Leveraged Liquidity: Bear Raids and Junk Loans in the New Credit Market

58 Pages Posted: 25 May 2008

See all articles by José Gabilondo

José Gabilondo

Florida International University (FIU) - College of Law

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Date Written: May 24, 2008

Abstract

As instability in the credit market has spread from sub-prime mortgages to commercial sectors, demand grows for a cogent account of current liquidity dynamics and their implications. To that end, I distinguish between market and funding liquidity and analyze how these distinct forms of liquidity contributed to financial instability in the corporate leverage market since July 2007. After introducing the major themes in terms accessible to a nonfinancial reader, I draw on economist Hyman Minsky's work on financial instability to analyze the liquidity dynamics of leverage cycles. In particular, I focus on four shifts in credit market structure that are vexing financial market regulators: the rise of nonbank lenders, the growth of floating-rate debt; the 'marketization' of corporate credit; and the attitude shifts that come with financial euphoria. I then zero in on the corporate version of sub-prime borrowing that many U.S. corporations used to finance the recent wave of mergers, acquisitions, and other types of "shareholder-friendly" transactions: leveraged loans. These are secured, sub-investment-grade, floating-rate loans priced off LIBOR, an asset class that corelates most closely with junk bonds. I conclude with recommendations for how regulatory and financial models can better reflect the new realities of the credit market.

Keywords: Hyman Minsky, liquidity, leverage, business cycle, sovereign wealth fund, repurchase agreement, discount window, Federal Reserve, securities lending, asset bubble, financial cycle

Suggested Citation

Gabilondo, Jose M., Leveraged Liquidity: Bear Raids and Junk Loans in the New Credit Market (May 24, 2008). Available at SSRN: https://ssrn.com/abstract=1137168 or http://dx.doi.org/10.2139/ssrn.1137168

Jose M. Gabilondo (Contact Author)

Florida International University (FIU) - College of Law ( email )

11200 SW 8th St.
RDB Hall 1097
Miami, FL 33199
United States

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