preserving corporate liquidity in a crisis

Update: Apparently something like this has existed for asset-backed loans.

Buffett's letter got me thinking a bit more about liquidity and solvency, and I've slightly-more-baked an idea I had two years ago, in particular to the point where it now contains a policy prescription.

In another post here I mentioned maturity transformation, noting reasons corporations are induced to borrow short-term for long-term needs. The problem is that, if you need to roll over loans every day or two, a market event can put you in default even if you're unambiguously solvent. There's a level on which the obvious response to this is "don't do that", but it seems that the genuine benefit of being able to borrow short for some of your long-term money is of large value, and that the social cost of a large, solvent company having a lot of short-maturity debt in a financial crisis is a great deal less than the official penalty, which is bankruptcy. Aside from this is the time-consistency problem; I would prefer a set of rules that our regulators would be more willing to actually stick with in a crisis, rather than leaving harsh enough ex post consequences that they lack their intended ex ante effect.

At the same time, my leanings are still libertarian, and I prefer that privately negotiated contracts be taken seriously. I also prefer fairly incremental changes to formal rules. At the moment, the regulations relating to publicly traded debt securities are easier for instruments with maturities of no more than 270 days; I'm proposing that this include instruments with maturities of up to 450 days, provided that such instruments

1. are callable within 270 days, and
2. have a yield from the call date to the maturity date that is substantially — say 12 percentage points per year — above the yield to call.

The idea is to allow firms to write into their bonds that, in the event of extreme crisis, these private bond-holders, rather than the public, would be essentially providing emergency funding to the company, but under penalty terms of such a nature that the company will seek to avoid abusing this flexibility, or using it when it is not under simultaneous pressure to borrow at longer durations elsewhere.

If this really operates as intended, it may benefit money-market fund holders who own (beneficially) these bonds; if the company is solvent, this is results ultimately in some extra yield, and even for those who are seeking to cash out (perhaps because their own need for liquidity has risen at the same time as everyone else's), the values of the bonds are likely not to fall very much, and may even rise — as I envision it, the primary effect of this sort of clause is to solve a coordination problem, in which all lenders are profitable as long as the firm doesn't need to borrow money it can't borrow in the short term, but in which the last ones out lose if it becomes a race to the exit. The firm, facing a suddenly high cost of funds, would be induced to issue a 3 or 5 year bond a month or two later, whenever it can do so at interest rates even a couple of points above what it might hope to pay by waiting longer, because of the penalty rate on the commercial paper, which it would rather retire as soon as it can.

This may have an adverse effect on the credit profile of these instruments. If a firm is in actual trouble — its flagship product turns out to kill its users or something — it seems that the holders of these instruments will almost certainly lose money, though it seems likely that in a lot of these situations they would be likely to lose that money anyway.* I expect that, if these instruments started to appear, investors would quickly start to get used to them and would price the credit risk reasonably, rather than simply refusing to buy them at any price.

While it is certainly possible that these sorts of instruments would lead borrowers to skew more of their borrowing toward the short end and, more generally, to take fewer steps than perhaps they do now to take other steps to insure their access to liquidity, it seems likely to me that any systematic mispricing of these instruments is likely to make them less attractive to borrowers than they should be; these would be a cheaper mechanism of dealing with liquidity concerns only when they truly do less overall harm than other options available to borrowers. They create a new tool, ultimately, for doing maturity transformation, and solving some market failures associated with that at the present time.

* I have mixed feelings about the extent to which I think short versus long duration lenders should have effectively different seniority in a bankruptcy claim — short-duration lenders, in principle, are in a better situation to see problems coming, and in that sense are more at fault than long-duration lenders, but the problems often develop over long periods of time, and long-term lenders might be in a better position, through the imposition of covenants for example, than short-term lenders in imposing discipline to make sure the borrowers don't get into that trouble in the first place.