THE ECONOMICS OF THE PRIVATE MARKET
Prospects for an Easing of the Crunch
As a group, life insurance companies are unlikely to resume investing in below-investment-grade private placements at pre-1990 levels until their asset problems have improved and public concern about the health of the industry has appreciably diminished. As this improvement hinges mainly on a recovery of the commercial real estate market, many analysts expect that insurers will, for the foreseeable future, remain reluctant to provide funds to the low-grade sector of the private market. This prospect has already led some insurers to cut staff and to reduce resources devoted to credit evaluation and monitoring. If the cutbacks become widespread, the long-run ability of the insurance industry to supply credit to medium-sized, below-investment-grade companies could be impaired.
Risk-based capital standards, which become effective at the end of 1993, could reinforce the reluctance of insurance companies to buy below-investment-grade securities. The new standards are aimed at measuring the prudential adequacy of insurers' capital as a means of distinguishing between weakly capitalized and strongly capitalized companies. To this end, insurance companies will report the ratios of their book capital to levels of capital that are adjusted for risk. As an insurer's ratio falls progressively below one, successively stronger regulatory actions will be triggered.
In the current environment, most insurers will probably attempt to achieve ratios in excess of one. One way they can raise their risk-based capital ratios is to shift into low-risk assets. In this regard, below-investment-grade securities carry risk weights much higher than those on investment-grade bonds and even those on commercial mortgages. Over time, however, as the financial condition of insurance companies improves and public concern about their health recedes, insurers will be more inclined to consider risk-adjusted returns in reaching investment decisions and thus may allocate a greater proportion of assets to higher-risk categories, such as below-investment-grade bonds.
Despite the almost three-year absence of insurance companies from the below-investment-grade sector and the persistence of unusually high spreads, new lenders have not picked up much of the slack in the private placement market, primarily because of the high start-up costs of entering the market. Long-term investments in expensive internal monitoring systems and staffs of credit analysts, lawyers, and workout specialists are required. Also, the market operates largely on the basis of unwritten, informal rules enforced by the desire of major agents and buyers to maintain their reputations. Thus, to an outsider, the way the market operates may be hard to understand. Being a newcomer to the market with no established reputation may involve costs. These factors may inhibit outside investors from risking their money in this market.
State and large corporate pension funds are natural candidates to fill the gap left by the insurance companies in the private market because of their demand for fixed-rate investments. Many pension funds, however, have charters that prevent them from investing in below-investment-grade or illiquid assets. Most pension fund managers are also reportedly reluctant to invest in an unfamiliar market. Because pension funds generally lack the necessary capabilities for due diligence and monitoring, their managers have difficulty familiarizing themselves with the private market by making small initial investments. A decision to invest in below-investment-grade private placements involves a significant long-term commitment of resources that few pension fund managers appear to find attractive. In the case of state pension funds, even if they wished to invest, many would face problems in hiring the necessary personnel because state legislatures generally control staff sizes and salaries. Any attempt by state pension funds to hire large numbers of credit analysts thus could run into political obstacles.
Pension funds (and others) might quickly enter the private market by investing in funds managed by professional private placement investors. Several funds have been formed in the past two years, but they are unlikely to operate on a scale sufficient to fill the void left by the insurance companies. Pension fund managers appear reluctant to invest even indirectly in a market with which they are unfamiliar. In addition, some are concerned that fund managers would not monitor borrowers with sufficient diligence. Also, insurance companies, which would be the primary source of the managerial resources necessary for operating of managed private placement funds, have thus far not set up funds on a large scale, even though some companies currently have excess capacity to analyze and monitor lowerquality credits. Some are unwilling to make a long-term commitment of resources to this effort because they expect eventually to resume investing in below-investment-grade private placements for their own accounts. Finally, most institutional investors would expect insurance companies acting as investment managers to purchase some of the securities for their own accounts. Such a requirement lessens the incentive to establish managed funds because of insurers' current aversion to purchasing below-investment-grade bonds.
Finance companies face much smaller start-up costs than pension funds do, but their participation has traditionally been in the highest-risk segment of the private placement market, a segment in which life insurance companies have not generally been active. Insurers typically have made unsecured loans, mainly to the highest-quality speculative-grade borrowers. In contrast, finance companies specialize in secured lending, normally with equity features attached. Thus, the risk-return profile of the typical insurance company borrower does not suit finance companies, nor would such borrowers generally find finance companies' terms attractive. In addition, several finance companies that were significant lenders in the private market have reduced their lending to low-rated firms because they have been faced with credit problems of their own.
Marginal increases in the number of lenders and in their commitments to below-investment-grade private placements may not have much effect on the credit crunch. With only a few lenders remaining in this segment of the market, and with most of these willing to lend only a limited amount to any one borrower, agents often have difficulty putting together a syndicate of lenders sufficient to purchase even medium-sized issues. Because the agents must incur fixed costs before a deal can be proved viable, and because they are paid only upon success, most agents have also withdrawn from the below-investment-grade segment of the market. This situation explains an apparent paradox: Those few remaining, willing lenders sometimes complain that not enough prospective issues are coming to market to permit them to lend all their funds available for below-investment-grade borrowers. Thus the crunch may disappear only with a wholesale return of life insurance companies to this market segment or with the entry of a significant number of new lenders.
One development that may have eased the crunch for a few borrowers is the increased frequency of ratings of private placements by major rating agencies. Issuers on the cusp between a NAIC-2 and NAIC-3 often obtain ratings from one of the agencies before seeking ratings from the NAIC. Because the agencies charge higher fees for ratings than does the NAIC and are less overworked, they can often gather more information and conduct more extensive analyses, which sometimes justify investment-grade ratings. 154 The NAIC generally accepts such ratings but reserves the right to overrule them.