Month: April 2018

Here’s A World I’m Not Ready to Live In…

“NY Post – Global wine output fell to its lowest level in 60 years in 2017 due to poor weather conditions in the European Union that slashed production in the bloc, an international wine organization said.“

Sound the alarm, folks – we’ve got a crisis-a-brewin’!

According to a newly published report by the OIV on Wednesday, it looks like global wine production dropped -8.6% in 2017 to the lowest level since 1957. That’s 12 years before we even went to the moon, for some context. The culprit was poor growing conditions, more specifically, frost, in the “old world” stalwart regions of Italy, France and Spain. The good news here is that while production has plummeted to 250 hectoliters,  global consumption inched up only slightly to 243 hectoliters in 2017 (that’s about 33.25B bottles of production to satisfy 32.3B bottles of consumption). So like, should we be investing in wine then?

It’s hard to say, really, and it also depends on your risk appetite. The best benchmark to monitor price fluctuations in the secondary fine wine market is the Liv-Ex 100. It used to be free, but with success comes a paywall I suppose (check it on BBG if you have one: LIVX100). Anyway, prices have been relatively subdued in 2018, but that comes on the heels of a 31% run-up in the index since YE 2016. So it would appear that a lot of the impact of last year’s small yield is already baked into the market. That doesn’t mean there aren’t opportunities to make money, though.

Wine is becoming an increasingly, well… liquid asset. Aside from becoming the go to data source for wine markets, Liv-Ex also runs a secondary marketplace where participants all around the world buy and sell fine wine. This also consists of trade settlement / logistics operations which manage payment, delivery and storage in the Liv-Ex bonded warehouse. So if you think you’re able to day trade around the wine markets and make a profit, have at it (it obviously isn’t that liquid yet, so keep an eye out for those elusive arbitrage opportunities).

Outside of trading wine on your prop account, there are many private investment vehicles investing in all facets of the wine industry: real estate, rare wines, you name it. A lot of the managers take nuanced approaches that suit investor appetite, too, like equity vs. debt, or region-specific approaches.

So, there are mechanisms to profit in a market with increasing demand and waning supply, but you want to do it the right way in order to limit your downside. You want to play the macro trend here, especially if you’re going to lock up capital in a private vehicle for 5-10 years. Demographics are changing and with it, tastes in wines. Millennials are now drinking more wine than baby boomers, and it shows in not only sales but in varietal and regional preference as well. While Bordeaux, Piedmont and Burgundy are timeless, the younger crowd has really taken an affinity to new world wines out of Chile, California and Washington (no doubt a function of cheaper prices and increasing quality). Were supply imbalances in the global wine market to become a relatively normal occurrence, I fully expect the new world regions to pick up the slack both in production and, perhaps more importantly, agricultural and distribution technology. That’s where the money will be.

It was Inevitable…

As I speculated previously, Deutsche Bank is going to be firing a bunch at 60 Wall any moment. Per Bloomberg:

“Deutsche Bank AG is abandoning its ambitions to be a top global securities firm as it embarks on possibly the most sweeping overhaul yet of its struggling investment bank.“

Sheeeeesh. I suppose this is for the best, though, take a look at these highlights:

  • 1Q net revenue EU6.98 billion, down 5%; analyst estimate EU7.27 billion
  • 1Q sales and trading revenue EU2.45 billion, down 17% while U.S. counterparts rose 12%
  • 1Q net income attributable to shareholders EU120 million

Look at that last one! Ladies and gentlemen, €120M is NOT a lot of money.

Sewing knew coming into his new job that this had to be a “rip the band-aid off” type of restructuring and I commend him for wasting no time in getting down to business. They mentioned on the call that there would be a “significant reduction” in headcount this year, and they’re targeting U.S. rates S&T,  U.S. corporate finance and the coup de grâce, global cash equities trading. If you don’t make markets in rates and equities or advise companies on raising capital in the U.S., are you even really an investment bank? Maybe in practice you retain some IB capabilities, but people won’t be doing business with you in an IB capacity – which is fine. Sewing’s job, first and foremost,  is to make money, and he’s going to do it the only way he knows – traditional commercial and retail banking, with a sprinkle of asset management. So good luck to Sewing, and even more best wishes to all of the DB employees updating their resumes right now. Don’t cry because it’s over, smile because it happened.

Netflix Likes On-balance Sheet Debt, Too

“Bloomberg – The world’s largest online television network sold $1.9 billion of senior bonds in its largest-ever dollar-denominated offering“

Here’s an unpopular opinion: Netflix really isn’t that great of a product – like, at all. I’ve always felt that their movie catalog was downright awful, filled to the brim with low-budget features that close to zero people have ever heard of. Their television and original series content definitely offers a better selection, but they’ve never been able to convince me to pony up cash on a monthly basis. Alas, the numbers don’t lie – Netflix continues to beat street estimates for new user growth quarter over quarter. So when they announce they’re issuing a bunch of high yield debt to finance new licensing acquisitions and original content production on the back of parabolic customer growth, it shouldn’t surprise anyone. But I’m a cynical numbers guy, so I’m here to poke some holes in everyone’s favorite stock (and one of my least favorite products).

The content industry is very fond of off-balance sheet transactions, and Netflix is no different. The transactions materialize in the form of commitments to purchase content from production houses (Disney, Warner Bros., NBCUniversal, etc.) in the future for a few billion dollars. This ensures that Netflix is able to provide newer content for its audience as tastes change. The weird thing here is how these transactions are accounted for. Netflix amortizes these costs, through COGS adjustments, across the shorter of (i) what they deem to be the length of time viewers will continue to stream that particular show/movie or (ii) ten years, starting on the date that the content becomes available for streaming. As of 12/31/2017, Netflix had amassed $17.7B in content acquisition liabilities, of which $10.2B never makes an appearance in their financial statements as the content isn’t yet available for streaming on the platform.

Once you adjust for the off-balance sheet obligations, Netflix’s total liabilities jump from $15.4B to $25.6B at YE 2017 and $27.5B after this latest bond offering. Normally this wouldn’t be worrisome as your assets and liabilities rise in tandem – or so you thought, until you find this gem they buried in the footnotes of their 10-K:

“…content assets, both licensed and produced, are reviewed in aggregate at the operating segment level when an event or change in circumstances indicates a change in the expected usefulness of the content or that the net realizable value or fair value may be less than amortized cost. To date, the Company has not identified any such event or changes in circumstances. If such changes are identified in the future, these aggregated content assets will be stated at the lower of unamortized cost, net realizable value or fair value. In addition, unamortized costs for assets that have been, or are expected to be, abandoned are written off.”

Ah, yes – there’s always the risk that all of those content assets acquired in the off-balance sheet transactions may not really be worth the acquisition cost, in which case there will be sizable charge-offs that will directly impair their free cash flow (which is already running huge losses as they follow the Amazon business model). As the company continues to grow its customer base, it will need to go to market and increase the size of their content acquisitions, which will inevitably lead to a few charge-offs as their content portfolio expands. This isn’t really an issue from a microeconomic standpoint. It has the ability to become a macroeconomic issue though, if content providers decide they want a bigger slice of the Netflix pie and start jacking up rates for licensing, even as Netflix begins to experience some standalone charge-offs. Any rate increases will continue to hit Netflix right in their cash flow statement. This is the point at which they’d need to pass those costs onto consumers, but who is to say they’ll continue to pay up? Netflix has the benefit of being structured like a low-cost gym membership, where customers forget about (or don’t mind) the cheap, recurring charge hitting their account each month. Were those costs to rise, customers may be a little more sensitive as to what they really gain from their membership, and whether or not it’s worth it.

I’m not saying any of this poses a going concern risk for Netflix, either. I do, however, think it does pose downside risk for equity investors, especially if you’re buying at these levels. Institutional investors are well aware of the off-balance sheet transactions and their cash impact, they just haven’t cared because customer growth has acted as a buffer. If there are any hiccups in customer growth or worse, retention, then lookout below as content cost and cash flow profile move up the ladder of importance in valuing the company.

P.S. – If they knock The Irishman out of the park I will disavow everything I just wrote. Can’t lose with Scorsese directing that cast.

The Deutsche Bank Difference

“Bloomberg – Deutsche Bank Inadvertently Made a $35 Billion Payment in a Single Transaction“

Look, it’s 5:00pm on a Thursday – I want to go home, open up a nice old world red. Something to get the pallet dancing while I watch some playoff hoops. Complex tannins, high acidity, but nothing too extravagant. A nice every day wine, a workhorse wine if you will – Produttori del Barbaresco, perhaps.

But all that is on hold until I stick it to John Cryan one more time. As soon as I saw this headline come across, I absolutely knew that this wasn’t a recent event, that they buried this thing and, now that Cryan is gone, somebody spilled the beans. Turns out, they did this before Easter and by my quick calcs that falls under our boy’s tenure. Some back office kid in Germany was tasked with wiring the variation margin that day to their clearinghouse, Eurex. That’s it, just send some money to a different account. A simple task for most, but when you’re DB, you manage to bungle the easiest of things.

Now, I don’t want to get on this lowly analyst too much. I understand fat fingers happen – that’s why there’s industry jargon for it. But when you’re wiring cash in excess of the bank’s entire market cap, I know for a fact that there are multiple channels that have to sign off on releasing a wire instruction that large (I started out in ops, don’t lie to me). So unless I’m missing something, at least two people decided to send $35B to their clearing house that day – and that, my friends, is what we call the Deutsche Bank difference.

P.S. – that wine link isn’t even an ad. That’s just, in my opinion, one of the better, reasonably priced, old world’s you can find. Do yourself a favor.

Christine Lagarde: Noted ZeroHedge Reader

“CNBC – Global debt is at historic highs and governments should start cutting levels now, the IMF says”

*Sigh*

So, there’s been a lot of debt chatter coming out of the IMF recently. Just yesterday, we had them offer their unsolicited analysis on how the U.S. debt/GDP ratio will be worse than, gasp, Italy’s by 2023.  Today, we have Christine Lagarde, former French finance minister and current head of the IMF, imploring governments around the world to reduce their debt loads now while the getting is good. Don’t get me wrong, if you have the ability to reduce your debt burden in a responsible manner, do it. That said, just telling people debt is too high and that it’s a risk shows either a misunderstanding of the global financial system or an unwillingness to actually explain to people how it works and why we’ve racked up $164T in obligations.

The IMF piece focuses mainly on public sector debt as that has increased the most in the last decade, but we should touch on private debt first. Private, non-financial debt accounts for most of the debt globally, about 63% of it. In the last decade of low rates, households have borrowed to purchase houses, and corporations to fund domestic operations while leaving cash overseas and away from the tax man. In the case of the former, a house is a huge asset that can appreciate in value, be sold or be collateralized. In the case of the latter, the newly raised cash shows as an asset on the balance sheet while the bond appears as a liability, largely canceling each other out minus some interest expense. To the extent the cash is used for capex, that too will appear as an asset on a balance sheet as new equipment, property, investments, etc. In the end, the macro impact of private borrowing is a relative wash (barring credit cards and other consumer lending products, those are poor financial choices).

Let’s jump into public debt though, because that seems to be what’s worrying the IMF the most. They claim that debt/GDP ratios for advanced economies have only been this high once before: WWII. This is very true, but also very misleading. It’s helpful to understand the role government debt plays in a modern, credit-based economy before losing our minds.

Modern economies all have a (i) Government, (ii) Central Bank and (iii) Banking System. There are slight nuances here and there (especially in the Eurozone), but their functionalities are generally the same. Since all three of my readers are here in the U.S., we’ll use our system as a proxy for all developed economies. The Federal Reserve is the arbiter of the dollar. It controls the base money supply, credit availability / expansion, the cost to borrow in dollars, etc. It does this through what is called Open Market Operations (“OMOs”). This means that when the Fed wants to increase the money supply, they create some dollars and use them to buy shorter dated U.S. Government bonds. This pumps dollars into the banking system and reduces short term interest rates with the intent of stimulating the economy, and vice versa when the Fed wants to do the opposite. In a nutshell, the Fed uses the credit of the U.S. Government to conduct monetary policy. It’s no coincidence people say the dollar is backed by the “full faith and credit of the U.S. Government”, it’s a fact. Because of this relationship between the dollar and U.S. Government bonds, the two are more or less accepted universally as collateral in financial transactions (this is true for most other developed nations as well). At this moment, there are trillions upon trillions of dollars worth of government bonds posted as collateral all around the world, reinforcing trust in counterparties to transactions and keeping the system humming along. So while governments would be doing right by their taxpaying citizens to reduce or eliminate fiscal imbalances, a global, coordinated effort to actually pay down outstanding debt would wreak havoc on the financial system as bonds posted for collateral would cease to exist. Not only would there be a need to source new collateral to conduct transactions, the need would be great enough the materially impact interest rates and dollar reserves around the world. There’d be funding shortages, leading to soaring overnight and repo rates. It would be a mess (not cataclysmic, but messy regardless).

What’s also grinding IMF gears is not just the amount of public debt/GDP, but the pace at which it has accelerated over the last decade or so. The concern is understandable, but also a bit misguided. Since the financial crisis, central banks in the developed world have pumped trillions of dollars of liquidity into the financial system through Quantitative Easing (“QE”). This is a monetary policy tool in addition to the standard OMOs we discussed up top, and is used when conventional methods of stimulating the economy aren’t sufficient. The main difference between OMOs and QE is that the latter is more broad in its bond purchases, targeting government agency (Fannie, Freddie, et al.) and longer dated bonds. During and after the crisis, governments around the world, in tandem with their central banks, undertook an effort to recapitalize the global banking system through QE. For example, the U.S. Government would issue bonds directly to banks, who would turn around and sell the bonds to The Fed. At the end of the process, the U.S. Government has more debt, the banks have newly created cash and The Fed owns the bonds. This is where a lot of the incremental debt came from – a decade long effort to recap and stimulate the global economy through QE is directly responsible for the sharp uptick in public sector borrowing.

And that’s not a necessarily a bad thing. The Fed is what’s considered a quasi-government entity, but for all intents and purposes, it functions as part of the U.S. Government. If you think about it along those lines, you have bond issuance showing up as a liability on the U.S. Government’s balance sheet, but as an asset on the Fed’s. What’s more, the U.S. Government is paying interest to The Fed on the bonds, and The Fed turns around and writes a check each year to the Treasury to return the proceeds (minus operating costs). Lastly, The Fed reserves the right to buy and sell those bonds to conduct OMOs in the future, but it can also hold the bonds through maturity if need be, at which point the U.S. Government will either pay the principal to The Fed who will give it back at year end, or simply refinance the bonds in an endless cycle: wash, rinse, repeat. So yes, governments have been borrowing hand over first since the crisis, but when you combine central bank participation alongside how much government debt is owned by public and private retirement vehicles, much of it is actually owed to ourselves.

And that’s my problem with pieces like these. They’re all show and no substance. People read this stuff with the IMF stamp on it and then think they’re making informed decisions on how to invest, vote or spend – but they’re not. The only way modern capitalism works is the expansion of credit, not the contraction of it. Take a lap, Lagarde.

 

 

CLO Market Structures Credit Problems for Itself

“Reuters – US leveraged loan borrowers are increasingly switching to a cheaper short-term Libor rate to reduce interest payments, which is squeezing the returns of some Collateralized Loan Obligation (CLO) investors…”

Here’s an interesting battle brewing in the structured credit world, which was borne out of recent developments in the debt markets that originated on rates desks across the pond. Got it? Good.

So, there is this thing called LIBOR, which stands for London Inter-bank Offered Rate. It’s the rate at which banks around the world are willing to lend money to each other for different short-term maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. The longer the maturity, the higher the rate (for the rest of this blog, any reference to LIBOR means 3-Month LIBOR unless stated otherwise). Pretty simple. This rate is incredibly important because, logically, banks borrow money from each other at any LIBOR, add a few percent onto it (the spread), and then lend that money to retail and commercial clients (think car loans, credit cards, mortgages, corporate loans, revolving credit, etc.).

Some of those commercial clients are companies with poor balance sheets that need to borrow capital to operate, so they’ll tap what’s known as the leveraged loan market to do so. In a leveraged loan transaction, a bank will arrange and structure the loan, then sell pieces of it to other banks or investors to transfer some of the risk in a process known as syndication. Because the company borrowing already has a poor balance sheet, the participating banks view them to be at a higher rate of default and that is factored into the interest rate they charge, which is typically LIBOR + the spread (normally between 200 – 500 basis). Now, the thing with loans tied to LIBOR is that it changes every single day. Because of this feature, banks will usually reset the coupon every month or two in order to reflect whatever the current LIBOR is. It’s for this reason that you’ll see the terms leveraged loan and floating-rate loan used interchangeably. It just means that the interest rate on the loan changes periodically based on where LIBOR is moving (and you should check your credit card – I bet your interest payments are ticking up, as they’re floating-rate as well).

We said before that when a loan is syndicated, other banks and investors buy a piece of it and receive their portion of the interest. We know what a bank is but who are the other investors? CLOs. These are shell companies that go out and buy a bunch of different loans, structure their cash flows into debt tranches and sell them to asset managers, pension funds and insurance companies as investments. The debt tranches are just like bonds, each having a credit rating and an accompanying coupon payment based on the credit risk an investor is taking. There is also something called the equity tranche. Investors here are taking the most risk and only receive interest payments after all of the debt tranches have been paid off. Now, let’s get to the good stuff.

The post-crisis era has been a boon for the leveraged loan and CLO markets. Rates were low, so risky companies were able to borrow and investors were searching anywhere for yield, so demand for CLOs skyrocketed. Alas, the party wasn’t going to last forever, and now we have quite the credit quandary on our hands. 3-Month LIBOR has gone parabolic since about Thanksgiving 2017, which means that loan interest payments are ticking up in lockstep. No worries, though, we have a fix for that. Like we mentioned before, these loans are floating-rate, so their interest rates reset every month or two. Wouldn’t you know it, creditors are resetting these loans at the much cheaper 1-Month LIBOR in order to ease the interest burden on companies and prevent defaults. That seems great, and it is, for the banks and the companies that borrowed. CLOs aren’t enjoying it as much. See, the CLOs issued the debt tranches at fixed coupons which were tied directly to the interest they expected to generate from loans referencing 3-Month LIBOR. However, the underlying loans are now paying less interest as they reference the cheaper 1-Month LIBOR, which has created a mismatch between the CLO’s assets and liabilities. As a result, you have CLO managers trying to renegotiate coupons on tranches they promised to investors to reflect the cheaper rate, but investors are saying, “no thanks”. Can’t really blame them for not willingly accepting a lower return, can you? At the end of the day, these CLOs are taking in less money than they’re paying out, so someone needs to lose.

Raise your hand if you’re thinking “equity tranche”. That’s correct, these guys are gonna get smoked. They only receive what’s left over after the debt tranches are compensated, so any shortfall in funds will erode returns for these guys and impact what investors are willing to pay for an equity tranche in the secondary market – and that will also impact new CLO issuance as investors require more yield for their risk. At the end of the day I don’t think you’ll see any material impacts here, but you’ll most likely see funds write down some positions and perhaps a downtick in new issuance. The structured credit markets have always been fans of ingenuity, though, so I have no doubt they’ll come up with a mechanism to rectify this hiccup as well.

 

Larry Fink Only Needs to Build Another Eleven BlackRock’s to Catch Up to Schwarzman

“CNBC – Larry Fink, the chairman and CEO of investment management company BlackRock, is one of the latest Wall Street investors to surpass $1 billion in personal wealth, according to the Bloomberg Billionaires Index.”

On behalf of everyone at Leveraged Burnout (myself), I’d like to congratulate Larry Fink on finally crossing the billion dollar mark. After years of building BlackRock into the asset management behemoth it is today, Larry is finally reaping the rewards of his 0.7% stake in the company.

There is an interesting history between Larry Fink and Steve Schwarzman, CEO and founder of Blackstone. In 1988, Fink and his team was given a $5M credit line from Blackstone, in exchange for 50% of the equity, in order to build out an institutional fixed income platform. They named it BlackRock in order to establish that it was an entity within the Blackstone family. BlackRock began to take off and, with its success, came disagreements on management style. Fink and Schwarzman butted heads over equity compensation. Larry favored distributing equity to new hires to lure top talent, while Steve wanted to keep ownership with management in-house. Schwarzman and Fink amicably agreed to go their separate ways, allowing BlackRock to pursue any management style it saw fit.

The split was important not only for the two companies involved, but the broader financial services industry and its comp structure. Steve Schwarzman is worth about $12B today, while Larry just only crossed $1B. If you were to compare the two solely on the size of their wallets, Schwarzman obviously came out on top. Larry, however, used his equity as cash to build the largest asset manager on earth. At over $6T under management, BlackRock’s asset base crushes Schwarzman’s $430B, making it a much larger and more valuable company – which came directly at the expense of Fink’s own net worth.

So, I guess beauty really is in the eye of the beholder. Would you want the money, or the prestige that comes with upending an entire industry and becoming legend? It’s easy to be cynical and say take the money, but anyone that fancies themselves a Sandlot fan knows the answer isn’t so simple.

Extending Credit to Instagram Chefs Likely Not a Prudent Investment

“Bloomberg – Salt Bae Restaurant’s Owner to Start Talks on $2.5 Billion Debt“

So as a disclaimer, I’m pretty indifferent on Salt Bae. He rose to prominence last year, after the internet decided having a guy run salt through his arm hair before landing on your steak was appetizing. If that’s what the people want, then who am I to judge? I just saw this Bloomberg headline and knew immediately that I wanted to make a meme of him sprinkling coupon payment stubs on a steak, so now we have a blog post.

Anyway – it looks like Salt Bae’s restaurant, Nusr-Et, is owned by a Turkish Conglomerate, Doğuş Group, under their food and beverage subsidiary, d.ream International BV. From what I can tell, the Company has borrowed pretty heavily to bolster its international presence in the hospitality space, including restaurants. Oddly enough, the Bloomberg piece doesn’t mention why they’re looking to restructure 40% of their outstanding debt, so I’m going to infer that they’re currently dealing with an unfavorable coverage ratio. However, without the debt-fueled spending binge, NYC wouldn’t have been blessed with a Nusr-Et of our own – and what would NYC be without another overpriced, underwhelming steakhouse?

The company is looking outside the realm of restructuring to repair its balance sheet as well, including selling off assets. It recently sold a 17%, or $200M, stake in d.ream International BV to Temasek and British PE firm, Metric Capital Partners. Doğuş has also floated the idea of offloading its entire stake in d.ream International BV through an IPO, which should frighten Salt Bae. Once the public market gets its hands on a restaurant chain, the dynamic immediately switches to cost cutting and maximizing shareholder value. For a guy who built his entire brand on showmanship, quality ingredients and cachet, nothing should terrify him more than becoming the Turkish equivalent of Outback Steakhouse. So best of luck to our friend, Salt Bae, because if he doesn’t actually start raining coupon payments soon, he may be serving gimmick meals like unlimited Meze on Turkish Tuesdays, instead.

Barney Frank is Gonna Be Pissed…

“CNBC – Sub-prime mortgages make a comeback—with a new name and soaring demand“

The wheel. The printing press. Sub-prime mortgage securitization.

The three greatest innovations in human history. Prior to the wheel, ancient man was destined to live a relatively stationary life. There was no ability to explore, hunt and migrate beyond the area that you could walk and carry your belongings. It resulted in tribes and solitude. Before Gutenberg, Western Civilization was mired in a medieval rut. People relied on scribes to replicate texts, making it almost impossible to spread new ideas en masse. Once the printing press entered the scene, the great enlightenment took off, leading to what we know as The Renaissance. Preceding the boom in sub-prime mortgage securitization, banks were relegated to making markets in the infinitely boring world of agency paper and prime, private label mortgages. It was almost impossible to make a decent buck, the typical structured finance banker usually only had two or three different pairs of Gucci 53’s – these were trying times, indeed. Once Angelo Mozilo started slingin’ subprime credit around the West Coast, though, things would never be the same. Bankers were closing deals and collecting fees hand over fist. Working at a ratings agency wasn’t nearly as bad (this pertains to working in the structured finance group, can’t say the same for corporates or munis). There were even new industries growing as bankers left their analysts behind to set up their own shop as CDO managers. This was the height of human ingenuity and it changed the world (while making a handful of people a bunch of money).

Look – I’m not here to praise what happened with the sub-prime mortgage boom, but I’m not here to relentlessly bash it either, no matter how snide and sarcastic the previous paragraph was. There is no doubt that the boom in sub-prime credit and the securitization machine that fueled it played a large role in the financial crisis (side note: I wonder when we’ll stop calling it THE financial crisis, like there haven’t been many before and will be many after). But there were also other causes as well, like the rewrite of the Community Reinvestment Act in 1995, which incentivized banks to extend mortgage credit to communities with outsized populations of “credit deprived” citizens in order to stimulate local economies that needed it (good!). That also meant that banks needed to throw their standard underwriting practices out the window and lend money to people who were previously deemed unworthy of credit in the first place (bad!). One could also look to Alan Greenspan’s tenure at The Fed, where he opened the monetary spigots and took, what some believe to be, too much of a laissez faire attitude toward regulating the exploding sub-prime mortgage markets.

Securitization (sub-prime included) is a much-maligned, but widely misunderstood capital markets mechanism that does have great benefits. It plays a very important role in a modern, credit-based economy that takes place largely behind the scenes. The purpose of securitization is to assist banks in financing the borrowing activities of a large pool of individuals or corporations through the use of third party (investor) capital. The beauty is, you can securitize almost anything: mortgages, credit card balnces, aircraft leases, capital assets, you name it. Hell, even David Bowie securitized the future profits from his catalog. In a nutshell, banks are able to extend credit to borrowers, structure the future interest/principal cash flows from the borrowers into securities and sell those to investors. This allows the bank to move the debt off its own balance sheet, freeing up the capital to continue lending into the economy. This is a great thing if done in a proper way and I doubt everyone really understands how much of an impact it has on their daily life (including allowing us to live and spend the way we do).

Sure, things got out of hand last time and it really did blow up in our faces. But when I see alarmist headlines like this out of CNBC it makes me shake my head, because lending to people who need it is a good thing and all that does is perpetuate the belief that these funding mechanisms are inherently detrimental to society. Sub-prime mortgages and securitization didn’t cause the financial crisis, people did (and odds are, they’ll do it again with something else).

Blackstone Doing Its Damnedest to Ruin Blythe Masters’ Legacy

** UPDATE **

The CEO of Solus was on Bloomberg this morning explaining the situation. Great video if the blog below is a bit too arcane to read through.

“Bloomberg – The Great Blackstone Swaps Saga Just Became a Whole Lot Crazier“

Buckle up. This is a doozy, but it’s also one of the more ridiculous stories from the street in the last few years. It’s also a great example of what I alluded to in my very first post, where I opined that financial services has almost completed its transformation into a parody of itself. This may be the story that pushes it over the proverbial goal line.

Credit-default swaps (“CDS”) were invented in the early 90’s by Blythe Masters and her team at J.P. Morgan in response to the Exxon Valdez incident. JPM extended $5B in credit to Exxon for remediation costs after the spill and wanted to hedge the credit risk associated with it. For the uninitiated, investors buy CDS to hedge their long exposure to a company’s bonds, or, in the case below, short the company’s bonds outright and make money if they default. It’s simply an insurance policy against a company defaulting on their obligations.

The CDS market is governed by the International Swaps and Derivatives Association (“ISDA”), which is a self-regulatory committee that has developed the framework for what constitutes a technical default in the CDS market. There are many nuances and mechanisms  in the framework  that make determining whether or not a credit event has occurred more difficult than it should be (we saw this in the Greek sovereign debt debacle of 2012, which was eventually ruled a default after much debate). I don’t want to get into the weeds too much, but there is one mechanism we do have to touch on – that is “cheapest-to-deliver”.

The idea behind CDS is that they protect investors from default generally, not specifically. Meaning, it doesn’t matter which of a company’s bonds actually trigger the default. Once the ISDA committee determines a credit event has occurred, the company is now “in default” and CDS will pay out across the capital structure (equity not included, of course) in what they call a credit auction. The auction consists mainly of banks and investors determining at what prices they would be willing to buy and sell the defaulted bonds, which then sets the recovery and payout amounts. Once the trades clear and a recovery price is determined, the CDS will payout via a cash settlement. The payout will be equal to (1 – recovery %) * CDS notional amount. This is where cheapest-to-deliver comes in. If you are short bonds through CDS, you need to deliver bonds to the bank to settle the trade. Remember, we said CDS protects investors generally and not specifically, meaning if you need to deliver bonds for settlement, all you need to do is go out and source the cheapest one possible for delivery to the bank. For example: If I’m short a company’s bonds, I don’t actually own a particular bond to hedge. I’m purely gambling that they’ll default one day – so when they do, I just need to go out and find the cheapest company bond possible for delivery to maximize the payout. If you have the option to deliver a $20 or $30 bond on a $100 CDS, you deliver the $20 bond every time and take the $80 payout (this is oversimplified for purposes of the blog).

K, now that we have that out of the way we can get into the actual story. A couple of years ago, Blackstone (through their credit entity, GSO) put on a large CDS position against a New Jersey-based homebuilder, Hovnanian. They were betting that the company would default on its debt, triggering the CDS to payout and padding some MD’s pockets. Well, the thing is, that never actually happened and Blackstone decided they were going to do what it took to force a default. They offered to structure a refinance package which would have Hovnanian exchange their current bonds for newly issued ones at longer maturities, lower rates and, hilariously, a higher notional amount of debt on their books (while technically the incremental debt wouldn’t hurt them since the rates are so low and maturity so long, its funny to hear of a company solving their debt problems by adding more debt to its balance sheet). This means that the company says “Hey, we know you had $100 bond from us, but we’re gonna replace that with a new bond that says we owe you $125 now. Oh, and it’ll also be at a much lower rate and take us much longer to pay you back.” That crushes the value of the new bonds in the market, which would work precisely in Blackstone’s favor if the company defaulted and Blackstone was forced to deliver the bonds for settlement in the auction under the “cheapest-to-deliver” mechanism. The only thing left was figuring out how to structure the default. Well, the parties decided that a Hovnanian affiliate would buy back some of the old bonds before the exchange, and there would be a clause in the new bonds that prohibits the Hovnanian (and its affiliates) from making any interest payments on the old bonds prior to maturity, triggering a default – through a subset of bonds that only Hovnanian itself owns! For the avoidance of doubt, Hovnanian was going to halt interest payments it owed to itself in order to trigger the default. That’s just shameless.

Naturally, the banks and hedge funds that were on the hook for CDS payouts were less than excited about this newest feat of financial engineering. One fund, Solus Alternative Asset Management, is taking their grievances to the courts, which is fine (but arduous). However, there’s always been one firm that’s never been afraid to go to the mattresses, who wasn’t going to take this disrespect lightly. One firm who wields so much power in the markets that anyone would be crazy to cross them: Goldman Sachs. Goldman was one of the largest sellers of Hovnanian CDS, and they stand to lose a hefty amount if Blackstone pulls this off. They had been relatively quiet on the matter, until some chatter started popping up last week that Goldman, alongside Solus and Anchorage Capital, had been lining up enough demand for the defaulted bonds in the upcoming credit auction that they would be able to push the price up high enough to materially impact the recovery amount and wipe out most of Blackstone’s potential CDS payout – which makes sense! There should be demand for this company’s debt, they’re in an even better financial position in default than they were beforehand thanks to the refinance package. The value of Hovnanian CDS dropped sharply on the rumors and it appeared that Blackstone had met their match. That’s a veteran move by a market-maker that knows exactly what they’re doing – kudos to GS.

BUT… if you thought that was the end of it, you don’t know how petty money can make people. Hovnanian has now announced it’ll be exchanging an additional $840M worth of bonds at, once again, a higher notional amount, with a 3% coupon and a maturity date of 2047. That, my friends, is the most preposterous thing I have ever seen in my life. That’s almost exactly on par with what it costs the U.S. government to borrow money for thirty years, and these guys just build houses for a living. As you can expect, this will depress Hovnanian bond prices further should they decide to move forward with this newest exchange, once again putting Blackstone in a perfect place to cash in on their CDS position in the upcoming auction. As a result, their position has materially increased in value over the last couple of days.

Truth be told, this is a sad day. Blackstone is making a mockery of, if used properly, a great market mechanism to manage the risk associated with financing growing companies around the world. The CDS market suffered greatly in the post-crisis era of tighter regulations, but this will likely be the straw that breaks the camel’s back. The ability for a company itself to determine if and when it will trigger an unnecessary technical default makes the instruments utterly useless and, if that’s the case, then maybe the CDS should die because Pandora’s Box is now open. Markets do need a way to hedge credit risk, though. There just isn’t a clear alternative in the works yet. In my opinion, the easiest mechanism would be for re/insurers to be paid a nice fee to wrap each individual bond issuance with market standard triggers (just like their regular insurance policies), but that is probably unlikely after what AIG, MBIA and AMBAC did to themselves in the financial crisis. If anyone has any ideas, I’d love to hear them.