Happy Inauguration Day (I hope).
Every turning of the year makes for a convenient point to look backwards, and of course, forward, but this year seems to actually denote some sort of inflection point and, as a card-carrying member of the blogosphere, I feel compelled to burden you with my views as to what the next year will hold for us all. I am unburdened by anxiety or discomfiture in doing so, as the prediction business is one of asymmetrical risk and reward. An anodyne exercise, I trust. No one actually expects talking heads to be right, and no one remembers when you’re wrong; but in the blind cat finding a dead mouse type of way, if you are right, you get to annoyingly trumpet your breathtakingly erudite and accurate prediction over and over again for the rest of the year.
After predicting a terrific 2020 last January, how wrong could I be this time?
Apologies if you are overly excited about this opportunity to get my thinking about geopolitical risk, macroeconomic events, the absence of the orange swan, the presence of new black swans, etc., which I surely can understand, but I must disappoint as this is a much more modest exercise. (I don’t see much point in speculating about the unknown unknowns at this point, although it’s fun, but I will observe in passing that we seem to be having 500-year floods at 5-month intervals of late.)
I’m going to focus on the election and the regulatory state. The Democrats have run the table, and unless poor Senator Manchin does a runner or Mr. Schumer or Ms. Pelosi have unanticipated trouble with the right wing (and left wing) cohorts of their respective caucuses, we should expect legislative change in the next year. But whether we see material legislation or somewhat more diminished and modestly ambitious, legislative change is coming and directionally it’s very clear.
I work assiduously here in my CrunchedCredit blog to avoid the nakedly political and I think I’ve done a terrific job of hiding my neo-Marxist, radical, anarchist, progressive tendencies in the past. With, however, my commercial real estate capital goggles firmly in place, I am comfortable observing that change we will see in 2021 will, regardless of its positive or negative impact on our polity writ large, negatively impact capital formation. It will require a certain nimbleness from market participants. We need to be ready to respond.
New legislation is really not essential to achieve change because, in large measure, people are policy. Butts in seats have always affected outcomes. Now, with the government’s regulatory writ already so large, and with successive denizens of the White House ruling in some significant measure by executive order, regulatory action is even more impactful. Moreover, our gloriously elected and work-adverse representatives have gotten very comfortable booting enumerable real decisions about how laws actually work to the apparatchiki. This means that what people in the regulatory establishment think and do will significantly impact our business, regardless of whether such regulatory energy is compounded by actual legislation.
Now, the instincts of the new team in town are radically at odds with the last (duh). For our purposes, the new team in town has some (some?) level of hostility, or at least significant suspicion, about what is perceived as “unrestrained” capitalism. Similarly, the new team has very real suspicions about financial markets in general and absolute certainty that financial engineering (whatever that actually means to those who say it) is more bad than good and certainly RISKY. This is mother’s milk stuff for the center left. It’s foundational. For these folks, once you get much beyond Jimmy Stewart in It’s a Wonderful Life, everything else has a whiff of brimstone and sulfur. Coupled with a much higher level of faith in the ability of the government to achieve positive outcomes (to actually be fair, the Trump administration also suffered from this delusional malady in full measure), we are certain to see robust regulatory activity. The Biden administration will do stuff proudly and boldly. While the data is compelling that the plans and schemes of succeeding governmental regimes rarely survive contact with the real world, no one with their hands on the lever of power ever fully appreciates the negative externalities of everything they do, so caution will be subordinate to “Ready, Fire, Aim!”
But I get distracted. The question is how a more left of center administration with considerable faith in its ability to do good will affect capital formation.
Change is coming. Change is coming for the prudentially regulated bank and likely everyone else in the financial sector. At the most basic level, bank examinations are likely to be elevated in importance and are likely to be more vigorous and more intrusive. At a minimum, this predilection towards more robust supervision will be costly for the banking sector and create transactional friction and anxiety about what the new sheriff in town may do, a sheriff who wants to make a difference, and needs to be seen as making a difference. It will have a suppressive impact upon financial institutions’ level of aggression in terms of growth and innovation (that is, except for innovation highly aligned with the new team’s political objectives and that will largely be limited to the residential mortgage market, consumer credit and ESG/greenness – more on that later).
Beyond simply more intrusive regulatory oversight, let’s think Basel, let’s think FASB and let’s think about the possibility of new and fun regulatory initiatives. The Current Expected Credit Loss (CECL) regime has been put on hold until the beginning of 2022. Similarly, the accounting rules around troubleddebt restructuring (TDR) have similarly been pushed out for a year by the CARES Act just passed. We have written about the core illogicality of CECL before and won’t repeat it here, except to simply observe that the application of CECL across our entire financial sector will have a depressing impact on the ease of capital formation. The TDR rules were developed in their current formulation after the Great Recession out of a suspicion (which in some respects was fact based) that financial institutions had been inappropriately able to delay recognition of actual losses, causing in the end, more catastrophic failure. However, like CECL, the TDR rules are procyclical and by accelerating the recognition of losses before actual stress is identified, will impair the capital position of the financial institutions, reducing the enthusiasm with which these financial institutions will engage in additional lending activity and cause them to tighten lending standards. Consequently, both CECL and the TDR rules, while in some ways useful in protecting the economy from rogue lenders, are procyclical and to the extent they depress capital formation during periods of financial stress, that’s not an unalloyed good. (Think the 55 mph highway speed limit following the first Mideast oil crisis.)
There are also other initiatives that have and may flow from the gnomes of Basel, including the Fundamental Review of the Trading Book (FRTB), also deferred, that all put the regulator’s finger on the scales in the balancing of safety and soundness on the one hand and growth on the other.
There is certainly some possibility that the current administration will try to bring the CECL and TDR rules forward through pressure on the marketplace to early adapt to avoid a capital cliff when the rules are imposed in early 2022. While CECL and the TDR rules apply to all lenders, it’s fair to say that the bite is likely to be deeper in the regulatory sector with the banking regulators empowered and energized by new political masters.
Might we see that the face of the government also turns to the alternate lending marketplace with a sour and distrustful mien? Remember, in certain circles, this marketplace is called the shadow banking system, and that’s not a compliment. The Europeans have figured out how to extend prudential regulation to the shadow market. Might we do that here? Unregulated lenders are the equivalent of an attractive nuisance to children and politicians alike.
Look, the new administration has more of an internationalist and Atlantist sensibility, so what comes out of Basel is not likely to stay in Basel and we will begin to look more European on the financial markets regulatory front. Look, this little essay is hardly designed to be comprehensive, but I invite you to fill in the blanks. When you do so just think Europe. If you haven’t looked across the pond recently, there’s a lot there that could radically change how we do business here.
As to the “independent” Fed (as Inigo Montoya said to Vizzini in that great flick, The Princess Bride, “You keep using that word. (Inconceivable!) I do not think it means what you think it means.”), the new administration is likely to continue the current administration’s pressure on the Fed to keep interest rates low because hey, the government owes a gazillion dollars now and can’t really afford to see the interest curve shift up materially. The Fed will continue to buy Treasuries, will continue to artificially roil capital markets in ways that we both understand and in some ways we do not. And the deficit is already in excess of $25 trillion and growing. Call me silly, but I keep thinking that matters. Might we see some significant inflation tiptoeing back into our markets? Now, many have lost a lot of money by betting on the return of inflation, but even a stopped clock is right once in a while and it may be time for this clock to stop. However, as long as markets don’t wake up any day soon and decide that Modern Monetary Theory is snake oil, and deficits might actually matter, we will see credit priced very cheaply (regardless of whether the banking sector keeps sitting on deposits). Consequently, we could see significant inflation in 2021. How do our deals function with a three handle on the ten year?
Okay, I’m not buying this one. I don’t see inflation as one of our 2021 issues. Let’s face it, our government has simply borrowed too much money to allow the cost of governmental debt to go up by the hundreds of billions that would occur if the curve moved up materially.
On the social engineering front, the new administration is likely to continue to strongly support more forbearance and more protections from eviction/foreclosure that began under the prior administration. Unfortunately, policies with feel good nows often have significantly bad laters. Do you think it affects lenders if one knows that one cannot foreclose? How about if the tenants cannot be evicted, even for significant non-payment? What happens when defaults spike when some of these forbearances, foreclosures eviction rules eventually burn off, and they will eventually? Hmm.
Sticking with social engineering, it’s going to be good to be green; good to be more ESG. I can’t tell you the number of ESG/Environmental Social and Governance calls we’ve had lately. A wrapping of virtually everything in the ESG flag will be good and indeed might become increasingly essential (but how easy will it be to actually enforce remedies when doing so puts green goals at risk? Hmmm.).
And finally, let’s spend a moment thinking about the Securities and Exchange Commission. There are two hanging chads out there relevant to our market (at the very least) which, with a new majority in control of the Commission might be revisited. The first is the application of the full panoply of Reg AB to the 144A market. Back in 2008, Dodd-Frank teased us with this possibility, but it didn’t happen. With the instincts of the new regime, it would not be shocking to see the regulators believe that full application of Reg AB to the private marketplace would enhance safety and soundness of the financial marketplace writ large. Now, this is a marketplace where we are not defending ma and pa from the wolves of Wall Street, this is a market where extremely well-capitalized institutional investors with the resources to make their own decisions about credit, but nonetheless, the instinct to enhance regulation will be on full display.
The other hanging chad at the SEC since the days of Dodd-Frank, is the requirement that the SEC improve the ratings process. The SEC has had a process underway for years to improve the bank pay process by which the NRSROs give credit ratings and the process has failed, not for lack of trying, but for a lack of a better idea. However, there are other ideas that could fundamentally and radically change the ratings process including a lottery allocation of deals to agencies and the like; not better ideas, but new ideas. We could see this happening and it would have a negative impact on capital formation to be sure. The agencies are different, they are not homogenous in how they look at credit and the world, and there are indeed horses for courses. To randomly allocate transactions to agencies will create technical failures and a bias toward increasingly conservative levels, as that which you don’t understand, gets penalized. Lower levels, lower proceeds, higher cost of funds, less capital formation. That’s a certainty.
To conclude this tour of woeful places, we should assume, in general, that the regulatory heat on our sector will only get worse. More hearings, more investigations, more awkward times for CEO in front of the great and good in the United States Congress. Beyond law and regulation, the process of public shaming is real. Virtue signaling unbound! If you don’t think that impacts the way major financial institutions behave, I’ve got a bridge for you. Now, in the political sphere, punishing the financial sector for perceived recklessness in capital formation while at the same time ensuring that there is plenty of money for the consumers and other policy goals will be a difficult balancing act, but that’s not going to stop political elites from banging on about reckless banking while pressing institutions to provide easier and cheaper credit in the consumer marketplace, for green initiatives and to serve other policy goals. Makes your head hurt, doesn’t it?
So that’s what I see in terms of major elements in the changed regulatory environment. Capital formation will be tougher, C-suite anxiety over foot faults will be greater, capital preservation will matter more to the regulators than capital formation and growth and innovation will no longer be top of mind and indeed might even be punished.
So, what’s that all mean for us denizens of the financial landscape (what some new to town may call a new swamp)?
The alternate lending marketplace should thrive (albeit we need to watch our government’s European tendencies here). It will thrive notwithstanding its current relative cost of funds disadvantage to the banking sector. Moreover, that advantage will erode as regulatory pressures on the banking sector goes up. The landscape of increased regulatory friction and the larding of capital costs on capital costs for the prudentially regulated will squeeze much of that advantage out. Increasingly the alternate lending space should look like a good place to deploy capital and there is plenty of dry powder.
Notwithstanding the aforementioned suspicion that the new team has about financial engineering, I expect securitization to grow in importance. The moving company model keeps assets off balance sheets, keeps risks off balance sheets and de-risking will be a thing. Therefore, the SASB, conduit lending and CRE CLO market are likely to have a good year in 2021.
At the same time, look for a growth in the market for distressed and credit-impaired assets as banks and other lenders pursue a Caesar’s wife strategy for their book. Look for a growth in credit risk transfer transactions where banks and other lenders can de-risk portfolios through the derivatives market. Already a growing trend, this is likely to be a significant part of the marketplace in 2021. Liquidating trusts transactions anybody? We’re going to see them as distressed portfolios change hands.
Prepare to find innovative ways to drape the ESG flag over…everything. Start working on that enhanced ESG disclosure now. You’ll need it. Might we see the securitization of ESG-only pools? ESG loans with lots of governmental largess functioning as additional equity. Almost surely. Once again, squaring the circle of serving ESG goals and making good credit decisions will be an increasingly difficult exercise.
Finally, it’s more than conceivable that some lenders will exit the commercial real estate marketplace or significantly reduce their footprint in response to all this change. That will create opportunities for the trading of pools of loans (which is great fun from a lawyer’s point of view).
So it’ll be an interesting year. Opportunities for the alternate lending space to expand its footprint will be significant. Notwithstanding, the banking sector is hardly dead yet and will continue to transact, albeit at higher cost and with more transactional friction which will be evidenced both in structure and process. Net/net, innovation will continue as we try to turn 3% yields into 12% returns. Dealing with broken toys will be a thing and we’ll see a robust marketplace for impaired and distressed loans. The combination of the enhanced regulatory state (and the buildout from the pandemic) will generate risk and opportunities. But with plenty of capital, plenty of dry powder and an innovative mindset, there will be plenty of transactional activity.
So, there you are, folks. If I’m right, I’ll tell you about it later; if I’m wrong, we’ll all have more important things to do than take me to task.
Here’s to a better 2021.