I have spoken to a number of people over the past months who have raised money or built technology to take advantage of a broadly anticipated distressed opportunity which was certainly to be occasioned by the pandemic. Did I miss it? Was I distracted by the First Family’s secret service chomping dog controversy or the upcoming UFO big reveal? Did it get by me when I simply wasn’t at my desk, making coffee?
Well, I don’t think so. Consequently, I have three questions. First, will we have a distressed cycle at all, second, if it’s coming, what will trigger it, and third, will it deliver enough alpha to make all the preparation for it worthwhile?
I’ve heard a lot of petulance and whining about the lack of capitulation out there. What’s with that? How dare owners of financial assets refuse to roll over and give them away for nothing. The nerve!
Why hasn’t capitulation occurred (yet)? Maybe it’s pandemic relief and the foreclosure and eviction bars that are in still in place. Maybe it’s because the tsunami of monetary and fiscal support provided, promised or threatened by Uncle Joe and his buddies at the Federal Reserve means the cycle really is dead and we won’t have a distressed debt interregnum at all. Maybe it’s simply that everyone is reveling in the reality that they’re vaccinated and alive and too pleased with life to dun anyone. Maybe it’s because lenders, landlords and investors won’t get invited to the best parties by the landed gentry of the coastal elites if they are seen as rapacious capitalists, aggressively enforcing remedies against counterparties.
For whatever reason, hanging on a bit longer and waiting for it to all end still seems to be a viable strategy. But how long can that continue?
Well, there’s lots of theories about why we haven’t seen any material distressed debt trading and perhaps all of the foregoing contribute. The base case must remain that given the vast disruption to everything caused by the pandemic, and the riptide of economic contraction, shouldn’t we see some distress? Moreover, as the pandemic struck at the end of an unprecedentedly long growth cycle, where we were already contemplating the ninth inning, we simply have to have a distressed debt cycle, don’t we?
While I’m not entirely convinced, let me make the case that if you’re hungering for distressed debt, you should not return investors’ money raised for the distressed debt trade yet, don’t throw away your distressed debt business plans and don’t give up hope that there’s a lot of mispriced assets out there in need of a good home.
For the impatient, you might remember that the distressed debt business following the Great Recession didn’t actually begin at the nadir of the recession, nor immediately following the collapse of capital markets in the lee of the Lehman failure. Things actually froze up for a time and transactional activity dipped to near zero. Crickets. Nothing really traded. It was only as the economy began to recover that distressed debt began to trade with velocity.
If a distressed debt cycle is coming, what will trigger it now that the pandemic is fading? Let’s list the candidates. First, on the ground, all the forbearances, foreclosures and evictions moratoria and the jawboning around good citizenship (in other words, doing what politicians want in order for them to tell their voters that they’ve done something for the “folks”) will burn off over the next nine months. Then the butcher’s bill will come due. Although personal and business balance sheets have largely been repaired from the pre-pandemic go-go years due to a combo of an absence of anything to spend it on and the breathtaking government largesse, consumers and particularly small businesses are unlikely to be able to rapidly repay all the deferred rent and debt from the pandemic interregnum. And remember, this bill is likely to come due against the backdrop of many properties continuing to underperform, functional obsolescence and the need to refinance a considerable share of existing debt (over in the corporate space, the love affair with COV-light won’t give lenders and bondholders a lot of tools before these loans just hit the wall). Ridiculously low coupons might have kept many fundamentally distressed assets afloat, but new valuations and higher coupons will make it near impossible to refinance these assets.
The pandemic has been a broad-based accelerant of all sorts of underlying trends in the economy. It is being blamed, in large part rightly, for everything from a lack of the work force’s interest in re-engaging in work, a disinclination of white-collar cadres to return to the office environment, a secular diminution in the demand for office space, and destruction of great swaths of the retail and hospitality inventory. It may even prove to have resulted in a significant reduction of the attractiveness of vertical multifamily housing. That’s all pretty obvious if you pay any attention to the data or even simply read the headlines and meander the high streets and central business districts of American cities (NYC Midtown is still not anywhere near back, based on my meanderings yesterday).
A broad-based diminution in demand for real estate and other business assets, coupled with a spike in contractual obligations for deferred rent and debt service will be a considerable shock as the demand tide recedes for many assets.
And all that is playing out against our current monetary follies. Notwithstanding the protestations of the Fed (which seems increasingly to look like a wholly owned subsidiary of the Treasury) inflation may really be coming. For the life of me, I can’t quite embrace the argument that what we’re seeing is illusory, merely a transitory phenomenon caused by the reflation of individual consumer demand and supply disruptions in a post-pandemic world. $28 trillion in debt and still growing, the spigot fully open on liquidity with bond buying continuing and a wildly expansionist fiscal policy whose outer boundaries we have not yet seen. How do you feel about a $9 trillion fed balance sheet by the end of 2022? Oh, and all of this monetary and fiscal gasoline is being poured onto an economy that seems already on fire and might be growing by as much as 10% in the second quarter. Overshoot anybody?
I can hear the tut-tutting of the truly sophisticated economic professionals (just ask them and they will confirm that they are indeed very sophisticated) whose say, “No, no my good personal friend, inflation is indeed a mirage.” They talk sterilization, supply chain restoration, excess capacity and modern monetary theory. Why worry about money anyway? This all seems a bit contrived to me, a theory in service of a fiscal and monetary regime embraced by the current occupants of the governmental heights. Who’re you going to believe, me or your lying eyes?
Okay, so if inflation is on the way, is it good or bad for our business? I’ve heard both sides argued and perhaps I’ve argued both sides myself. Inflation can erode value and increase costs, drive up interest rates but, of course, also increase nominal dollar-based income streams. It can be good if you own income-producing property with the ability to increase prices to keep pace with inflation. It’s certainly bad for the ownership of fixed coupon financial assets and indeed often bad for any financial asset with term in a continuing and ultimately losing battle to keep pace with changing valuations and interest rates. Inflation and inflation expectations may drive up interest rates beyond the ability of the Fed (note the $9 trillion balance sheet mentioned above) to continue to suppress either the short or long end of the curve. Then we have a horse race between revenue inflation and expense inflation. Expense inflation has won more often than not, making assets that were already potentially untenable because of receding demand, simply not work.
The other problem with inflation is that the pendulum inevitably swings back. When the Fed gets twitchy about inflation, it will endeavor to gently tap the brakes to slay the inflation dragon. The first problem here is that the Fed’s toolbox is pretty empty, leaving the Fed with some rather blunt instruments to tweak the economy. The risk, of course, is to overshoot. Tapping versus slamming is a nice distinction, one we have regularly gotten wrong. When that happens, we watch gentle deacceleration turn into an economic crash into the guardrails. Let’s be really clear here, if we get tapping wrong, we will get a recession caused by the resulting monetary and credit contraction. Deflation is not good for anybody.
And let’s not forget regulatory change. We are in the grasp of an administration with a high level of confidence in the ability of government to do good and the value of the regulatory hand on the markets’ levers of power. The proposed tax changes from the Biden administration, in and of themselves, might be enough to trigger a distressed debt cycle. I’m not sure that many outside the commercial real estate space understand how important 1031 is and the consequence of its potential loss. My hope is that enough of Mr. Biden’s donors would pine for 1031 as much as any odious republican! A super high capital gains rate, marginal rates across the board and the loss of carried interest and other proposed changes to the tax code by the Biden administration could also spike the recovery.
Bank regulation is another thing to watch. While we could argue that the balance sheets of our prudentially regulated banks (and non-banks) are stronger than they have ever been, expect continued supervisory pressure on our prudentially regulated banks to mediate investments in loans, and pick winners and losers. Regular way commercial real estate lending is not one of those winners. The current administration with its faith in governmental action likes the work of the gnomes of Basel more than the last administration. The potential impact of many new Basel regulatory schemes into the United States is likely to increase the cost of capital with a common and depressing impact on access to leverage and valuations for commercial real estate as well as other hard assets. Finally, it is certainly not unlikely that we’re about to see our gloriously elected representatives attempt to do to the non-bank sector which has already been done to the regulated sector and what may be true for banks today may be true for many alternate lenders tomorrow. That would not be good for capital formation and access to leverage.
Causality is funny. Only with hindsight is it ever clear what caused what. Could runaway inflation trigger a distressed debt cycle? Sure. Remember a 5% one-month LIBOR? Could happen. Can you image the devastation if that runup is rapid? What if in response to signs of inflation and growing inflationary expectations we end up with an overwrought correction from the Fed? Stagflation or deflation could follow. Could that trigger a distressed debt cycle? Absolutely. How about changing patterns of jobs and work and use of CRE? How about a Covid 2.0 or 3.0? You bet. All are candidates for the trigger of a distressed debt cycle as we sit here today. Who knew that assassinating an obscure Austrian aristo in 1914 would usher in the cycle of twentieth century great wars which ultimately killed tens of millions?
The point here is that change is upon us. It feels like an inflection point, a pause after the pandemic and a commencement of a reflation pattern. While it feels sort of good at the moment, actually damn good, one must wonder if this is the phony war before the proverbial shooting actually begins. Is the bloom on the economy’s cheek fair health or fever?
So, here’s how I answer my questions: There are very good reasons to see opportunities to trade the distressed debt still yet in front of us. If we get a wave of distressed debt, we are likely not to understand what triggered it until after the fact, if at all (notwithstanding the numerous talking heads who will claim to have brilliantly and insightfully seen this coming). Likely as not, its causes will turn out to be manifold and stochastic. Who knew? Will there be enough alpha to make the wait worthwhile? I rather thank so.
So, after thinking through all this, I rather buy the case that a material distressed debt opportunity is yet in our near-term future. Don’t throw away the distressed debt playbook; the cycle may be late, but the cycle hasn’t been banished.