Many of us first encountered the word “covenant” in the Old Testament story of the bond forged between God and Abraham and his descendants. In the context of faith, “covenant” conveys a mutual commitment of the most intimate sort.
Later in life, we encounter “covenant” in its more secular context when we take out a mortgage to buy a home, establish a line of credit to launch or grow a business, or in other realms in which we accept the status of borrower or lender. In such relationships, the covenants have come to mean the formal terms of the relationship, the metrics to which parties are to be held accountable, the conditions to which both parties are bound, and the consequences for violating those terms.
Perhaps more important than these formal agreements have long been the informal covenants between lenders and borrowers, that is, the societal expectations that supersede those drawn up by legal compact.
Think about the word “bond” for a moment. We use it to describe a security now, but what is it really? When investors buy bonds, they really are loaning money to a country (United States Treasury), a company (General Electric), or municipality (Los Angeles Public Schools). They also might be loaning money to a pool of credit card holders, a pool of mortgage holders, a pool of churches, or other borrowers. This use of the term “bond” is no accident, for the security represents a literal binding between lender and borrower, the forging of a relationship of mutual trust, confidence, and respect that provides assurance to both parties.
Over time, social convention has defined that bond or relationship between borrowers and lenders: A lender will not change the terms of the loan outside of parameters agreed upon in advance; a borrower will repay the lender in a timely fashion as promised; the lender will receive the rights commensurate with the lender’s position in the capital structure (secured, unsecured, senior, junior, etc.); the borrower will conduct itself with due care and loyalty to the lender at least until the borrower has fulfilled is obligations. In this social framework, the lender-borrower relationship remains built on the premise that loans are bonds and that covenants are sacred. But is that framework still operating?
Modern securities markets are such that lenders and borrowers rarely know each other. In the vast majority of cases, the lender knows neither why the borrower wants or needs the money nor how the money will be used. Instead, many lenders rely on a credit rating, yield, and maturity to ascertain whether the borrower is worthy. Likewise, the borrower rarely knows the lender. A municipality raises funds from thousands of faceless lenders located across the municipality and many living outside of it. The corporation borrows money from lenders seeking yield and some level of safety but who may have no other investment in the success of the corporation.
This evolution of the borrower-lender relationship from a true bond to one that is largely detached from a sense of mutual obligation is causing some intriguing and troubling events. In Harrisburg, capital of Pennsylvania, Mayor Linda Thompson is faced with a choice of maintaining city services or paying the city’s lenders (aka bondholders). For her, the choice is clear: do not cut services. According to the Wall Street Journal (“Harrisburg Surrender,” 9/8/10), Ms. Thompson said, "To disrupt [services] because we can't make a bond payment would just be unconscionable. And as a leader I couldn't do it," To her credit, she also is concerned about scaring off bond investors, recognizing that to do so would impact a critical source of financing.
A similar tough choice is faced by Michael Thomas, a leader of the Pequot tribe in Connecticut, owners of one of the world’s largest casinos at Foxwoods: Pay dividends to tribal members from Foxwoods’ revenues versus pay bondholders who have lent money to build Foxwoods. (WSJ, “Tribe’s Roll of Dice Rattles Lenders,” 9/17/10) The Pequot and other Indian tribes are in a privileged position for now because as sovereign nations, they can’t be forced into bankruptcy, and even if they declared it, their lenders would not be allowed to operate casinos on reservations. That said, the casino business will suffer greatly if by stiffing current lenders, the pool of future lenders dries up.
Ms. Thompson and Mr. Thomas are not alone in this dilemma. Municipal borrowing (states and cities) has grown from $1 Trillion in 1990 to $2.4 Trillion in 2010, an increase of 140% over 20 years. Not evident in these numbers is the concurrent sharp increase in unfunded or underfunded pension and health care obligations municipalities have accepted. These commitments paired with a sharp decline in tax revenues have converged to confront municipalities with multi-horned dilemmas of epic proportions: Pay underfunded pensions versus support public education versus build infrastructure versus support unemployed citizens versus pay secured lenders versus maintain vital emergency services versus raise taxes versus encourage new business investment versus get reelected versus…
An early sign of the current economic crisis occurred when banks stopped lending to each other following BNP Paribas’s announcement that it could not adequately value the loans on its books. The overnight interbank lending rate spiked and the crisis of confidence began. Soon after, investment banks stopped supporting the auction rate market, another marketplace where lenders and borrowers met to support each other’s interests. The municipal bond market experienced its greatest shock since the 1860s. These events occurred in late 2007 and early 2008, well before the escalated fears of municipal defaults, declining tax revenues, and unfunded pension obligations, and before the failures or near failures of Bear Stearns, Washington Mutual, Lehman Brothers, AIG, Merrill Lynch, General Motors, Wachovia, Goldman Sachs…you get the idea.
So where are we today? We all operate with an investment marketplace driven by computer algorithms and high frequency trading, an investment industry populated with countless exchanges, traders, product engineers, and money managers, a regulatory framework with agencies possessing complex mandates without rationalizing guidance to address conflicts like those described above, and a global pool of millions of borrowers and lenders striving to make the most effective decisions for themselves every day.
Despite these complexities and technological innovations, at the end of the day, we have borrowers and lenders who desire confidence in the larger system and in their relationships with each other. For all of our wizardry, those who lend and borrow want to have the assurance that comes from relationships built on a shared commitment to each other.
America is at a crossroads in so many ways, and the most difficult of our collective economic decisions still lie ahead of us. Before we further diminish the sanctity of the relationship between borrower and lender, we need to recognize how doing so irrevocably impacts our culture. This is not a time to say that our social contracts do not matter because they force difficult choices; this is a time to make difficult choices precisely because our social contracts are what bind us.
