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Ayotte, Kenneth; Bolton, Patrick --- "Covenant Lite Lending, Liquidity, and Standardization of Financial Contracts" [2011] ELECD 152; in Ayotte, Kenneth; Smith, E. Henry (eds), "Research Handbook on the Economics of Property Law" (Edward Elgar Publishing, 2011)

Book Title: Research Handbook on the Economics of Property Law

Editor(s): Ayotte, Kenneth; Smith, E. Henry

Publisher: Edward Elgar Publishing

ISBN (hard cover): 9781847209795

Section: Chapter 8

Section Title: Covenant Lite Lending, Liquidity, and Standardization of Financial Contracts

Author(s): Ayotte, Kenneth; Bolton, Patrick

Number of pages: 16

Extract:

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 under-
stood, 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 regard-
ing 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 restric-
tions in their organizational documents. These restrictions provide a list of characteris-
tics to which the manager must adhere in assembling the loans in ...