that results in ever-increasing systemic fragility, and you’ve got the basic premise for how a decent portion of the credit market works.
Cantankerous finance blog Zero Hedge today points to a letter Goldman Sachs has written to the Financial Accounting Standards Board, the private organization that establishes accounting standards that the Securities and Exchange Commission subscribes to. The letter, written by Matt Schroeder, managing director and global Head of accounting policy for Goldman, details the widespread practice among financial firms of giving sweetheart loans to companies that have enlisted them to underwrite their initial public offerings or conduct other business on their behalf. This results in a heap of low-interest debt (which seems less risky than high-interest debt) entering the securities market at off-market prices, thereby increasing risk of defaults and creating fragility in the system.
Here’s what happens.
A company that’s going to file for an IPO so its stock can trade on an exchange will stipulate with an underwriter (that’s the company that gets hired to price the stock on the day its client goes public) that, in order to get its business, the underwriter has to float the client a “relationship loan.” This is a loan that carries terms favorable to the client. Goldman writes:
In many situations the borrower will be very explicit and inform the bank that it will not be permitted to participate in future underwriting business without participating in these “relationship loans.”
Because the terms of these loans are favorable to the client, their price does not accurately reflect the risk involved. That problem is made worse by current accounting standards, which do not force banks to value these loans at their market value, but rather at the price they’re worth if all goes well and the borrower doesn’t default. But the resulting dysfunction in the credit markets isn’t even the biggest problem. Zero Hedge writes:
Setting aside the fact that loans, both those held on books, and traded in the secondary market, are by implication largely mispriced (although one could make the argument that sophisticated investors should be able to adjust for this syndicator arbitrage… of course one could also make that claim of CDO purchasers in 2006 and 2007), the bigger question is just how major the conflict of interest is to the firms that serve as both lender and IPO underwriter.
A company that has just lent to a client on terms that are favorable to the client, having created a loan that doesn’t accurately reflect the risk of default, faces an incentive to encourage people to buy the client’s stock to help maintain adequate capital levels. “does one realistically see the possibility of a bank issuing anything less than a Buy or a Strong Buy in a name in which it was forced off the bat to put in debt capital, and whose equity buffer could be largely impaired if the same firm’s Sell rating were to decimate the equity market cap?” Zero Hedge says.
In other words, banks are bribing IPO clients with loans whose prices create market instability. These loans are either held on banks’ books or are securitized, spreading throughout the financial system. On top of this, banks face incentives to artificially prop up the stock prices of their clients to minimize risk of default on the sweetheart loans. Call it loan payola.
Why is Goldman so generously pointing this out? Zero Hedge says it’s in Goldman’s interest to do so, because unlike other financial firms, it mainly makes money by trading and does not hold risky assets on its books. It would be very harmful to Goldman’s competition were a solution to this problem — marking debt assets to their market value instead of valuing them at the price they would have if held to maturity. In this particular case, it appears that Goldman Sachs’ interests are aligned with those of the financial system writ large.