THE ECONOMICS OF THE PRIVATE MARKET
Sources of the Credit Crunch
A credit crunch can occur for several reasons. It may result from actions taken by regulators that affect lenders' ability or incentive to assume certain risks. It may result also from internal developments at lending institutions, such as unexpectedly large loan losses, that cause portfolio rebalancings involving greater conservatism in lending. For lenders that are financial intermediaries, a credit crunch may result from liability holders' becoming concerned about the intermediaries' financial condition. The ability of intermediaries to raise funds to support their investment activity may be adversely affected in such circumstances and may lead to their adoption of more conservative investment strategies to restore public confidence. The latter mechanism appears to have been primarily responsible for the crunch in the private placement market. Problems of asset quality at life insurance companies, a change in regulatory reporting requirements, and runs on a few insurers combined to raise doubts about the solvency and liquidity of insurance companies and to focus the public's and the rating agencies' attention on the proportion of an insurer's assets invested in below-investment-grade securities as a signal of its solvency.
Publicity about high proportions of poorly performing commercial mortgages in insurance company portfolios was one event raising doubts among the public about the solvency of insurers. Commercial mortgages make up 25 percent of general account assets at the twenty largest insurance companies, which include most of the major participants in the private placement market. Additional exposure to commercial real estate risks comes from direct real estate investments, which at many life insurance companies consist primarily of real-estate-related limited partnerships. As the press has widely reported, delinquency and foreclosure rates on these commercial real estate investments have risen sharply over the past few years. These problems heightened public awareness of the financial problems of life insurance companies and thus added to the pressure on those with significant holdings of commercial real estate loans to shift out of all lower-quality assets. Also, since even sound commercial real estate loans turned out to be riskier than anticipated when they were made, life insurance companies shifted investments toward high-quality assets.
Publicity about losses on some publicly issued junk bonds also raised concerns about the quality of below-investment-grade securities in general, and a change in regulatory reporting requirements made insurance companies' holdings of such assets seem to have increased. In June 1990, the National Association of Insurance Commissioners (NAIC) introduced finer distinctions in its credit ratings of corporate bonds, including private placements. Under the old rating system, many securities, especially public bonds, with credit quality equivalent to BB or B received an investment-grade rating. To correct this shortcoming, the NAIC adopted a system with categories more closely aligned with those in the public market (table 13). NAIC-1, the top rating, was given to securities rated AAA to A; NAIC-2 to BBB securities; NAIC-3 to BB securities; and NAIC-4 to B securities. Although insurers' actual holdings were probably little changed, the reclassification resulting from the new system caused insurers' reported holdings of below-investment-grade bonds, both private and public, to rise between 1989 and 1990 from 15 percent of total bond holdings to 21 percent. The level of reported holdings of high-yield bonds jumped more than 40 percent.
The sudden appearance of a much increased percentage of below-investment-grade securities on the balance sheets of life insurance companies focused the attention of policyholders and other holders of insurance company liabilities on the composition of insurers' bond holdings. As evidence of increased public sensitivity, a recent study by Fenn and Cole (forthcoming) found that stock prices of insurance companies with high concentrations of junk bonds were adversely affected in early 1990 by the publicity surrounding the financial problems of First Executive, whose insurance units subsequently failed because of losses on junk bonds. In contrast, stock prices of insurance companies with little exposure to junk bonds were not affected. The public's greater sensitivity to the quality of life insurance companies' assets discouraged many insurers from purchasing lower-quality private placements from fear of losing insurance business to competitors with lower proportions of below-investment-grade bonds in their portfolios.
That public fears regarding below-investment-grade private placements were warranted is not clear, as market participants report that loss rates on those securities have not been unusual. Loss rates on such securities may be expected to differ from those on similarly rated public junk bonds because private placements typically contain covenants or collateral and because only a few information-intensive lenders are involved; thus corrective actions are more timely, and workouts are less difficult. Because nonparticipants lack a clear understanding of the private market, however, the public has a tendency to equate below-investment-grade private placements with public junk bonds.
Another development pressuring insurance companies to restrict purchases of below-investment-grade private placements has been the concern of credit rating agencies about the lack of liquidity of private placements, especially those that are below investment grade. This concern appears to be a consequence of the July 1991 collapse of Mutual Benefit, which lacked the liquidity needed to meet heavy redemptions by policyholders. Driven by a fear of being downgraded, insurance companies have sought more liquidity in their bond portfolios by concentrating on higher-grade credits, which are more readily sold in the secondary market. 152
Another regulatory move by the NAIC appears not to have been a significant cause of the crunch. This move involved changes in the mandatory securities valuation reserves (MSVR) held against bonds in life insurance company portfolios. For bonds that would have been rated investment grade under the old rating system, but fell to NAIC-3 or NAIC-4 under the new system, required reserves jumped from 2 percent of the bonds' statement values to 5 percent for NAIC-3 and 10 percent for NAIC-4. 153 Also, the time allowed to reach the mandatory reserve levels was shortened. At year-end 1991, however, all of the twenty largest life insurance companies had MSVRs that were more than adequate to meet the fully phased-in standards.
The individual importance of these factors as causes of the credit crunch is hard to isolate. They are, however, interrelated. For example, the effect of the new NAIC rating system probably would have been much smaller had insurance companies not experienced problems with commercial real estate loans. Futhermore, the new rating system, combined with the failure of First Executive, focused public attention on below-investmentgrade private placements as an asset that could add to the industry's financial problems. In any case, the main impetus behind the credit crunch has been life insurance companies' fears that liability holders might lose confidence in them and redeem insurance policies, annuities, and guaranteed investment contracts should they exhibit above-average holdings of below-investment-grade securities.
Source. Securities Valuation Office, National Association of Insurance Commissioners