Primary and Secondary Markets for Corporate Debt

In earlier posts, we compared the pricing of corporate loans and corporate bonds.  Here, we'll look at how these markets interact, both in primary issuance and secondary market trading.  First, some definitions:

• The Primary Market is where financial instruments are sold from the issuer to investors.  This is often referred to at underwriting (in the bond and equity markets) or syndication (in the loan market).  As part of this process, securities often pass through an intermediary, such as an investment bank.
• The Secondary Market is where financial instruments are sold from investor to investor.  The issuer is not involved, and there is no underwriter (although there are brokers, and many underwriters also trade securities in the secondary market).

The Investors

• In the loan market, banks and institutions (such as collateralized debt obligations (CDOs) and prime rate funds) are the most active investors.
• In the bond market, institutions (such as mutual funds, pension funds, insurance companies and CDOs) are the most active investors; banks rarely buy corporate bonds.

The key to rational pricing in these markets are the crossover investors - institutions, such as CDOs and certain other investment funds, that can buy loans and bonds in the primary and secondary markets.  By analyzing the relative value of loans and bonds, they decide which to buy.  For example, if the spread between loans and bonds is very large, investors may buy the bonds and shun the loans.  This increased demand for bonds will bring down their spreads in the secondary market, while the lack of demand for loans will increase their spreads in the secondary market.  Eventually, the spread between loans and bonds will narrow.  Thus, the secondary markets for loans and bonds are related.

Likewise, the primary and secondary markets are related.  The spread a company will pay on new bonds or loans should be about the spread at which its existing debt is trading in the secondary market (or, if the company has no debt outstanding, the spread at which the debt of companies with a similar risk profile are trading).

Risk Flows Through All Markets

Thus, if debt investors becomes more risk averse, as happens at the beginning of a recession or credit crunch, we would see it first in the most active market, say the secondary market for corporate bonds, where spreads would widen dramatically.  This would lead to a sharp rise in spreads in the secondary market for corporate loans, and finally to the primary markets for both loans and bonds.  Finally, investors will also be comparing loan and bond prices to the other market for corporate credit risk, credit default swaps (CDS).

Lehman Did Everything Right

Except convince anyone it was doing anything right at all. In his new book Too Big to Fail, Andrew Ross Sorkin portrays the firm’s fall as a tale of arrogance, blindness, stupidity, complacency, and greed – nearly every vice but gluttony and lust. But the numbers don’t bear that out: Lehman reacted decisively to the problems it was facing.

	November 2007	February 2008	May 2008	August 2008
Assets	$691,063	$786,035	$639,432	$600,000
Equity	$22,294	$24,832	$26,276	$28,443
Leverage	30.7x	31.7x	24.3x	21.1x
Liquidity pool	$35,000	$34,000	$45,000	$42,000
Repo financing1	37%	35%	33%	NA

¹ as a percent of total funding

For financial institutions in trouble the prescription has always been: reduce assets, increase equity, improve liquidity. What did Lehman do? It cut total assets and raised shareholders’ equity, driving leverage down by 31%. It boosted its liquidity reserves to $42 billion, and trimmed short-term repurchase funding.

Lehman’s $2.9 billion loss for the third quarter of 2008 was hardly good news, but it came from what the Wall Street Journal called “savage cuts” to the value of its real estate. The Journal went on to say, “even longtime bears on the stock thought the firm was finally marking its residential portfolio to realistic levels.”

By the end of August 2008, Lehman had written down its troublesome real estate assets by 25% from the beginning of the year to $46 billion. With $28 billion in equity, it could afford to write them down by another 39% without destroying its capital base.

So why did Lehman’s damage control efforts fail? What sank the company? We’ll explore that in future posts, but it’s clearly not because Lehman ignored its problems, failed to act, or didn’t make real improvements to its finances.