Where the Shekel Stops / Behind Closed Doors in the Capital Market

The latest wrinkle in the capital market is private loans - secret, illiquid loans that institutional investors are making directly to companies, and the worrying thing is that these are happening behind closed doors.

Years before she was running for the top job at Bank Leumi, Rakefet Russak-Aminoach made the news for an unfortunate remark about the difference between borrowing from the banks and from the capital market.

"If a problem arises during the life of the loan, in the capital market, you have to report to the regulators, you have to report to the trustee, the media starts partying and the bottom drops out from under the bond price," she said in 2005. "With us at the bank, things can be handled behind closed doors. We can talk and think about rescheduling the debt, preventing matters from snowballing."

Closed door - Yuval Tebol - February 2012
Yuval Tebol

Her comment won her barrages of criticism for highlighting the lack of transparency at the banks and their capacity for sweeping things under the rug. In retrospect, seven years later, the critics would do well to heed their own criticism. Not only has the lack of transparency at the banks not improved, the capital market has followed in their footsteps.

The latest wrinkle in the capital market is private loans - secret, illiquid loans that institutional investors are making directly to companies. Each loan is put together as a private transaction between the company and the institutional investors. Data published a month ago by the credit rating agency S&P Maalot show that the volume of private loans more than doubled from NIS 3 billion in 2010 to NIS 7.4 billion in 2011.

From the start of 2012, the pace of such lending on the q.t. has been accelerating. Just last week a giant loan was reported: The IDB group, which owes tens of billions of shekels to banks and bondholders, wants to borrow NIS 200 million to NIS 300 million from institutional investors.

Clearly, the habit of deals behind closed doors has reached the capital market big time. The worrying thing is that these closed doors are proliferating, in parallel with a pullback transparent capital-market lending - through bond issues.

The volume of issues in 2001, of shares but mainly of bonds, was the lowest in five years, except for the slump in the crisis year 2008. Fewer and fewer companies are raising capital from the public through bond issues; they're using private loans negotiated behind closed doors.

Why? Opinions differ. There's no question that the capital crunch at the banks, forcing them to scale back their lending, is a big part of the issue. "The banks aren't competing with us anymore. They're not grabbing our deals," a heavyweight investment manager told TheMarker. "We couldn't get a foot into the private lending market until a year and a half ago because the banks wouldn't let us in, and they wouldn't release collateral for the companies to give to us. Now the banks are letting everything go, especially in the case of real estate companies."

Just as clear, the flourishing of private loans also stems from the crisis in the capital market, which has led the public to withdraw heavily from mutual funds. That in turn has depressed demand at bond issues.

There's also no question that the plague of debt settlements in the capital market has highlighted the closed doors' advantages for companies. It's easy for them to lavish collateral and agree to financial terms knowing that if trouble arises, "things can be handled behind closed doors. We can talk, think about rescheduling the debt, prevent matters from snowballing." Easier than it would be at a bondholder meeting.

But it's also clear that the popularity of closed doors could be based on the bad reason that they're less transparent and subject to less supervision. The restrictions and constraints that David Hodak's committee imposed on public bond issues - following the rash of debt arrangements after the 2008 crisis - don't apply to private loans.

So, did private loans made behind closed doors become popular because they circumvent Hodak? That's a highly worrying possibility; it suggests that instead of the committee's restrictions and constraints improving the quality of institutional investors' loans to companies, the market found a way around them.

This possibility is especially worrying because of the gaping difference between the closed doors at the banks and at the capital markets. In Russak-Aminoach's closed room, the bank is imperiling its own equity in making the loan, so the bank has an incentive to manage its lending carefully. In institutional investors' closed rooms, they're imperiling mainly pension savers' money, not their own. Their incentive to be careful is a lot smaller.

Furthermore, in the absence of transparency, it's far from clear how these private loans are supervised. They're handled by a separate credit committee than the one handling bonds. Their handling is based on a circular that the insurance and capital markets commissioner issued years ago, and these loans are reported to nobody but the commissioner.

In practice, the commissioner admits that his supervision over private loans isn't the best. The circular isn't detailed enough and is currently being revised. But the commissioner says he routinely checks institutional investors' illiquid loan portfolios and has found them to be well managed.

The institutional investors also claim that in utter contrast to the impression that has been created, the threshold of caution in private loans is higher than with bond issues. More collateral is provided and the interest rates are higher. The threshold for private loans is much higher than Hodak sets, the institutionals say.

One even showed TheMarker a copy of his report to the insurance commissioner about the proportion of doubtful debt in his portfolio. The report showed that the ratio of loans under supervision (indicating a problem ) was 3%, compared with 3.7% to 5.6% at the banks. The proportion of nonperforming loans (that aren't paying even the interest) is 0.04%, the report said, compared with 0.9% to 2.3% at the banks. These figures look excellent (though we also have to remember that the loan portfolio in question is a young, small one compared with the bank portfolios).

But you have to feel some unease at the fact that these figures are not known to the public, even though its money is changing hands behind closed doors. The public has the right to know more about these private loans. Alternatively, the public has the right to demand that binding criteria, like the Hodak rules, be applied to private loans to make sure they're properly supervised.