For instance, if in liquid times, investors in structured products become complacent, they may not fully evaluate or accurately model the nature of the underlying assets in structured entities. Complacent investors also may be willing to buy new debt offerings that are light on traditional covenants if they come to believe that outcomes are assuredly benign.
Moreover, without strong covenants on existing debt, firms can raise additional funds without triggering defaults, which may decrease defaults in the short run, but perhaps increase them in the long run. In these cases, this “gloss” of confidence could cause a misallocation of resources, if companies or consumers without compelling prospects for full repayment nonetheless readily obtain credit.