Esoteric Debt

What Is Esoteric Debt?

Esoteric debt refers to a complex set of securities offered to innumerable investors. It has detailed pricing and structural mechanism. The term classifies a pool of debts created in the form of protection provided as an investment product. 

The pooled-up security offers some portion of payments by borrowers to investors. 

The process of pooling various debts into single security is known as securitization. This refers to the classification, structure, and evaluation of debts into one security. This security acts as an initial investment into the earnings derived from the amount repaid by borrowers. 

The distribution and separation approach transfers the risks and credits to the institutions capable of bearing them.

This can lead to minimal standards for lending, risk management, and credit. The esoteric assets allegedly contain recommended investments based on assumptions of conventional planning - focused on allocation and forecasting.

Understanding Esoteric Debt

These investment vehicles offer repayment options with swapping mechanisms. The securities are offered to a restricted audience, considering the distinctive pricing and structure.

One example is the credit default swap derivative that partially caused the 2008 global financial crisis. The global 2008 financial crisis decreased the value of the credit default swap market from $45 trillion to $26.3 trillion in 2010. This further declined to $25.5 trillion in 2012. 

The problem was that there were no laws regulating credit default swaps and very little transparency on what these swaps contained.

Credit default swaps are essential instruments for lender protection, despite the taboo associated with them due to the 2008 crisis. Due to the crash, central banks have developed various guidelines to incorporate these swaps safely into markets.  

Pooling debts create debt securities offered by institutional investors. Thus, debt acts as a form of investment. They are generally traded in specific sets of markets amongst large banks. Often, the challenge remains in the classification and creation of the structure. 

This investment works on fixed or variable payments offered by debt borrowers. Securitization allows for selecting debts into security classes or subgroups based on various factors like risk.

How Do Esoteric Debt Securities Work?

Esoteric debt has many intricacies in the pricing process. This involves the valuation of the securities pooled together.

These assets are a type of debt instrument and investment. The problem is that their structuring is unclear and complicated. 

The mode, principle, and creation of esoteric debts rest on the complicated underlying financial & monetary arrangements. 

Considering the lower interest rates, these assets no longer offer the same benefits. Early in the history of debt instruments, esoteric debts offered structure and classification for relocating and restructuring debts. 

The perks generally yield higher as long as the associated risks turn out positively. However, illiquidity and pricing problems can arise if these assets don't provide yield due to a lack of repayment. 

Principles and Issues 

The principles and issues are:

1. Scope and risk of Illiquidity. 
2. The inscrutability of the structure and classification. 
3. Inadequacy of the management of risks. 
4. The resultant product of securitization arises out of derivative contracts. 
5. The pricing of these securities is contested. 
6. It refers to a wide range of debt investments. 
7. They are collateral-based investments instead of formalized asset-backed securities. These include patents, fees, and licensing agreements. 
8. Like almost any other investment, the higher the risk, the higher the yield. 

Critical Analysis

The valuation of debt securities comes with risks and uncertainties. During economic booms, it offers higher liquidity and yields. 

The common disadvantage of these debt instruments is the higher risks. However, these higher risks are compensated with yields sometimes higher than regular and even junk bonds.

These instruments often have complex repayment terms, creating further intricacies and skirting regulations.
An example of the above statement is pay-in-kind toggle notes. These allow for delaying the payment of interest by taking on more debt.

Issues in Application

Its applications include speculation, arbitrage, and hedging. But, again, this holds similarities to other debt instruments. 

The speculation involves trading these debt instruments to profit from future price changes.  

Arbitrage is buying a security in one market and selling it in another, reaping profits based on price discrepancies. Opportunities for this arise from quick changes in the outlook of a company. 

Hedging allows the risk of loaning funds to be decreased. 

Esoteric Debt Usage and Instruments

Esoteric debt includes a wide range of debt investments. Each instrument doesn't need to be backed up by the collateral. Instead, it is often supported by informal collateral like patents, fees, licensing agreements, etc.

Asset-backed securities or ABSs are a familiar type of esoteric debt. These debts are pooled together and then brought to the public market. This is defined as the process of securitization. 

For securitization, the assets are backed up by securities of commercial mortgages, residential loans or mortgages, car loans, student loans, etc.

The first step in creating esoteric debt is during the borrowing process. First, the individual or group of individuals borrows money from the lender. 

This borrowing acts as an entry of assets for the lender in their book of accounts. Then, the lender sells the assets, termed special purpose vehicles or SPVs. 

The securities are then bought and sold to the public in the secondary market. These rights to interest payments are then passed on to the asset-backed securities investors.

Common Instruments

The common instruments are:

 1. Pass-Through Securities

Pools of individual fixed-income securities are backed up as assets. The intermediary of these assets makes a collection of monthly payments from debtors. 

These fees are then passed through to the holders of the securities.

 2. Mortgage-Backed Securities

These are subsets of pass-through securities. They have a backup from the derived value of unpaid mortgages. The security owner receives money on the grounds of partial claims to repayments made by various debtors.

Complications in the repayment process often lead to complex pricing models. 

3. Auction Rate Securities

These esoteric debt vehicles have been shut down since the global financial crisis of 2008. Then, it was a form of variable-rate debt security, sold through auctions either as a bond with long-term maturity or as preferred shares of stocks. 

Risks Associated With Esoteric Debt Securities

The failure of debt instruments brought about the global 2008 - 2009 financial and economic crisis. This period was marked by the credit flow and popularization of speculation through debt instruments. 

The purpose was the creation of fees and capital. Esoteric debt also helped fulfill institutional capital requirements. The challenge lies in the valuation of the holdings of mortgage-backed securities as well as how to ensure that every loan is of equal risk.

The risks associated are namely:

• Counterparties risks
• Prepayment risks
• Market risks
• Credit risks
• Legal risks

The legal risks are mainly technical loopholes in the agreements. The credit risk is the possibility that debtors will default.

The market risks include cross-currency issues and interest rates associated with the market. The loan repayment is an issue as it provides lower interest rates (returns). The fact that the two groups involved are counterparties can lead to friction. 

Authored and Researched by Anannya Sahani

Reviewed and edited by James Fazeli-Sinaki | LinkedIn 

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