The Next Recession: Something…Perhaps Not Really Wicked… But Certainly Annoying…This Way Comes

With full and complete credit to the Bard (Macbeth), and to Mr. Ray Bradbury who repurposed this line as the title for his 1962 dark fantasy (of which I was and still am a huge fan), there is just not a better title for this note. Trust me. A few weeks ago, I inked a note about whether the current expansion was soon coming to an end and whether it made sense to begin to “get the distressed debt band back together again.” Tongue slightly in cheek then because things seemed awfully good, I made the argument that we are not really all that far away from an abrupt right turn off the highway of good times onto the dirt road of distress. It apparently resonated (or at least there’s lots of people who think like me). Dechert is hosting a distressed debt conference on October 18, 2018 in New York which will touch on a wider range of issues but will include a distressed debt panel and we now have almost 400 RSVPs. We’ll report on that next week. That’s either 400 people with nothing better to do, or 400 folks who think it might just as well be time to start thinking about the end of days. Continue Reading

IMN 2018 ABS East Conference

Last week, an estimated gathering of over 4,700 of the industry’s finest descended on Miami for IMN’s ABS East conference. The mood was upbeat and the meeting rooms (and the lobby bar) were crowded, as participants raced to fit in as many meetings as possible. If there was one overall takeaway from the conference, it was that there is a lot of money looking to invest in the ABS sector, which continues to enjoy strong fundamentals and a hearty appetite for deal making. We are excited to see all the term sheets that come out of this conference and help get some of those deals closed. Continue Reading

Proposed Rule Regarding HVCRE ADC Open for Comment

Are you ready? The proposed rule regarding HVCRE ADC has been published in the Federal Register today and is open for comment. You know the drill, comments are due in 60 days (by November 27, 2018). Give us a ring for more background on HVCRE ADC and the proposed rule. We’re always happy to discuss the questions posed by the regulators and consider potential responses. And be sure to check in to Crunched Credit in the coming weeks as we do a deep dive into the whole new world of HVCRE ADC as a result of the recent amendment.

Are you there FDIC, OCC and Fed Res? It’s us, Crunched Credit: Regulators Request Feedback on HVCRE ADC

On September 18, 2018, the Federal Reserve, FDIC and OCC released a Notice of Proposed Rulemaking (NPR) regarding HVCRE. The good news is that the stated intent is not to alter any of the improvements made by EGRRCPA, instead the agencies describe the proposed rulemaking as conforming the regulatory capital rule to the new statutory definition of HVCRE ADC and providing interpretations of certain terms consistent with their usage in other regulations. This is good news indeed.  We were somewhat concerned that the regulatory state in full might try to steal some back here, but they seem to have gotten the message.

There are a few immediate takeaways from the NPR – namely, HVADC is dead and that the test for whether a loan qualifies as an HVCRE ADC exposure occurs only once – at origination. So, after origination, you can fall out of HVCRE ADC (with the new reclassification provisions) but you can’t fall into HVCRE ADC.

Embracing hubris, perhaps, we’d like to think the agencies are readers of Crunched Credit.  They certainly address many of the provisions we highlighted in our prior commentary. Here are some of the highlights:

Crunched Credit: What does “primarily finances” mean?
NPR: The agencies request comment on whether the term[] … “primarily finances,” … [is] clear or whether further discussion or interpretation would be needed.

Crunched Credit: When is development “substantially” complete?
NPR: The agencies invite comment on whether [substantial completion of construction] is ambiguous or needs interpretation? The agencies invite comment on what, if any, operational challenges would banking organizations generally expect when determining whether an HVCRE exposure under the proposed revised definition can be reclassified as a non-HVCRE  exposure?

Crunched Credit: What is the “cash flow” test?
NPR: The agencies invite comment on what, if any, operational challenges would banking organizations generally expect when determining whether an HVCRE  exposure under the proposed revised definition can be reclassified as a non-HVCRE exposure?

Crunched Credit: It’s clear that HVCRE ADC supersedes the old rule for loans made after May 24, 2018 (and provides grandfathering for loans made prior to January 1, 2015), but it’s unclear what it does to loans made from January 1, 2015 – May 24, 2018. Are these loans now subject to HVCRE ADC for re-classification? We would like for clarity (although maybe we already have it) that the new HVCRE ADC applies to those loans as well.
NPR: For ADC exposures issued on or after January 1, 2015, banking organizations would follow the interagency statement that permits them to either apply the statute on a best efforts basis or classify HVCRE  ADC exposures according to the superseded definition until the final rule is effective. The agencies invite comment as to whether the final rule should require reevaluation of ADC loans originated on or after January 1, 2015 under the revised HVCRE exposure definition. What are the advantages and disadvantages of requiring reevaluation? What alternative treatments, if any, should the agencies consider?

Crunched Credit: Can mezzanine debt and preferred equity count for the 15% Borrower equity contribution test?
NPR: The agencies invite comment on whether their proposed interpretation of the 15 percent contributed capital exclusion is appropriate and clear or whether further discussion or interpretation would be appropriate. What other issues, if any, relating to the contributed capital exclusion require interpretation?

Well, glad you asked!  As with the last rodeo, the public will have 60 days from the date the rule is published in the Federal Register to comment. It has not been published yet, but rest assured readers, we are watching the FedReg for it and will post an update once the comment period begins.

Review our archive of commentary for more background on HVCRE ADC and EGRRCPA. Better yet – we make house calls! We would be happy to do a teach-in or host a Q&A session on the changes. Please let us know if that would be helpful and we’d be happy to set up a time! And- stay tuned for further commentary as we digest the posed questions and consider potential responses.

HVCRE (The Reformed Loan): Musings and Next Steps

Since my last post, the Economic Growth, Regulatory Relief, and Consumer Protection Act (which some are referring to as EGRRCPA – oof.) was signed into law by President Trump on May 24th. Section 214, titled, “Promoting Construction and Development on Main Street,” amends the Federal Deposit Insurance Act to clarify what loans are subject to HVCRE, when loans are measured for HVCRE exposure and what we call loans subject to HVCRE (spoiler alert: it’s not HVCRE!). Long story short, despite all the grumblings about this reform, Dodd-Frank has not gone the way of the Dodo. Here’s what we know, what we think we know and what we think you may be able to do.

What We Know

  1. (For loans made after May 24th) HVADC is out – HVCRE ADC is in.

Under Public Law 115-174, regulators “may only require a depository institution to assign a heightened risk weight to a high volatility commercial real estate (HVCRE) exposure (as defined in 12 C.F.R. 324.2) under any risk-based capital requirement if such exposure is an HVCRE ADC loan”. So, after all the back and forth with HVCRE and HVADC, it is finally settled: only those loans classified as “HVCRE ADC” can be subject to HVCRE. Wait, what?? (We hope this means that the regulators will abandon HVADC…).

So, what is an HVCRE ADC loan? An HVCRE ADC loan is a credit facility secured by land or improved real property that (A) primarily finances, has financed, or refinances the acquisition, development, or construction of real property; (B) has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and (C) is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility.

Let’s start with the good: thankfully, the revised definition clarifies that only credit facilities secured by land or improved real property are subject to HVCRE ADC. One addition to the definition from the prior incarnation is that an HVCRE ADC loan “primarily finances” acquisition, development or construction. We have no idea what “primarily finances” means – 50%, 60%, 95%? But – maybe this ambiguity is good. Should we be racing to the regulators to fill in all of the “grey”? If we do that, we have no room to make calculated and reasonable decisions (that are good for the bank and the borrower) and ask forgiveness (if it ever comes to that!) later.

Another new addition to HVCRE ADC is the requirement that the loan “has the purpose” of providing financing for ADC. Again – what does this even mean? We are in new territory with the regulators being concerned about the “purpose” of a loan. How do you even figure this out? “Purpose” seems to be in the eye of the beholder. And, when is the “purpose” decided? At origination? Hopefully! Banks should not be required to continuously monitor the borrowers’ use of funds in order to be technically compliant.

We’re not thrilled that unimproved land (without any construction or development component) still falls under HVCRE ADC, especially where the loans are fully guaranteed (how much sense does that make?).

Further, we worry that now that any loan that “has financed” the acquisition, development or construction of real property could potentially fall under HVCRE ADC, does that mean that a loan made after January 1, 2015, that, “had financed” the acquisition of real property but wasn’t previously subject to HVCRE now would be? Practically, probably not, but well worth the thought exercise (at least to us dorky lawyers).

  1. HVCRE ADC loans are not:

    • Loans that are secured by one- to four-family residential properties, real property that would qualify as an investment in community development or agricultural land;
    • Loans to acquire, refinance or make improvements to existing income-producing properties with cash flow generated by the real property that can support its debt service and expenses (in accordance with the bank’s underwriting criteria for permanent financings);
    • Commercial loans with (i) an LTV less than or equal to current standards as determined by the regulators, (ii) a borrower contribution (in cash, marketable assets, out-of-pocket development expenses or real property and improvements) of at least 15% of the appraised “as completed” value and (iii) such contribution was made prior to any advance under the credit facility (and such contribution is required to remain in the project until the loan is reclassified as non-HVCRE ADC); and
    • Loans made prior to January 1, 2015.

It’s now clear (at least as clear as these things get) that ground-up construction is HVCRE ADC (Yup – makes sense…risky lending deserves some regulation) and already improved property (that IS cash flowing sufficiently to pay debt service and expense) is NOT HVCRE ADC. And that’s where banks find themselves with a lot more breathing room: now, the “construction-lite” loans where the property is improved, cash flowing and the loan is being made to finance some sort of renovation, face list or tenant improvements may NOT be HVCRE ADC (depends).

The above exemptions are substantially similar to the original HVCRE regime (so repurchase facilities and loan on loans are exempt, as is mezzanine debt secured by borrower equity with ADC), with a few important tweaks: first, the calculation of what counts as Borrower equity contributions is different and second, the div stopper is less onerous.

As we all know, to be exempt from HVCRE ADC, Borrower must have 15% equity in the deal. The equity contributed can come in the form of cash, development costs spent at the property, and the value of the land (based on a current appraisal). Note, under the old HVCRE regime, the value of the property was determined at acquisition, so no appreciation benefit was given. Now, the appraisal will be based on the “as completed” value of the property (so borrowers can get the benefit of an appreciation in land value making holding onto real property well worth it!).

In addition, under the new HVCRE ADC rules, if the property starts cash flowing, the cash can be distributed to the borrower’s equity holders so long as the 15% contributed capital described above stays in. Whereas under the old regime, no money could be leaked out during the life of the loan. Hooray! Gotta celebrate each victory!

  1. Loans that are made under the HVCRE ADC regime can be “reclassified” as a Non-HVCRE ADC loans.

Probably the biggest breakthrough in the reform is the ability to reclassify loans. This allows banks to reduce their capital stack once the loan is stabilized. Under the new regime, a loan can be converted to a “Non-HVCRE ADC Loan”:

  • Upon the substantial completion of the development or construction; or
  • Once the property generates enough cash flow to support the debt service and expenses in accordance with the bank’s underwriting criteria for permanent financings.

Going forward, loan documents for HVCRE ADC loans should build in mechanics (or not- the language seems to suggest the bank can reclassify on its own but borrowers may want some certainty built in) for reclassification (e.g., upon substantial completion, satisfaction of a DY/DSCR test, etc.) as this would remove the div stopper and allow internally generated cash flow (above the 15% required capital contribution) to be dispersed (mezzanine lenders rejoice!). We would expect to see, at a minimum, a spread step-down in the interest rate too…maybe? There are other ways too we can think of to handle the “cash flow” test which we will be discussing with our clients.

Giving borrower’s greater optionality may be one way to make “Main Street” like banks again.


The Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation issued a statement on July 6, 2018, clarifying that banks “may refine [estimates regarding HVCRE ADC loans] in good faith as they obtain additional information but will not be required to amend previously filed regulatory reports as these estimates are adjusted.” In addition, the agencies gave banks the option to continue to report and risk-weight HVCRE exposures in a manner consistent with the current instructions, until the agencies take further action. The agencies also indicated that they plan to promulgate regulatory revisions in the future. In response, Representative Pittenger and others sent a letter to the agencies on August 1st, thanking them for their assurances that the agencies will work to conform the existing regulations to EGRRCPA.

We too are jazzed up about the promised regulations. We’d like to see (at a minimum) the following addressed (or maybe we don’t…are we better off with ambiguity so then we can ask for forgiveness later?):

  1. What does “primarily finances” mean?
  2. When does a loan “ha[ve] the purpose” of providing financing for ADC?
  3. When is development “substantially” complete?
  4. What is the “cash flow” test?
  5. It’s clear that HVCRE ADC supersedes the old rule for loans made after May 24, 2018 (and provides grandfathering for loans made prior to January 1, 2015), but it’s unclear what it does to loans made from January 1, 2015 – May 24, 2018. Are these loans now subject to HVCRE ADC for re-classification? We would like for clarity (although maybe we already have it) that the new HVCRE ADC applies to those loans as well.
  6. Can mezzanine debt and preferred equity count for the 15% Borrower equity contribution test?

Check back in the coming weeks as we discuss the above and consider whether the FAQs apply to HVCRE ADC and the fate of HVADC. The forthcoming regulations, coupled with how banks adapt to HVCRE ADC will determine whether we finally got the major HVCRE reform we’ve been looking for or if EGRRCPA failed to move the needle. In the meantime, we will be sitting here musing over the new HVCRE ADC legislation, thinking of creative solutions to a problem someone has got to have. Give us a ring. Let’s see what we can make stick!

The Boundaries of Risk Retention Now That the D.C. Circuit Has Spoken

In February, the D.C. Court of Appeals ruled in The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System, No. 17-5004 (D.C. Cir. Feb. 9, 2018) (the “LSTA decision”) that a manager of an open market CLO is not required to retain risk under the Dodd-Frank Act and Regulation RR, because only a securitizer which transfers financial assets into a securitization vehicle must retain risk.  No transfer, no risk retention.

In its decision (joined by Judge Brett Kavanaugh), the Court was very clear in its analysis.  Essentially, the decision said “thank you very much, we can read simple English sentences, and the law is crystal clear on this point (if not on much else).”  The regulators may not elide the transfer requirement of the Dodd-Frank Act by calling managers of open market CLOs securitization sponsors, when they don’t transfer assets to a securitization vehicle.  The Court went on to point out that if this was a loophole, it needed to be fixed by Congress, not the regulators.  Blessedly, a satisfying, albeit rare, victory for a plain reading of our mother tongue.  The regulations actually mean what they say!

The broadly syndicated CLO business has taken this ruling to heart and has been beavering away on transaction structures that no longer provide for the retention of credit risk. One big issue in that space now is whether you can square the circle about avoiding risk retention in the US, while somehow meeting the EU risk retention criteria.  But that’s a bit of legerdemain for discussion another day.  What I want to talk about is the utility of the LSTA decision in spaces other than the broadly syndicated CLO space—particularly for commercial real estate single-asset, single-borrower (SASB) securitizations, a product representing almost half of all CRE securitization offerings this year. Continue Reading

Securitizing Marijuana Dispensary Properties in the Sessions Era

In 2013, the Obama administration issued the Cole Memorandum, which called a truce between federal prosecutors and marijuana businesses operating legitimately under state law.  After regime change in Washington, however, it may come as no surprise that Jeff Sessions—the Attorney General who once opined that “good people don’t smoke marijuana”—rescinded the Obama-era guidance.  The only real surprise is that it took him a whole year to do it.

Since at least 2013, marijuana-related businesses have generally been operating on predictable, albeit legally shaky, ground.  Dispensaries have expanded dramatically.  Though details vary wildly, nine states currently allow recreational use and medicinal use is currently permitted under the laws of all but four states.

As a result, commercial real estate lenders have to grapple with the increasingly common problem of the dispensary tenant, and a number of lenders are dipping their toes into lending in expectation of securitizing loans secured in part by dispensaries.  But given the January 2018 announcement that the Cole memo is no longer in effect, the question everyone’s asking is: are things really that different?  The answer, we think, is no—but with an asterisk. Continue Reading

The Deep State, Area 51, Elvis Sightings and the Illuminati: Complexity is the New Mythos-Maker

The shear complexity of the modern world makes fools of us all.

It’s no wonder that conspiracy theories, just plain weird ideas and deeply counterfactual views abound these days. We don’t like to be bewildered or shocked by unexplainable events, and, regrettably we confront plenty of these every day. Confronted with the inexplicable, it is human nature to find patterns, to weave disparate, and unrelated, facts into narratives or memes. The problem is we seem entirely comfortable drawing conclusions, seeing causality and taking action on what often turns out to be wildly wrong-headed notions of what’s really going on. Ready, fire, aim. (A particularly troubling infirmity of our governing elites…see below.)

Long ago, there was a wide swath of the world that was not susceptible to understanding through observation and would have been completely confounding but-for mythos and religion (for this purpose, we’ll keep those as distinct categories to avoid offending anyone).  The supernatural was real, its evidence was all around us and it provided a comforting answer to almost everything outside the boundaries of the observable known. It created a nicely closed system of knowledge.

But isn’t this the modern world, the world of science and logical deductive thinking? It’s the 21st century, baby. The truth is that we are just as befuddled as we ever were when confronting reality and are as likely to do dumb things because we don’t really get it.

Complexity is our new supernatural.

Two hundred years ago, a well-educated gentleman could actually know a very large percentage of what was then considered knowable. He or she (okay it was largely hes in those days) could understand how a steam engine worked. He could appreciate the basic principles of Newtonian physics and grasp what medical knowledge (albeit not much and almost entirely wrong) that was in circulation. He read the cannons of literature, knew how gunpowder was made, had an easy familiarity with the extant theories of history and pre-history and the known laws of the land and generally, probably had a self-satisfied sense that he understood the world. What wasn’t observable was the realm of myth, but that was okay. Everyone agreed that those myths were real but were, in fact, objectively observable. (Hell, as late as the 21st Century, notable authors were writing non-fiction accounts of fairies – for fun, read Robert Kirk’s “The Secret Commonwealth of Elves, Fauns and Fairies,” a very serious book…it’s a hoot.) Of course, much of this was wrong, but that’s not the point here.

Today, we have largely given up on reliance on the transmundane for answers and expect that through observation and ratiocination we can explain the world around us. But none of us have more than a very imperfect understanding of the observable. The problem here is complexity. I saw a report somewhere that said there’s only 250 people in the entire world who really understand how a cell phone works. I understand almost nothing about how computers work. Medical science is largely a mystery. I don’t really get electronics nor what in the world is string theory, and heaven knows whether the universe is contracting or expanding. I have an undergraduate degree in economics and know enough to understand that I don’t understand economics. (The evidence suggests that professional economists don’t either.)

I couldn’t begin to tell you that I know all the laws that affect the life I live every day and certainly have never read the United States Code back to back, nor, God help me, the three quarters of a million pages in the Code of Federal Regulations without mentioning the similar compilations from each of our states, counties and local governments that I’m sure say something relevant to the way I live, the business I run and the clients I serve. Even technical specialists, within the realm of their own specialization, don’t know “everything” (trust me on that). Our understanding of the reality in which we function is largely impressionistic and assumptive, based on the few things we really know and guesses, perhaps educated guesses, one might even call them biases, about what we don’t.

So in large measure, we have exchanged one world of the unknown for another, and in fact, notions, based on the easily observable, what we all know for certain, are generally about as reliable as explanations based on the doings of angels, fairies and demons.   With our God-given confirmation biases that tend to allow us to elide from our consciousness troubled thoughts that might challenge our ideas, we can comfortably live our lives. We have embraced a false hubris that we actually do understand how things work while continuing to pity the poor Hobbesian denizens of the past for relying on superstition and religion for answers.

While it’s one thing for Tom down at the hardware store to pontificate about aliens on ice in Area 51, or fluoride in our water turning us into Communists (showing my age) or free trade causing Tourette syndrome (watching the evening news, I sort of get how one could think that), it’s somewhat more troubling when our elected representatives and the doyens of the swamp similarly embrace simple easy to understand yet wholly invalid narratives about how the world works. Girded with certainty, they apparently all believe that they have been given a God-like ability to design our polity and economics and continue to tinker away. They’re certain that they understand cause and effect. They’re certain they understand how the world works. They know they can fix stuff. The flash is they can’t. And as time goes by, the accretion of more and more wrong-headed initiatives based upon fundamental misunderstanding of how the world works has an accumulated impact that causes the edifice of our economy and polity to wobble more and more.

What got me thinking about all this is a small example of a “whoops” that I noticed in a recent FT story that discussed how the U.S. Treasury yield curve has been impacted by a provision of the tax reform bill that essentially allowed corporate entities to continue to deduct contributions to their pension schemes at the old 35% applied corporate tax rate and not at the lower 23% rate that applied to their actual income in 2018. Apparently that was designed to help corporate America address an underfunding problem in their pension schemes (put aside for a second that the real underfunding problem is in the public pension scheme). But in consequence, it has depressed pricing at the long end of the yield curve as these pension schemes have piled into ten to thirty year paper. That, of course, in turn has flattened the yield creating at the least anxiety about the performance of the economy in out corners and depressed the earnings of our banks who live for an upward tilting yield curve. Even anxiety about the future shape of the economy has real life impacts. Does it affect hiring? Does it affect Cap X? Does it affect expansion plans? Does it affect the use of excess cash for buybacks or further investments? Sure does. And so here we are, blindsided by a tax policy change that has significant real world impacts of which I was entirely unaware (but I’m sure my ERISA partners are all over this).

I was ready to view this potential inversion of the yield curve as a strong cypher for an upcoming recession and maybe it’s not. Maybe it’s not aggregate demand, it’s the unintended consequence of a misfiring pension scheme. Who knew?

So you see my point – when we don’t understand how things actually work, we make stuff up. Think about the poor Turks whose president is convinced high interest rates cause inflation and therefore is driving its poodle-like central bank to continue to expand the money supply and pave the road to hyperinflation. Or how about the doomed Venezuelans whose government has destroyed almost every part of their economy while concluding that the solution to this problem is more of the same medicine, administered, if necessary, at bayonet point.

And here at home, look at what we did knocking around after the Great Recession of 2008 to “fix the problem.” The Volcker Rule – what did it do? It constrained liquidity and as far as I can tell, it fixed nothing. Skin in the Game – what did it accomplish? It increased legal fees (not necessarily a bad thing), but has it changed the calculus of risk and reward across banking and finance?

I am virtually certain that when the next denouncement arrives and the economy turns south, we will find out that it did not. Something else, something not on our radar will be the culprit. We ballooned the Federal Reserve balance sheet to over $4.5 trillion. Seemed like a good idea at the time. Do we have any idea of what will happen when we unwind it? (A candidate for the next bad thing? I’m just saying….) Our world is so damn complex that we marinate in a sea of unintended consequences every day. My point here, to the extent I have a point, is that we all need, from voters to legislators to regulators to business leaders, to really internalize the notion of unintended consequences. To try mightily to think beyond the easily observable to the underlying structures of things. We need to find some humility in the face of a world that in fact is so complex that it’s no more easily navigated than the world of Gods, demons and angels. (What really is the difference between a handheld computer with more computing power than on all the computers that took us to the moon some 40 years ago and magic? As far as I can tell, it’s sort of the same thing.) We need to be more clear-eyed about unintended consequences and we need to be prepared to act as the previously unrevealed become apparent. Churchill famously said (or is reported to have famously said), “when the circumstances change, I change my mind.” Not a bad approach to life. We don’t do it enough and we tend not to honor those who do. We do love stubborn certainty, don’t we? We need more willingness to reset our course when new facts and new relationships are uncovered, to fight our confirmation bias and to once again look beyond the easily observable. Causality is easily obscured. In many cases, the direction of the arrow of causality is not at all clear.

So here’s a fervent wish for all of us to be a little less certain, to have a little less hubris about our ability to act and affect the world; to be a little less certain of theories upon which policies are based are right simply because they appear to accord with the data we have observed.

Probably a fruitless hope, but, hey, even a blind cat finds a dead mouse once in a while.


Night of the Living Dead: LIBOR Playing a Zombie in a Reality Near You!


iStock / gremlin

LIBOR is going away, but that’s sort of old news at this point.  However, it has been received wisdom that only after the Bank of England stops imposing an obligation upon member banks to publish LIBOR quotes as at the beginning of 2021, would LIBOR go away and then we would need a replacement.  That’s troubling, but of course most of us have plenty of other more immediate things to worry about between now and 2021.  (NY Football Giant’s 2018 Season, impeachment, drone assassinations, hand size, etc.)

Here’s the deal. We’re not going to have all that time to get a LIBOR replacement right.  It’s nightfall in our zombie movie and it’s always a bad sign when the mostly dead are shuffling about.

At the Alternate Reference Rate Committee (ARRC) Roundtable at the Federal Reserve Bank a couple of weeks ago, I, at least, was shocked to find out how breathtakingly thin the actual data behind LIBOR is day in and day out.  Folks, it’s a $200 trillion market and the median daily number of actual borrowing transactions which are observable in the marketplace in Q2 2018 for 1-month LIBOR was five.  Five, that’s not a typo.  Five.  Now, we’ve always known that LIBOR is a bit of a shell game where reporting banks generally report the interest rate that they would borrower at if they did borrow, but of course, they don’t.  The LIBOR quotation process has always had a certain number of actually observed transactions floating like raisins in the rather odious blancmange of a made up data set, but only five actual quotations?  We’re moving trillions of dollars of cash and synthetic product based on that little bit of real news?

LIBOR has been in the news for quite a while, ever since we confronted the fact that it’s largely a fabulist invention.  However, the focus has been on prosecuting traders who allegedly diddled the process (Diddling data fields which, in the first instance are entirely made up, is sort of an interesting thought exercise, don’t you think?  Can you fake, fake news?)  Maybe justice must be served, but in the great scheme of things that was a distraction.  If we end up with a sloppy end of LIBOR without a transition to a new reference rate, it will be bad. This is not Y2K.

We have a process underway designed to replace LIBOR.  It’s deliberative and it’s gradualist and it’s linear.  At the ARRC roundtable, Fed officials even bragged that we’re about six months ahead of the schedule they set in their Paced Transition Plan, but remember that Plan contemplates the presumed successor to LIBOR will only be available on January 1, 2021.  Taking just in time inventory just a bit too far if you ask me.  This effort will be frustrated by a disorderly early collapse of LIBOR.  We need to take that risk seriously.

I’ve been saying in this commentary for some time that I thought a significant risk here was that LIBOR would go away before 2021 because it’s simply not a reliable measurement of any reality.  Now, that we have been forced to confront the fact, it should be almost intolerable to continue to rely upon this reference rate.  How do we justify waiting for 2021?

Andrew Bailey, the head of the UK Financial Conduct Authority (FCA) that is responsible for overseeing LIBOR, said in July that the FCA could declare LIBOR nonrepresentative if it thought LIBOR was no longer a reliable basis to benchmark trillions of dollars of transactions.  No longer reliable?  Was it really ever?  If the FCA declares LIBOR nonrepresentative then, under the EU Benchmark Regulation, supervised firms in the European Union, including financial institutions, exchanges, trading facilities and clearing houses, would only be able to use LIBOR for legacy contracts and not new business.   The Federal Reserve Vice Chairman for Supervision Randal Quarles in his prepared remarks at the ARRC meeting directed markets to take note.  Read the tea leaves folks: LIBOR is not making it to 2021.  And the only thing worse than a disorderly handoff from LIBOR to SOFR on a date certain is to have LIBOR and SOFR both published and used in tandem for a considerable period of time.  Can you imagine the dissidence in the borrower and counterparty community when efforts are made to switch to SOFR under these circumstances?  Winners and losers will abound.  Call the trial lawyers!

This all is very troubling because notwithstanding all of the committees, task groups, study groups and industry forums that have been organized to think about LIBOR, there’s very much more sound and fury than light right now.  We’re still fixing to address the problem with the sort of desultory absence of urgency long associated with southern climes.  A good process is fine when the risks are at a certain remove, but we no longer have that luxury.  The silver is all lined up neatly in the silver chest and all the chairs are put away, but we’re still on the Titanic.

We need an executable plan for LIBOR replacement now.  We need a plan that could be implemented as early as next year.  We’re not going to get any smarter.  It’s time to stop studying and start doing.  We need to make decisions.

While there may be other runners still in the game, the Secured Overnight Financing Rate or SOFR, a rate derived from overnight repos of treasuries seems the consensus choice as the basis for the new reference rate.  In some quarters, alternatives are still being considered.  This should stop.  SOFR is already trading in a semi-robust way and producing real pricing from real trades.  Shocking! We’ll actually price financial assets off real trades.  Let’s embrace SOFR and move on.

We’ve had some very productive conversations about how SOFR, an overnight, largely riskless rate, can be utilized to determine term rates and how to address a riskless rate as a reference rate.  Industry groups have come up with a pretty good answer.  We will use a hierarchy of SOFR derived rates based on what’s available at that time.  If we have published term SOFR, fine.  We’ll use that (maybe we will have a term SOFR sometime in early 2020…maybe).  If we don’t have term SOFR, then we’ll use interpolated term SOFR.  This could be derived from a futures product that exists now and is likely to grow more robust over the next few years.  If neither of those exist, we use spot quotes or average spot quotes.  Not perfect but it’s an answer.

There is lots of palaver on what triggers the swap out of SOFR for LIBOR.  There are two important questions here.  The first is when and the second is who says.  On the first, there are institutions saying we need to phase SOFR in over a considerable period of time but others say we need a hard date or a date certain. I don’t know the right answer here, but we need to get that nailed down.  None of these options are perfect, but it’s likely that all can be made to work.

Who drops the flag and commences the race to transition?  Will it be the Treasury?  Do we switch when the prudential regulators tell the banking community that it’s no longer prudent to price assets off LIBOR?  Maybe we should take our lead from the GSE’s.  Can we have industry groups get together and decide when to do it?  I don’t know the answer, but again – all will work.  No choice is perfect but we need to decide and decide now.

We’ve had lots of conversations about how to spread adjust SOFR to reflect something that looks like current LIBOR.  Remember LIBOR is a rate that has economic risk baked into it.  SOFR does not.  How do we adjust one to look like the other?  This is an important question for the legacy book, which no matter how many folks try to dismiss it as a real problem, remains a very real problem, and will continue to grow as a problem until the new rate is fully implemented.  Pick something and stick with it.

Finally, we are talking about the fact that our Zombie LIBOR may get even more zombie-like before we’re done.  A zombie of a zombie, if you will.  As mentioned above, it may be that LIBOR remains viable for legacy deals through 2021 while SOFR is used for new deals.  All of which may be happening against a backdrop of various regulators essentially continuing LIBOR, a no longer reliable reference rate.  One shudders to think of the chaos when borrowers are confronted with their lenders purporting to change the interest rates on their loans by using SOFR when something called LIBOR is still being published and used.  Wash, dry, fold and repeat!  Call the trial lawyers!

We also need to talk about operational difficulties.  In my securitization world, no one has adjusted the data collection or data transmission medium to account for a new index rate, a new spread and a new interest rate.  No one is really certain who will make the decision in securitization.  No one has really comprehensively reviewed their book to see what their existing alternate rate language is, let alone begin to install uniform industry-wide alternate rate language.

Progress has been made, but we’re nowhere near ready.  Look, unless we’ve decided to have the government somehow legally mandate a switch out of one rate into another, which seems both inadvisable and frankly, impossible, the decisions to change the reference rate are going to be deal by deal, instrument by instrument, participant by participant.  At best, that screams chaos.  However, if large segments of the market could move quickly and decisively to embrace a general consensus around the half dozen critical questions discussed above, some of that might be avoided.

Did you happen to see the FT’s article from Sunday, August 5th entitled “Banker warns of Herculean task to escape Libor’s tentacles by Joe Rennison and Robin Wigglesworth?  This article highlighted the problem that as our committees and study groups, bureaucrats and Wall Street types have been beavering away at the LIBOR problem, an awful lot of folks in the financial marketplace writ large have not yet noticed that LIBOR is going away.  Are all mortgage bankers, borrowers, service providers, the folks at our 7,000 sub-regional banks paying any attention?  Right now, recognition of the problem and the thinking about the fix seems to be largely confined to a small coterie of money center banks, major investors and Wall Street players.  That won’t work.  Even if we declare victory and agree on a new reference rate, agree on when the reference rate should be swapped in, agree on how to calculate that rate, agree on who tells us when the transfer will occur, it will be chaos unless the vast majority of participants in the financial marketplace are really tuned into the change and ready to move.  If we had two plus years to educate about the orderly transition to SOFR that might not be a terrible thing here in the dog days of summer 2018, but if I’m right and LIBOR is going away sooner, this lack of understanding across the marketplace about when LIBOR falls will greatly exacerbate the problem.

All that is a heavy lift and while, if we had two and a half years more to get this right then we probably would.  But now, I don’t think that’s true.  My guess is that someone is going to announce the emperor’s got no clothes and LIBOR is an inappropriate reference rate for market transactions sooner than that, and in that case those chomping zombies will be among us with a vengeance.

What’s to be done?  Accelerate the process of getting to a solution.  Eliminate self-congratulations for a good inclusive process, start to scramble for a solution and educate the markets.  If we don’t have a pretty good handle on a solution by the end of 2018, shame on us.


The Winter of Our Discontent May Be Over (If you are a Distressed Debt Investor)

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.  Continue Reading