The Wisecrack That Changed Wall Street

[This is a re-publication of an article first published on Seeking Alpha in June 2015, shortly after the sudden death of JPMorgan Vice-Chairman James B (“Jimmy”) Lee Jr. More than anyone, Lee had spearheaded the growth of leveraged finance and syndicated loan markets in recent decades, and especially the transition of traditional “commercial” banking into "investment" banking. He also played a huge role in my own career and in the credit rating industry, although he never knew it, all because of a throwaway line at a conference. I had intended to publish this article while he was still alive, so he might enjoy the irony of it. It is just another example of how someone who lives life “large” can impact so many people, often in ways they don't even realize.]

The Wisecrack That Changed Wall Street

How A Legendary Banker’s Quip Helped Jump-Start A Multi-Billion Dollar Industry

Today it is hard to imagine a robust corporate 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 collateralized loan obligations (CLOs). It is equally difficult to imagine an active loan market without a system for rating loans in terms of their default and recovery expectations, with links to the historical default and loss data that underpin those ratings, and the ratings themselves mapping to the capital and reserve requirements of the banks, the other institutional investors, and their regulators.

So it may seem like the "dark ages" of credit and lending to think back 30-plus 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 credit ratings like those routinely required in the public bond markets were deemed unnecessary. In fact, most banks regarded their own credit research on any loan they originated as proprietary and confidential, and only shared it with the other banks who were actively considering taking part in the deal.?

Credit analysis, back then, focused on a simple "yes/no" decision. Did the deal meet the bank's credit standards? Without credit ratings, it was hard to rank one deal against another in a statistically rigorous way, so pricing tended to be monolithic and inflexible, almost an afterthought. Credit was all: is this deal a good one or a bad one; should the bank make the loan…..or not?

I had seen and participated in the “old” system for many years as a credit officer at Bank of Boston; analyzing and approving loans, and then “working out” (a euphemism for “trying to collect”) loans that had “gone bad” in places as diverse as Australia, Panama, London and Greece.

So when my banking career petered out in the late 1980s, I tried my hand at journalism for a few years and then eventually landed a job back in the credit industry, this time at Standard & Poor’s. In joining S&P in 1992, I was just happy to have a job and was eager to learn about the rating business. But I had no particular aspirations about changing the industry in any way, and certainly had no notion of being a missionary to bring credit 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, where insurance companies underwrote privately placed bonds for companies generally not big or well-known enough to issue public debt. 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, where insurance companies had to hold more than twice the reserves for deals rated double-B-plus and lower than they did for “investment grade” deals rated triple-B-minus and higher. This provided a potential inroad for credit rating agencies to help define which deals made the cut and which didn't.

So it was, that in pursuit of the goal of learning more about that market, and schmoozing with participants in it, that I found myself in 1993?at an institutional private placement conference in New York City. Corporate loans, still being such a close-to-the-vest market, had not yet generated enough interest among non-bank institutional 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 professional credit analysis and ratings in the corporate loan market. ?

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 after it was acquired by Chemical. The panel's overall membership and presentation were pretty forgettable, but Lee's answer to one of the questions from the audience was memorable. It was also catalytic in its impact on me, on Standard & Poor’s 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, the conference ended, and everyone went home.

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 either 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 when I returned to the office and reported what I’d learned my colleagues and superiors at S&P would have jumped all over it.

Unfortunately, neither S&P nor any of the other rating agencies at that time had 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 was 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 and bankruptcy eventually 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.

So what was needed was a new type of rating. Not one that focused solely on the company, its business, earnings and likelihood of defaulting in its debt payments. But rather one that also evaluated what its assets would be worth in a “post-default” environment, and therefore how much would a lender who was secured by those assets be likely to collect if and when the loan defaulted, and how much of a loss would they actually take on the deal.

Two-Dimensional Ratings: Default and Recovery

Although it represented a major change from past practice, S&P's criteria and methodology gurus eventually agreed with me that a two-dimensional approach – one that looked at both default risk and expected recovery - was necessary if we wanted to serve the bank loan market. It required the organization to acquire a new analytical skill set and develop a new methodology to apply it, systematically, to hundreds of individual loans and other specific issues.

It meant that a major corporate issuer who previously had just a single rating, say a double-B, reflecting its likelihood of default, might now have a range of different ratings on its various debt issues, each of which now might be “notched” up or down from that corporate default rating, reflecting whether each issue was expected to do better or worse in a default scenario based on their security (or lack thereof) or rank in the balance sheet repayment pecking order.

This required a lot of organizational work and “culture shifting” in a firm that had been doing credit analysis quite successfully, but essentially the same way for decades. Fortunately, it helped that the bankers and institutional investors that we went out and talked to re-affirmed over and over again that such a two-dimensional analytical approach was absolutely necessary.

The rest is history. Rating syndicated loans became an integral part of S&P's corporate rating business, along with Moody’s and Fitch who were each engaged in similar transitions.??As the corporate syndicated loan market grew, loan rating volume some years even exceeded traditional high-yield corporate bond ratings. And the loan ratings themselves became essential analytical building blocks in rating collateralized loan obligations (CLOs), the specialized vehicles that ultimately became the primary institutional investors in the corporate loan market; and whose liability structures include more than a half dozen separate debt tranches, each with its own credit rating.

Now, over thirty years later, we might well ask: How could we imagine NOT analyzing the structure, security and loss/recovery prospects of a company's various debt issues as distinct elements of rating the total company? ?The answer may seem obvious today, but it certainly was not thirty years ago when Jimmy Lee took that question from the audience and helped spark a mini-revolution in the corporate finance business. I, for one, am very grateful that he did.

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Steven Bavaria is a financial writer. Check out?his books,?The Income Factory?(McGraw-Hill) and?Too Greedy for Adam Smith?on Amazon (https://www.amazon.com/Steven-Bavaria/e/B081S1N7YR/ref=dp_byline_cont_pop_book_1) , his Seeking Alpha articles here (?https://seekingalpha.com/author/steven-bavaria) and?his other activities here:?https://pontevedrarecorder.com/stories/nocatee-authors-income-factory-helps-investors-through-turbulent-markets,19327.??He is a graduate of Georgetown University and New England School of Law.