You can never go wrong starting off a commentary with a butchered bit from the Bard, right? “Now is the winter of our discontent” spake Richard III, an unamiable leader perhaps reminding us all today of our unamiable governing class. Old Gloucester rhymed to presage war and chaos. Apparently, all that happened because the poor dear couldn’t buy himself a date. But hey, chaos, war, desolation, burning and pillaging, etc., aren’t all bad, that is, if you are equipped to enjoy the carnage.
And now, back to the market. What am I rambling on about? Distressed debt opportunities are coming back. This is the silver lining, at least for some, in the cracks beginning to develop in our long, Goldilocks credit cycle. A slowdown is not here yet, to be sure, but it’s time to sharpen the knives and begin to think about our opportunities.
Are there tells? How much time do you have? There are enough of them to cause me to dust off my last set of liquidating trust securitization offering documents. Taking entirely off the table the black and orange swans, let’s start with Wall Street Journal reporting. Last week The Journal reported a worldwide material diminution in aggregate liquidity. Certainly this is worse in places where liquidity has always been under pressure, like the markets for dodgy sovereigns or, indeed, the larger European debt market where the float is so much smaller than here in North America. But liquidity is under pressure here as well.
The Fed is intent on shrinking its balance sheet and, as we have observed in this commentary before, while I am not entirely sure what growing its balance sheet to $4.5 trillion actually did, I am deeply concerned that shrinking it may have significant negative impacts on capital markets and liquidity. What will happen? We’ve certainly never done it before, and anyone speaking confidently about its likely outcome is delusional or talking their book.
The yield curve continues to flatten. The flat yield curve has predicted eight of the last twelve recessions and, while hardly a perfect predictor of economic distress, it’s certainly not a bullish sign and it’s pretty damn obvious that the flat yield curve is not good for financial intermediaries, whether they are prudentially regulated or are in the alternate lending marketplace.
Interest rates continue to grind up, particularly LIBOR-based rates, and there are several trillion dollars of C&I and CRE debt tied to that index. Refinancings get harder in a rising yield environment and may get considerably harder for the high yield markets in general and the mezzanine debt markets in real estate.
LIBOR is doing a dodo on us and there will undoubtedly be disruption beginning not later than 2020 as this unloved reference rate slithers away for good. That type of disruption will slow lending, will slow capital formation, and will also impair liquidity.
We are also getting to the point in the cycle where we need to refinance loans made when the interest rates were generally lower than the interest rates at which the loans can now be refinanced and therefore we’re losing the natural hedge of diminishing interest rates we’ve had for a long time. Just this week, Kroll announced that appraisal reductions are on the rise; reporting that among “post-crash conduit loans,” 38 mortgages totaling $828 million were hit with appraisal reduction amounts during the first half of this year. In the twelve step process to financial sobriety, appraisal reductions might be the first step; they are a proxy for future losses.
And for a walk down the regulatory memory lane. That Basel directive with the Orwellian doublethink-inspired appellation “The Fundamental Review of the Trading Book” is still out there and likely to become Fed policy within the next few years. The Rule would require regulated financial institutions to hold additional capital against assets which are held for sale as opposed to held to maturity. Sticking with alphabet soup, then there’s the NSFR or the Net Stable Funding Ratio Rule as well as the LCR or the Liquidity Coverage Ratio Rule. We have written about both of these before; both of them increase capital charges which effectively suppress lending. Given how capital rich our major institutions are right now, why are we piling on? You know the story of the scorpion and the frog? Scorpion convinces frog to carry it across the river. Scorpion stings frog…both croak…Scorpion apologies and says it’s its nature. If you are a regulatory apparatchik, is it just in your nature? Maybe. And don’t forget our old friend, Dodd-Frank’s Volcker Rule and its restrictions on market making. While the government recently proposed to amend this Rule, at best, the changes are certainly not going to be that material and will not readily encourage banks to reflate market making. That has been constraining healthy liquidity for some time.
Populist anger (see “God Hates Securitization”) directed at the banking and financial markets is real and doesn’t appear to be abating. That sort of generalized community hostility is a petri dish for the growth of the destructive infection of ill-thought-through regulation of the financial sector. Our current President may be a very public fan of deregulation, but he also appears to be no fan of the financial sector and any dissidence over deregulating on the one hand while re-regulating on the other is apparently tolerable and a small price to pay for a vote or two.
Finally, imbued with the wisdom of Monty Python, I note that the business cycle is not dead yet, and sometime in the next few years, a recession is virtually inevitable.
Predictions are always hard, particularly about the future. However, laying it all out like the entrails of a sacrificial lamb, and doing a bit of divination, it seems that a distressed debt market is going to start developing soon and will grow with the increasing stress in the marketplace (for history buffs, there was a whole wide range of really unpleasant things done to small animals to predict the future in Rome, such as haruspicy, extipicy and hepatoscopy, all involving the insides of small animals. Maybe the Fed should give it a try?).
An interesting question is whether the coming slowdown will replicate the riptide of 2007-2008 or follow the more normal contours of a US post-WWII recession. Remember in 2007, we expected a busy transactional market as repriced assets were shed. No such transactional tsunami occurred. Indeed, pretty much all lenders and asset managers sat on their positions (unless forced to move by the mighty repo monster), whether from an active strategy of waiting for a return of value or from just a dithering inability to make a decision and pull the trigger. Either way, distressed debt trading was suppressed for quite a while in that downturn.
Not the same this time. More high yield debt is parked in investors in the alternate lending marketplace, an enterprise led by people notoriously short of patience. Our major banks are extremely well capitalized. Thinking about fighting the last war, the regulators are likely to apply enormous pressure to dispose of or resolve problem assets early, and, this time, fortress-like balance sheets will enable the banking sector to tolerate the bad marks that would follow addressing troubled assets promptly. Finally, there will be a significant amount of dry powder available to step into distressed debt positions. The confluence of these factors suggests transactional activity will commence earlier and proceed apace when distressed debt begins to emerge.
For those of you who don’t remember (because you weren’t there) or choose not to remember because it was otherwise unpleasant, liquidating trust securitization became popular for several years as an excellent way to finance distressed debt positions.
In these transactions, pools of non-performing loans (“NPL”), slightly NPL and even REO assets were pooled and securities sold based on the cash flows of these assets (I love what the Italians call this stuff – UTP Loans — Unlikely To Pay; how gentile, and frankly, I’m sure it sounds even less jarringly unpleasant in the original Italian). Each asset had its own asset resolution plan and the structure was really focused on how quickly each asset would be resolved to cash and how much cash that resolution would produce. A complicated management exercise that placed a premium on the quality of the people, their technology and analytics behind the deals (it also created really complicated tax strategies but you really don’t want to hear about those).
So, think about starting to raise distressed debt monies now. It’s not too early. Dust off those NPL strategies and plans for liquidating trust securitization. Build your team and technology now. Establish relationships. Begin to track the dodgier balance sheets. Who’s giving it away in hot pursuit of volume? We all know there are the “What, me worry?” lenders out there. The winners here will be the buyers with dry powder with scale and a proven ability to execute.
Time to put on our dancing shoes and go looking for a grave.