What Is Esoteric Debt?
Esoteric debt refers to debt instruments as well as other investments (called esoteric assets) that are structured in a way that few people fully understand. Esoteric debt is complex and can be a product of securitization, or simply arise through a complex financing arrangement. As such, the pricing of these securities can be contested or seem to be known to relatively few market participants. Moreover, the structure of these instruments may lead to deceptively attractive risk/return profiles over other investments when the instruments function properly, but can also lead to illiquidity and pricing problems when markets are disrupted.
- Esoteric debt refers to debts or other financial instruments that have complex structure that is properly understood by only a few people with specialized knowledge.
- Because of their inscrutability, the true nature of their fair value and their risk/return profile can be unknown or misleading to market participants.
- Mispricings and inadequate risk management of these positions has therefore led to financial crises and large losses when esoteric investments fail to perform as advertised.
- Esoteric debt often arises through the process of securitization or in the form of derivatives contracts.
Understanding Esoteric Debt
Esoteric debt can refer to a range of debt investments. Some are based off collateral that isn't a traditional base from which to offer bonds or other debt securities, including things like patents, fees, licensing agreements, and so on. Others offer complex payment terms to the issuing company. Pay-in-kind toggle notes, for example, are debt securities that allow a company to toggle between two options—one is to make the interest payment, the other is to take on extra debt owing to the security holder. These investments come with higher risks and, therefore, offer higher yields than regular bonds or even junk bonds. They also come with the extra issues of liquidity, as the market for complex instruments is thin at the best of times and can completely vanish during periods of uncertainty.
A common type of esoteric debt are pass-through securities: pools of individual fixed-income securities that are in turn backed by a package of assets. A servicing intermediary collects the monthly payments from issuers and, after deducting a fee, remits or passes them through to the holders of the pass-through security. Mortgage-backed securities (MBS) are a common example of pass-through securities. They derive their value from unpaid mortgages, in which the owner of the security receives payments based on a partial claim to the payments being made by the various debtors. Multiple mortgages are packaged together, forming a pool, which thus spreads the risk across multiple loans. However, some mortgage owners are likely to refinance their home or sell, meaning that their loans will be paid off early. Others may default on their loan. These unknowns lead to esoteric pricing models that can vary among and between counterparties in this market.
Auction rate securities are another example of an esoteric debt vehicle that has been effectively shut down since the 2008 financial crisis.
Esoteric Debt and the Financial Crisis
The Financial Crisis of 2008–2009 introduced the global economy to some of the risks inherent in having too much esoteric debt and too many esoteric investments in general. During this time, credit was flowing so freely that many companies and third-party issuers were creating innovative and imaginative debt vehicles tailored to whatever a particular investor wanted. The primary driver, of course, was to make a lot of money in fees and meet the financing needs of some desperate companies rather than as a favor to investors.
When the credit market seized up as companies struggled to accurately value their holdings of mortgage-backed securities and credit default swaps, the oddball esoteric debt was considered too complex to even bother with. So, while there was a slow and painful process that eventually led to the troubled MBS being priced and then moved, the market for esoteric debt froze entirely. Without accurate pricing information, there were few buyers to help investors move esoteric debt off their balance sheets. This took down the auction rate securities market, which was once perceived as being slightly more risky than the money market. The SEC stepped in on that particular file to force settlements over improper disclosure of risk, but not all forms of esoteric debt received the same treatment.
Interestingly enough, esoteric debt began reappearing shortly after the Financial Crisis transitioned to the Great Recession. Starved for yield, investors were once again willing to take on complexity and liquidity risk for a better return. While these complicated instruments may be more attractive than plain vanilla debt in good times, they can present immense problems when the credit markets tighten.