The risk of execution
At the Mortgage Bankers’ Commercial Real Estate Finance forum in early February, the commercial lenders bemoaned the capital markets’ interconnectedness, for the spike in spreads along the risk curve had escaped its subprime single-family boundaries and infected all forms of commercial finance, as illustrated by this nifty annotated time line from the MBA’s chief economist, Doug Duncan:
From Doug Duncan’s presentation: can you spot the moment when the credit markets went kaflooey?
That slide’s principal point, echoed by several other speakers throughout the two-day glum-fest, is that with very wide spreads on lower-rated instruments, all kinds of entities are now unwilling holders of financial assets.
“I’m an unwilling holder and I don’t care who knows it”
As The Wall Street Journal encapsulates it:
• What’s Happening: The value of many buyout loans issued last year are falling sharply.
• What’s Behind It: Worries about corporate defaults and a drying up of the “leveraged loan” investor base is driving prices down.
• What It Means: Banks are having a hard time issuing new loans with the market prices of existing loans so low.
They expected to resell the assets, but now they find that even though the loans are ‘money good’ (lender-speak for covering their debt service and with collateral equal to the loan amount), the loan would today resell for a large discount simply because the spreads have widened.
With spreads open this wide, you’d take a discount just to get out, wouldn’t you?
As
Hyman Minsky was an American economist who died in 1996. His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view:
Minsky knew how to seize the moment
Periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of re-leveraging.
Investors start to borrow excessively and push up asset prices excessively high. In this process of re-leveraging there are three types of investors/borrowers.
First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows.
Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts.
Finally, there are “Ponzi borrowers” that cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.
But they’re not always lucky
They might also be called ’speculators,’ and they were a major force in this homeownership price inflation — only we didn’t realize it until now.
The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions.
Okay, so we’ve had our Minsky Moment, and the credit markets are gyrating wildly as they try to reprice risk. One look at
Things are crazily high … but when will they come down?
While chaos has an infinity of fathers, Mr. Duncan’s slide also picks out a selection of events that might plausibly be said to have triggered each of the major shifts. It’s evident that the capital markets are acting like a skittish observant herd, starting a stampede, then dissipating it, then stampeding again at the sounds of shots.
The thing is, there’s a lot of us, and when we stampede, it raises a cloud of dust
With risk spreads this wide, the music has suddenly stopped, and everybody’s holding large amounts of paper they don’t want, as described in this recent article from The Wall Street Journal:
A new problem is rippling through credit markets: Many of the corporate loans used to finance giant buyouts in the past few years are reeling in secondary market trading, making it virtually impossible for banks to unload other commitments they have made.
The holders of this debt are now facing a risk they never imagined would arise — the risk of execution.
I never thought I’d get into this position!
The ratings shakeout in the bond-insurance industry has helped cause the failure of municipal-bond auctions — the first known instance of this since 1991.
At least six sales of tax-exempt auction-rate securities — one of them by
My amygdala wants me to sell
We are dealing here with an anomaly — a credit-market seizure occasioned not by epidemic defaults, but rather because the new accounting rules (FAS 157 and beyond) implemented after Sarbanes-Oxley have had the effect of forcing entities to record ‘mark-to-market’ book losses on securities — or worse, to realize those losses by having to sell the paper.
“The market for this paper is in disarray,” said Joseph S. Fichera, chief executive officer of Saber Partners, a New York City-based financial adviser to public entities and corporations.
What’s remarkable is the scale of the discounts, arising so soon after issuance:
Tribune Co., which was taken private in April by investor Sam Zell for $8.2 billion, issued loans now trading a 26% discount.
We’ve got the money, and you don’t!
As I discussed regarding the Blackstone buyout of Equity Office, Mr. Zell’s timing looks impeccable, and the more impeccable that the paper he issued to buy his new business has dropped — meaning it’s now very cheap relative to current market conditions.
Double-digit declines in the market value of these loans are very unusual, and a big problem for many banks, which sit on a pipeline of $152 billion in loans that they have promised to make but have yet to sell to investors.
With the prices of existing loans tumbling, investors have little incentive to buy new loans unless they are sold at steep discounts, something banks are reluctant to do.
The result: More assets building up on bank balance sheets, growing tensions among rival bankers who had grown accustomed during the buyout boom to cooperating with each other and a deepening crisis in the market for buyout debt.
Everybody wants to sell. Nobody wants to buy.
Now, I’m sure we can make everybody happy
Another problem is that a source of investor demand for these loans has dried up. Investment vehicles called collateralized loan obligations were huge consumers of corporate loans in 2006 and early 2007.
CLOs, as they are called, hold bundles of loans and are sold to investors in slices with varying levels of risk and return. As defaults rise, demand for the riskiest pieces of these instruments is undermined.
There’s less demand for my housing assets
“We’ve lost a major source of funding, and the market is still struggling to find an alternative,” says Steve Miller, managing director at Standard & Poor’s Leveraged Commentary & Data.
Investment banks last year touted new investors in the loan market — hedge funds and high-yield bond investors that crossed over into loans. Many investors were burned on their bets in buyout-related loans when their secondary market values dropped.
My buyout loan’s hurting
“This is bizarre and baffling,” said Thomas Ewald, chief investment officer of Invesco Senior Secured Management, on a panel at a Loan Syndication and Trading Association event Monday [Early February — Ed.]. “Loans trading in the 80s are typically on the verge of bankruptcy or a major restructuring event.”
Financial instruments can experience discounts for either of two reasons: default risk, or yield risk. Setting aside yield risk — that is, if the current interest rate reflects market — then the discount from par can be thought of as P x L, where P = Probability of Default, and L = Loss given Default. A price of 88 is a 12% discount, which in credit terms is equivalent to assuming that 30% of the portfolio defaults, and that the average loss is 40% when they do.
It is far from clear that many of the companies behind these loans are flirting with that kind of distress.
If the loans are money-good, what we are seeing is yield risk re-pricing.
Falling short-term interest rates pose another challenge. Interest rates on leveraged loans typically rise and fall with the short-term London Inter Bank Offered Rate, or LIBOR [rhymes with Buy-more — Ed.]. LIBOR has fallen sharply in recent weeks, thanks to Federal Reserve interest-rate cuts, meaning these loans are giving their investors smaller returns. LIBOR at the end of December was 4.7%. It now stands at 3.2%.
Dropping yields on the instruments is good for the borrowers, bad for the lenders.
Private-equity firms say that in most of these cases their portfolio companies are performing well.
Their inability to move the paper is driving the bankers crazy
Nevertheless, investors are jittery about corporate performance, because defaults are starting to rise as the economy slows. Already this year, nine companies — mostly smaller ones — have defaulted on leveraged loans, more than the two defaults all of last year.
At some point, fear of default becomes shrinkage of credit, which becomes recession, which leads to weakened earnings, which leads to default.
Credit aperture narrowing
The saga of Harrah’s Entertainment Inc.’s loan sale is a sign of the distress in the market. Credit Suisse broke from a group of banks lined up to sell $7.25 billion in loans tied to Harrah’s buyout. It offloaded its commitment of about $1 billion through derivatives transactions in December, says a person briefed on the transaction. The move sent other banks scrambling to sell some of their own Harrah’s loan commitments in January, and the price of the loans dropped to between 91 and 92 cents on the dollar, bankers said.
Credit Suisse rolled the dice
The transaction roiled other underwriters involved in the deal who were unable to sell their portions of Harrah’s debt, but didn’t want to sell it at such a steep discount.
The deal “reset the market,” said Invesco’s Mr. Ewald. He says he now doesn’t want to buy any other comparable offerings at anything over 92 cents on the dollar.
“At these price levels we think some of them may be terrific long-term assets to hold,” said James Dimon, J.P. Morgan Chase & Co.’s CEO, on a conference call with analysts last month.
The New York bank was holding about $26.4 billion in leveraged loans at the end of the fourth quarter, after shedding about $16.5 billion of the debt during the period.
J.P. Morgan executives said they are considering hanging onto about $5 billion of the loans, which Mr. Dimon said appear to be “recession-proof,” until they mature.
All the banks have thus been caught by the risk of execution. This gives them a problem: they had no plans to be holders. Over at Recap’s Web site, I posted on State of the Market about the challenge of realizing value, in Resell or Farm?
What to do: what you cannot sell, you had better farm. Even if the market to resell these assets has gone into hiding, the assets (and the underlying properties) have significant value. They must be held. Yet structured real estate assets must be worked. Whether the position is debt or equity, a security holder owns a big slice of a property’s Net Operating Income (NOI), and as such, the security holder has an enormous interest in seeing the property’s NOI grow, against that moment when the stores reopen and normal trading can resume. These assets must be farmed, both to grow NOI and to harvest it (collect its cash flow).
When the stores are closed, find a good farmer. You thought you were safe holding paper because you could always resell it at a decent price. Now you can’t sell it, so you have to farm it. That means paying attention to the underlying asset value, which is way more work than you bargained for.
A whole lot of folks are about to become unwilling farmers, because they took the risk of execution.
This is how we’re supposed to make money?
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