Monday, August 27, 2007

Credit Hazards

Let's say I am starting a new business and want to borrow some money from my friendly, neighborhood banker to finance some of my assets. Leaving aside the issue that it's probably unlikely that I will be able to borrow any money unless I have sufficient personal assets to guarantee the loan, what are some of the likely terms of the loan agreement?

Well, I can almost guarantee that the contract is going to be loaded with 1) restrictions on what I can actually do with the money and 2) enumerations of a long list of the bank's rights to monitor my behavior. These are called "covenants" (promises that you make to Mr. or Ms. Friendly Banker that he or she can live inside your shorts with you until you pay the money back).

Covenants are designed to help solve the moral hazard problem; borrowers have an incentive to change their behavior after receiving a loan to engage in more risky behavior. Banks insist on covenants in loan agreements in an attempt to monitor and prevent this type of behavior.

What happens when banks starting easing off on covenants? Daniel Gross argues, in a recent Newsweek column, that "covenant-lite" loans are at least partially responsible for some of the recent troubles with the popping credit bubble.

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