MFA Financial and Invesco Mortgage Capital: COME ON DOWN! You’re the next mREITs to succumb to the turmoil in repo markets and beg your counterparties to enter forbearance agreements!
Jokes aside, these are big ones. Invesco and MFA have $17.5B and $9.5B in current financing arrangements, respectively. Both missed posting collateral to cover their margin calls as of close of business yesterday. I don’t see a need to get into details about why this is happening, as you already know the story.
This is a big deal, though. You now have four different companies that need to (i) either convince all of their counterparties to enter into the forbearance agreements or (ii) dump their assets into the open market to raise cash and basically implode the mortgage bond market – simultaneously. I can’t imagine a scenario in which they can all convince their counterparties to lay off, as I’m sure there is overlap between who is providing these companies with financing. Some of these firms will have to go away, and it will be the smallest to liquidate first.
In any event, there is a fire sale looming in the mortgage bond market and it may get pretty ugly.
You always have to think bigger picture. Just yesterday I touched on the mortgage market unraveling and, in my hubris, declared I thought that Cherry Hill Mortgage would likely be the next victim. Obviously, having a direct competitor of MITT and NYMT be the next shoe to drop seemed likely – albeit it predictably boring. Then, out of nowhere, Bloomberg drops this bomb about ED&F Man just to shake things up a bit.
To be clear, ED&F is not in the same business as MITT or NYMT. They’re a traditional broker-dealer, making markets and structuring products in a variety of different assets classes (they’re traditionally an agricultural and commodity-focused merchant). The firm is over 200 years old and much more well capitalized than the mREITS so, were things to get even more dicey, they would likely be able to source liquidity in some way, shape or form to avoid disaster.
Anyway, back to the fun stuff. ED&F transacts in a space known as the TBA (to be announced) market. TBAs are pass-through securities issued by Fannie, Freddie and Ginnie. It’s essentially a contract to purchase a mortgage bond in the future. To be clear, you’re agreeing to buy pools of mortgages in the future but you’re unaware of which pools at the time of the trade. This seems risky at face value, but the securities are issued by government agencies and are normally of the same general quality, so the market runs efficiently and the risk is generally well understood.
It seems that ED&F was long TBAs, essentially taking a long view on the price and performance of U.S. mortgages. The thing you fear when long mortgage bonds (besides non-payment) are falling mortgage rates. When mortgage rates decline, people generally tend to refinance their mortgages. This (i) eats into the interest payments an investor had planned on receiving when they bought the bond and (ii) forces them to invest the recently returned principal into lower-interest mortgages, leading to losses. As prudent risk managers, ED&F hedged against this by shorting 10-year treasurys because normally mortgage rates are inextricably tied to this benchmark. If mortgage rates were dropping, so would the yield on the 10-year, thus mitigating much of the downside risk for ED&F.
Wrong! Times are not normal, adjust your hedging strategy accordingly. The long mortgage / short treasury trade has exploded in the last few weeks, as investors have dumped mortgage bonds over non-payment fears related to COVID-19 and piled their cash into U.S. treasurys as a flight to safety. As a result, ED&f posted $100M in additional collateral just on Friday.If the precipitous fall in mortgage bonds continues, the firm will likely be hit with additional margin calls, further straining their liquidity profile.
Again, I actually do not believe that ED&F Man is in any real trouble. They’re relatively large, liquid and have great counterparty relationships. If they need to tap equity or debt markets to raise additional capital, I don’t doubt they’ll be able to do it. That said, they’re not the only firm with this trade on at the moment, so if they’re feeling the heat, I’d imagine some other firms are, too.
In my last post titled “I’m Back. Markets Are Not.”, I spoke about how repo market liquidity was drying up and why it would impact counterparties that rely on the market for financing. In the post, I used mREITs as an example of how dire the situation had become, as investors began dumping their shares hand over fist in an effort to get ahead of any possible solvency issues:
“The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.”
As of 6:30am ET this morning, we received our first look into how bad it had really become. AG Mortgage Investment Trust (NYSE: MITT), a publicly traded hybrid mREIT managed by Angelo Gordon, filed an 8-K stating that they had missed posting collateral Friday evening for their margins calls, and that they do not expect to be able to meet expected margin calls later this week. As a result, they’ve entered into discussions with their financing counterparties on forbearance agreements in order to avoid triggering a technical default under their current financing agreements. MITT’s stock cratered, both common (-38%) and all classes of preferreds (-66%). The only reason the common wasn’t down in tandem is because it had gotten absolutely massacred as of late, but pref investors up until now thought they may be spared from the carnage of dividends cuts / suspensions.
It’s hard to say what exactly is happening at MITT, but I think I have a pretty good idea so I’ll take a stab at it. MITT has an investment portfolio of $4.3B, but only $3.4B is comprised of relatively liquid mortgage securities. The rest of their portfolio is made up of illiquid whole loans, commercial loans and investments in affiliate entities (and very, very little cash). Alongside those investment assets, MITT has $3.5B in current financing arrangements. In and of itself, this isn’t a problem – MITT’s business model is to utilize leverage in order to juice returns for their investors. The problem is that the market for mortgage securities is, to put it nicely, in a state of uncertainty. Investors are worried that in light of the COVID-19 pandemic, mortgages will not be getting paid – which would impair the mortgage bonds that MITT owns and effectively eliminate the bid for the bonds in the open market. As a result, investors are dumping the bonds and as the value of the bonds decline, MITT’s financing counterparties are demanding they post more collateral to support their positions.
Enter the negative feedback loop. What I believe is likely happening to MITT is simple: (i) the value of the bonds they own decline; (ii) they’re required to post additional collateral; (iii) they become a forced seller of the bonds to raise cash at whatever respectable bid they can find; (iv) forced selling at buyer-friendly prices leads to larger bond price declines; and (v) MITT is now required to post more collateral. Trying to sell securities into a down market that’s experiencing liquidity issues in an effort to cover margin calls will usually result in one thing: insolvency. If they can’t convince a large majority of their counterparties to enter forbearance agreements, it will likely be impossible for MITT to liquidate assets in an orderly manner to fulfill immediate repayment obligations. Barring some sort of miracle, MITT is essentially toast.
I don’t want to pick on MITT though, because they’re not the only one going through this (and they won’t be the last). This evening, New York Mortgage Trust (NYSE: NYMT) issued a press release stating that they too were unable to meet margin calls issued for today. As a result, they’ve preemptively suspended all dividends on common and preferred shares, likely diverting that cash to help shore up their collateral position. I suspect we’ll see more actions like these from competitors and, as a betting man, I’d put my money on Cherry Hill Mortgage Investment Corporation (NYSE: CHMI) to be the next shoe to drop.
The regrettable part about this mess is that to a large extent, these firms didn’t really do anything wrong. They acted within the manner they told investors they would, using leverage to finance the U.S. mortgage market. The bonds they hold aren’t dogshit like they were during the GFC, they’re just being adversely impacted by some black swan virus that threatens to decimate the global economy. That won’t matter, though, people will still peg them as reckless when shit hits the fan:
In any event, I think this whole thing is just getting started. The credit markets remain strained despite all of the help pledged by the Fed. The government is amazingly repeating the mistakes they made during the GFC by bitching and moaning about fiscal stimulus. Markets will likely continue to decline and the real economy will continue to bare the brunt of everything. As I see this all unfolding, I’m reminded of a great quote from everyone’s favorite Marxist, Lenin:
“There are decades where nothing happens, and there are weeks where decades happen.”
There is a chance we’re living through a few weeks that will define the next decade and beyond. The bankruptcies of some obscure mortgage funds won’t cause the next great financial upheaval, but they’re sure as hell trying to let you know that one is lurking around the corner.
The bull market is dead, LONG LIVE THE BULL MARKET!
This fucking virus, man.
I’m not an epidemiologist or virologist, so I’m just going to focus on the market impact here. Cities around the world are effectively shutting down in an effort to contain COVID-19. Aside from the loss of life, these measures are also presenting real challenges to the short-to-medium term viability of the global economy. Credit is freezing up, equity investors are getting hosed and the real economy is suffering from reduced spending. So, what’s going on here?
The credit markets are shutting down, a la ’08-’09.Anyone that lived and/or worked through the GFC knows this all too well.
The first major problem is the commercial paper market. At a high level, this is where corporations come to finance their payroll, accounts payable and other short term costs. Essentially, a company will issue a short term note (usually for a few days but no longer than 9 months), issued at a discount to the par value of the note, in exchange for cash now. The notes are issued at a discount to par which then becomes the investors’ return upon repayment. Since we’re talking unsecured notes, the credit quality of the companies issuing commercial paper is relatively high quality. This is a very mature market that normally functions incredibly well.
Enter COVID-19. As citizens around the world hunker down to “flatten the curve” of new virus cases, the obvious concern for investors has become the implications of what it means to shut down the global economy and how that impacts the liquidity profile of companies. We should even be discussing whether certain companies will be able to operate as a going concern in the future. Worries about liquidity have forced the hand of commercial paper investors: if they’re not sure whether you’ll be generating enough free cash flow through ordinary operations to pay back the notes, then they’re also not sure they’ll lend you the money.
Were the entire market to seize up like it did in the GFC, the effects on both the real and financial economy would be devastating. You’ll see companies struggle to make payroll and pay their bills, which will lead to lay offs and plummeting share prices as equity investors try to assess what it all means for profitability.
The second major problem we have on the funding side is the repo market. This is where banks and financial institutions come for short term financing (similarly to the commercial paper market for companies). A borrower will sell high grade paper (usually government bonds or agency-backed paper) to investors, with a contractual agreement to repurchase the collateral from the investors at a slightly higher price in the future. The repo market is massive, trading anywhere between $2 trillion – $4 trillion EVERY. DAY.
There is an immense amount of friction within the repo markets at the moment. Banks see that a recession (possibly depression) is now inevitable, and there will absolutely be some corporate casualties. They’re becoming more and more skeptical of lending to each other and any market analyst worth their salt knows this is always the kiss of death. The Fed has implemented a handful of programs in excess of $2 trillion to keep the repo market open, but the impact of even those efforts has so far been, muted. If you need just one example of how exacerbated the issue has become, look no further than the mREIT space.
While most people are familiar with the equity REIT space (buying properties and profiting from rents and/or capital appreciation), mortgage REITs (or mREIT) are a bit more opaque. Their business model is to borrow in the repo market at 4-5x leverage in order to finance the acquisition of mortgage-backed securities or originate whole loans themselves. Here’s a one month look at what happens to a highly-leveraged repo participant’s share price when the market starts to freeze up:
That’s not great! The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.
But here’s my number, so call me maybe…
Equity markets are plummeting. Gold was rallying but then fell off a cliff. Bonds rally and sink every other day. Oil isn’t remotely putting up a fight. Even fucking bitcoin looks like shit. Everything is selling off. How can that be? Where are the safe havens? Oh, that’s right:
SELL IT ALL! The ultimate feedback loop. Markets spiral > PMs sell to cover margin calls > forced selling tanks markets further > PMs sell more to cover more calls.
The stock market has been on an 11 year tear. The economy has been on fire, juiced (perhaps irresponsibly) by the Trump tax cuts. Credit has been pretty loose in a post-GFC era. It’s not difficult to imagine why portfolio managers around the world borrowed money to buy stocks and, to be fair, I don’t think you can ask a PM to hedge for pandemic-related exposures, either. After all, they don’t make a derivative for that (paging all structured products desks).
That said, none of that matters in this moment. The leverage in the system has exacerbated the equity sell off we’re seeing now, and it’s impact is going to be felt not just by fund managers, but by anyone with a 401-k, IRA or brokerage account. Those are real losses that are going to trickle up into the economy via reduction in consumer discretionary spending.
C.R.E.A.M.
The dollar is absolutely ripping, no surprise. There are a few reasons for this outside of the traditional safe haven trade.
The first is that since the U.S. capital markets are so dominant in the global economy, international investors have a lot of U.S. exposure. Typically, they’ll hedge their FX risk by selling USD and buying their local currency in their portfolios. The problem is that when U.S. markets start collapsing or fund managers begin selling, they’re left with hedges that are notionally too large for their overall U.S. equity exposure. This leads the international fund managers to scramble for the dollars needed to pare down their USD shorts in their portfolios.
The other reason, which hasn’t been in the headlines yet, will end up being the Eurodollar market. A Eurodollar is essentially a USD-denominated bank deposit that lives outside the U.S. financial system. The purpose of this market is avoiding U.S. capital requirements. In a Eurodollar transaction, an international bank will issue a short term deposit instrument to investors that will be denominated in USD. The deposits immediately become a USD-denominated liability on the bank’s balance sheet. This is all well and good in prosperous times. However, the rapid ascent in the value of onshore dollars during a crisis has a devastatingly deflationary effect on the international bank’s USD-denominated liabilities. Every time the USD increases in value, it costs more money for the international bank to repay the deposit instrument (their liability). This will likely force the international banks to go to market and purchase dollars as quickly as possible to avoid any more losses, akin to a short squeeze:
Combine the traditional safe haven trade, a general unwind of FX hedges and a Eurodollar squeeze, and you’ve got the recipe for a global dollar funding shortage – better known as a good ol’ fashioned liquidity crisis.
Where do we go from here?
The pain is likely to just be getting started. As quarantines become more prevalent, so will their impact in the economy. Institutions will continue to have difficulty funding their operations and share prices will continue to fall. Aside from markets imploding, however, there will be real human costs to this crisis.
There are thousands of restaurants and bars across the country (and millions across the world) that will never open again. Those people will lose everything and so will their employees. The supply chain is going to become increasingly strained as borders shut, likely inducing shortages of some goods. People are going to lose their savings, and that will take an indescribable toll on some.
Who knows what the next 12-18 months holds in store for everyone. All I know is that it’s getting weird out there and I’m not sure I have enough wine stockpiled. All we can do is sit back, go cash and enjoy the show.
Waiting for the coming recession is going to be like ordering an UberX: you know it’s going to be a terrible ride, but you won’t really know just how bad until that black Camry with seat protectors pulls up.
Bill Ackman had the idea to raise a permanent capital vehicle a few years ago via a closed end fund (CEF). Without getting too much into it, many times a CEF’s stock will trade at a discount to its net asset value (NAV). This can happen for several reasons: (i) the fund has a high concentration of illiquid assets, (ii) it may have an outsized amount of leverage within the vehicle, (iii) it may just be a function of the yield / distributions, etc. Many times when the discount persists, funds will use cash flow to buy back stock, close the discount gap and keep investors happy. Bill Ackman is not doing this. He has instead decided to raise $400M in new debt and ante up, which has rightfully pissed off investors. Their argument is essentially:
“Look – we understand using leverage to increase returns for equity investors, but there are two ways to do that. Instead of raising new debt to purchase additional assets, why wouldn’t you just buy back a bunch of stock to reduce the discount to NAV? You could’ve easily done that and gotten your leverage ratio to the same levels as you did by borrowing the new money and forcing additional free cash flow to interest and principal payments.”
I’m not gonna lie, either – they’re right. It really doesn’t make any sense, when you have two options for levering up, to choose the option that is less advantageous for your shareholders – unless you understand Bill Ackman. AVI alludes in the following quote that Billy Boy is motivated by one thing only – greed:
“We note Bill Ackman’s comments in PSH’s annual report on buybacks and leverage: “Buybacks have other drawbacks as they reduce our shareholders’ equity and increase our leverage. We would not be surprised to find that a higher leveraged PSH trades at a greater discount to NAV when compared to a less leveraged PSH”. Given gearing was at 20% when this report was written and the new debt issue will see this increase to 25%, it seems Bill’s aversion to an increasing leverage ratio could more accurately be described as an aversion to shrinking the assets on which management fees are earned.”
While true that Ackman would lose fee revenue by shrinking the equity float, this isn’t why he’s chosen to forgo that strategy. Anyone who has been following Ackman throughout his career knows he isn’t motivated by greed – he’s motivated by his insatiable need to prove how great an investor he is. The real reason he’s decided it’s better to lever up with new debt vs. shrinking the float is that he believes he has a real, long term winner lined up and needs some capital to play with. In his mind, he is going to out gain any short term stock improvement from buybacks with good old fashioned alpha generation.
You have to remember, though, that Bill Ackman is the best, but he’s also the worst. He’s the guy that correctly called the subprime crisis and made a killing on his MBIA play. He’s the guy that parlayed a $60M investment in General Growth into a $1.6B stake post-turnaround. He’s also the guy that blew up his first fund, Gotham Partners, by piling capital into a portfolio of illiquid investments and golf courses. He’s the guy who lost, quite publicly, billions of dollars on a poorly executed bet on Valeant. Lastly, he’s the guy who picked a fight with both Herbalife and Carl Icahn, only to lose more money and his own dignity, on national TV, in the process.
That’s why I have zero sympathy for this rinky dink fund that is upset with this atrocious allocation of capital. Ackman is undoubtedly smart. Ackman is undoubtedly smug, as well. You pay him to manage your money, not the other way around. So don’t sit there and be a backseat driver while he’s out here picking winners (or massive losers). That’s always been Billy’s style and your diligence team should’ve picked up on that. Regardless, you’re about to make a lot of money or lose it all. The only thing you can do is sit back, enjoy the ride and just:
“The gift that keeps on giving: the 2008 financial crisis.”
Well six months later that statement still rings true, of course, as we see one of the juicier stories of the crisis resurrecting itself: Goldman’s family of Abacus CDOs. While this isn’t the same exact Abacus deal that placed Goldman and Paulson & Co. into the crosshairs of regulators, I can’t pass up an opportunity to discuss some crisis-era structured credit.
Goldman sold investors a synthetic CDO called “Abacus 2006-10” in the early spring of ’06. A synthetic CDO is a bit arcane of a concept but not that difficult to understand if it’s explained properly. Basically, Goldman had exposure to a bunch of mortgage bonds, known as reference obligations, and they were looking to hedge the risk of the bonds from default. They found a group of savvy investors to fund a special purpose vehicle (“SPV”) that would write Goldman a credit default swap on their reference obligations and Goldman would pay the investors quarterly premiums for that protection (just like insurance). But, if any of the reference obligations defaulted, then the investors would have to pay Goldman on that loss. At the end of the trade, the investors get back anything that’s left in the SPV (hopefully 100% of their principal) plus the premiums they had been receiving all along.
When the investors buy into the CDO, they don’t keep a bunch of cash in the SPV, though. That cash is managed by Goldman to build out a portfolio of high quality bonds, known as the collateral pool. Then, if any reference obligations default, the collateral is sold down to pay out Goldman. However, if nothing defaults then Goldman gets to keep any of the carry generated by the collateral pool – the CDO investors see none of it (which may sound unfair at first). But! While Goldman gets to keep any carry generated, they also need to reimburse any losses the pool suffers from poorly performing collateral so, ipso facto the CDO investors shouldn’t care about the collateral pool performance, just the reference obligations (which is exactly what they signed up for). The performance of the collateral pool has no bearing on the CDO investors’ return profile – only reference obligation performance does. It sounds quirky but this is just how the synthetic CDO market is structured and it’s players can at least agree on that much.
Here’s where it gets hairy. This distressed credit fund, Astra Asset Management, is claiming that Goldman breached the CDO’s collateral pool requirements in 2013 by purchasing riskier bonds that didn’t meet quality requirements laid out in the indenture. They’re now suing to terminate the CDO contract as of 2013 and insisting that Goldman return $124M in default payments that they received from the CDO over that period. On top of that, wouldn’t you know it, the CDO is overcollateralized by ~$70M and Astra wants that too. Although, it seems pretty clear cut the excess collateral belongs to Goldman – not sure what the legal basis would be for that.
Goldman’s counter to all of this is that the indenture is pretty clear that they’re responsible for any collateral shortfalls like I mentioned above, so even if they technically did breach the agreement they never put any CDO investors at risk as they’d make the pool whole. That makes sense, but it also makes sense that if there’s a technical breach of contract the infringed upon party has some sort of recourse. In the end, I doubt this moves works for Astra but kudos to them for trying. Either way, I’m just happy to be talking about Abacus deals again.
I never pass up an article about mortgage markets, so once I saw Bloomberg offering their opinion on why Fannie and Freddie are “still a mess” ten years into conservatorship, I was in from the jump.
Outside of the economic and reputational damage it caused, I’m a big fan of the Financial Crisis, even the fact that we call it “The Financial Crisis” – like there never was or never will be another one. I’m a big finance guy and even bigger policy wonk, so the storylines that emerged out of that period are right up my alley. Most have played out in full and been relegated to the dustbin of history, becoming more folklore nowadays than relevant discussions. There is one that remains, though: the re-privatization of Fannie Mae and Freddie Mac.
Fannie and Freddie are known as Government-sponsored Enterprises (GSEs). They’re private companies that were basically granted monopoly status by the U.S. government in order to keep the mortgage markets functioning smoothly and encourage home ownership. They each have lines of credit with the Treasury Department, are exempt from state and local taxes and, despite being publicly-traded, they’re not regulated by the SEC. Their business models consist of buying private label mortgages, securitizing them and then guaranteeing the mortgages to ensure that interest and principal payments are made on the subsequent mortgage bonds.
The idea at the time was to bail these two private companies out, stabilize the mortgage markets and then return them back to shareholders at a profit for the taxpayers a la the AIG bailout. However, ten years into the bailout and the government is not one step closer to figuring out what the future will look like for the companies. The problem is two-fold here and, surprisingly, has nothing to do with partisan politics. The first issue is that the two entities are so massive, so integral to the U.S. economy, that any sweeping changes would require years of heavy lifting and, with the stakes so high, nobody has tried in earnest to restructure the companies and return them to private investors. The second issue is that well, the current structure is… working? We’re ten years into this relationship and so far, so good. The mortgage markets are running as smoothly as ever, Fannie and Freddie have returned to profitability and the Treasury is clipping a 10% coupon on its preferred interests. Not to mention, the Treasury mandated that any profit Fannie or Freddie generate be remitted to taxpayers in the form of dividend distributions as well. If you need a summary: the bail out worked and the taxpayers are making a killing. Status quo is always good for governments and this situation is no different – if it ain’t broke, don’t fix it.
Unsurprisingly, not everyone feels that way. Some big name funds like Paulson & Co. and Fairholme have taken large stakes in the companies’ remaining public equity and have preached, quite loudly, that the companies should be returned to private investors and that they’d be able to were the Treasury not siphoning their profits each quarter. On the other hand, you have some politicians that believe the mortgage markets should be a private capital game or that the current situation is an unsustainable band-aid fix.
To these parties I ask: why? For what reason is the current situation unsustainable? Why is it imperative that Fannie and Freddie regain their status as private companies? Forget the fact that Fannie and Freddie were never truly private – any company with tax exempt status and a revolver with the Treasury is far from private. The fact is that homeowners are able to take out reasonably priced mortgages from private companies, bond investors are getting their low risk yield and the taxpayers are making money. The system works! “But it’s a band-aid fix! It was never meant to be this way!” True, very true. You know what else is true though? Every day the government doesn’t do anything to amend the current structure is a day the band-aid fix becomes a little more permanent. Slowly and slowly, as new and old elected officials move in and out of Washington, each Congress becomes a little more detached from the whole thing and will elect to do nothing – as long as everything is functioning as it should.
If you take a step back and actually look at how the system is working now, it seems like this is how it was always supposed to be. Private companies are investing in the mortgage market, consumers are buying homes, taxpayers are generating a profit and the government has a policy tool in Fannie and Freddie. Don’t get me wrong, that was not by design. It was a happy accident that the feds stepped in for a decade and have been successfully running the largest financial services companies on the planet. Let’s not screw this up.
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.
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.
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).
