Tag: credit

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.

 

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).

You Cryan, Boy?!

“Reuters – Large investors in Deutsche Bank have urged its chairman to provide a clear signal on whether the board backs the lender’s embattled chief executive or not…“

Dead man walking. John Cryan is inevitably out as CEO of Deutsche Bank, and the announcement will come sooner rather than later. He was appointed CEO in 2015 after their board gave Anshu Jain his walking papers. So now, after a few years of unlimited brats and kraut, it looks like this native Briton is back to bangers and mash.

You hate to see someone get embarrassed on the public stage like this, but you also hate to hire someone who sucks at their job. Cryan was unable to maximize shareholder value, which is like, prerequisite #1 for being CEO of a bank. It is worth noting however, that he didn’t inherit a perfectly healthy institution, either – but he knew what the job entailed and came out of the gates with an ambitious restructuring plan called “Strategy 2020”. The whole thing was predicated upon firing a few thousand employees, raising come capital and reducing costs. Pretty standard stuff.

His real problems started in Q3 2016, when the U.S. government levied a $14B (eventually settled for $7.2B) penalty on the bank related to the marketing of crisis-era RMBS. In response to the financial crisis, European banks were required to raise capital to buffer themselves against a future crisis, and they used Contingent Convertibles (CoCos) to do it. These securities are designed to be wiped out first in the event of a credit crisis, forcing creditors to bail-in the banks vs. having central banks bail them out. Once news of the U.S. fine hit, DB CoCos got pummeled because markets knew they couldn’t pay up based on their cap structure at the time. Long story short, this whole mess wiped billions in market cap off the Company and forced it to raise $8B in equity a few months later – at a 35% discount (sheesh)!

Fast forward to today and the Company hasn’t turned a profit in THREE YEARS. Imagine that, a bank not being able to turn a profit in 2017. You gotta fire this guy, and I’m surprised it took so long. The ironic part is that he knew DB had to raise that $8B to save the bank, and the same guys he sold the equity to are making calls directly to the board to fire his ass. Tough look, John. Tough look, indeed. So let’s raise a glass to John Cryan, because at the end of the day, he no longer needs to live in Frankfurt – and that my friends, is a victory in and of itself.

Here’s the Thing About Energy Markets…

“Bloomberg – A pipeline shortage that’s leaving gas trapped in West Texas’ Permian Basin means prices for the fuel there are the lowest of any major U.S. hub, wresting that distinction from Appalachia’s Marcellus Shale. Prices for Permian gas, produced alongside oil in the play, have tumbled 32 percent from a year ago, while output rose to a record. And the pipeline crunch is also pummeling the region’s oil market.”

Energy production has always been a highly capital-intensive business. The dirty little secret of the U.S. shale boom is that fracing (not fracking, that’s how they can tell who the Yankees are) is not cheap, no matter what it costs to fill your car up at the pump. The costs of equipment, surveying, labor, licensing, water, sand and waste handling will run into the millions before a single well even comes online. So what did the industry do to juice their returns and ease the burden on their end consumers? Everyone, say it with me now: they levered up! It’s no coincidence the U.S. shale boom coincided with the post-crisis era of cheap money. The ability to voraciously borrow money from investors looking for anything resembling a decent yield fueled the fracing boom, as well as its eventual demise.

I spent a few years in Houston at an energy-focused PE shop, so this is a topic that’s near and dear to my heart. The U.S. energy markets have been in disarray since the end of Q2 2014. Throughout the shale boom, the strategy for oil companies was to lever up or issue equity to fund acreage development, then turn around and sell the company or specific assets to a strategic buyer to pay down debt and cash out their investors. The playbook was similar for infrastructure sponsors, except they used the capital raised to fund new pipeline assets that they would drop down into MLP subsidiaries that would be brought public. They’d use the IPO proceeds, and any dividend payments from MLP shares they retained, to fund even more pipeline construction. It was financialization at its finest. Oil companies would then pay fixed rates on long-term contracts to the MLPs in order to have their crude or gas shipped around the country to refineries. This was all well and good until 2014, when the energy complex collapsed in on itself under the weight of debt and over-production.

This brings us to today (and to this Bloomberg piece). The MLP model still hasn’t recovered and I’m not positive it ever will. The big retail pitch for owning MLPs in a portfolio was that it was yield-generating energy exposure without the commodity risk (which was true, until it wasn’t). While the MLPs didn’t have direct commodity price exposure, they had indirect capital markets exposure, and that would be their death knell. Once oil producers started defaulting on their debt due to tanking commodity prices, the MLPs were shut out of debt and equity markets as well – a little guilt by association. Without access to fresh capital, the infrastructure sponsors were unable to fund new pipeline construction and sell the assets into their publicly-traded MLP subsidiaries. Now, with massive debt loads and capex commitments to unfinished pipeline projects, the infrastructure sponsors went into survival mode: cutting dividend payments, selling assets and operating strictly out of cash flow. That last part is important – operating out of cash flow meant using huge chunks of FCF to service debt instead of building pipelines, which is why the Permian is in the odd position of having inaccessible, near-worthless gas assets. That oil and gas isn’t worth shit without the infrastructure needed to sell it into markets, no matter how prolific your acreage is.

What a conundrum. All this PE capital flooded into the Permian in 2016 looking for bargain basement acreage deals – and they got them. Now that the PE firms are all there drilling, there is too much production coming online and too little pipeline to ship the stuff. This is ironic because oil and gas acreage assets are valued by what’s in the ground, not by what comes out and makes it to market. The new problem that will (inevitably) come to the forefront is that PE firms never pay for these assets with 100% equity capital, rather they almost always issue debt or take on a revolver and collateralize it with the asset alongside some equity to fuel the drilling capex. That leads me to wonder, if pipelines aren’t built quickly enough for these PE-sponsored DrillCos to ship and sell product, will funds run into cash flow issues and be forced to start liquidating at a loss or, even worse, engage their lenders for a little restructuring? Should either of those scenarios play out, it would have a ripple effect on acreage prices throughout the Lower 48, likely kicking off a deja vu of late 2014. Round and round we go.