In the runup to the crisis, all it took was reasonably attentive reading of the Financial Times to discern that Things Were Going to End Badly. The big reason was that the pink paper did the best job of reporting on the credit markets of all the major financial outlets (Bloomberg did provide some corroboration). As the crisis progressed, the Wall Street Journal and the New York Times were forced to up their credit market game.
It is important to understand that financial crises are credit crises. The dot-com bubble was enormous, and margin debt was at a high level before it imploded. But the amount of borrowing related to equities simply wasn’t that large relative to the economy. Similarly, even though end of the Japanese bubble era did feature a major stock market contraction, the really reckless behavior was banks lending against land in major cities, particularly Tokyo. The value of real estate in Japan is attributed almost entirely to land, and the valuations had nothing to do with the income it produced. Companies simply never sold land. It was so highly prized that it would have been seen as signaling a level of desperation tantamount to selling your children into slavery. And on top of that, taxes on land sales were so steep as to produce a further disincentive. So with virtually no sales happening, valuations were disconnected from any discernible reality. Yet Japanese banks would lend 100% against the value of land in urban centers. And residential real estate was frothy, with 50 year mortgages the norm.
I’m getting a bad case of déjà vu from reading the Financial Times over the last week. And remember, this comes against a backdrop of a rise in investors willing to take on more credit risk out of desperation for yield. For instance, see this March Bloomberg story about subprime auto loans:
A three-year lending boom to car buyers with spotty credit that helped push auto sales to a six-year high is starting to show signs of overheating.
The percentage of loans packaged into securities that are more than 30 days late rose 1.43 percentage points to 7.59 percent in the 12 months ended September 30, according to Standard & Poor’s. That’s the highest in at least three years, the data released last week by the New York-based ratings company show.
Here are some of the stories showing the frothinesss in other markets:
This Time It’s Different, Not. Bundled debt demand reaching levels of height of crisis, Financial Times, from Monday. This story discusses how investors are eager to invest in collateralized loan obligations, which are CDOs made of leveraged loans created mainly via private equity acquisition financing. Note that is not quite as bad as that sounds, since CLOs were merely badly damaged during the crisis just passed, while what are commonly described as CDOs, which were made from heavily subprime-related credits, had much less risk diversification and were much more prone to catastrophic failure (and fail they did).
However, what is disconcerting about this piece is the barmy pretense that these new CLOs are superior to the pre-crisis versions:
Sales of CLOs, which pool leveraged loans made to low-rated companies, dried up in the years after the global crisis but have since come roaring back as investors seek out the higher returns on offer from buoyant credit markets…
Sales of CLOs in the US so far this year have reached 42bn and analysts are upping their full-year forecasts to as much as $100bn, which means issuance could easily surpass the $89bn sold in 2007 and potentially even the $97bn sold at the CLO market’s peak in 2006.
The CLOs sold now, known as “CLO 2.0s”, differ from their pre-crisis predecessors. Bankers pack the second generation of the products with additional financial support and have stricter rules about underlying collateral that are meant to make the securitisations safer.
One of my credit market mavens, by e-mail, begged to differ:
There is no new CLO structure. People are referring to the post-crisis world as CLO 2.0, but very little has really changed: some tinkering with the reinvestment period, collateral mixes etc. Many changes for the benefit of equity, lip service for the senior investors.
The rating agencies put out new criteria that were mostly just gobbly-gook. The only substantive change is not a deal level requirement but an issuer level one: the 5% retention requirement.
CLOs are just hedge funds for high yield loans with a slight bit of structure imposed on them. What matters is the manager, what he buys and how he buys (price, duration, etc.). The structure is pretty much an afterthought – it is a way to trigger and “fast” pay the pool if credit deteriorates. Most of the managers are just buying the market for HY loans (with 40% turnover or so a year in the investment pool) – few specialize in a sub sector. So any trigger event is usually a market wide one, not a portfolio specific one.
See this example of nonsense being passed off as change: https://gupea.ub.gu.se/bitstream/2077/33349/1/gupea_2077_33349_1.pdf
Careless Risk Acceptance. We see the related phenomenon of investors throwing what little caution they had to the wind via compromising on investor protections. Two recent examples:
Investors give up protection in ‘junk’ loans scramble Financial Times, today.
Investors in loans made to US junk-rated companies are giving up basic protection as they scramble for higher-yielding securities in a market that regulators warn could be overheating.
Call protection penalises corporate borrowers for repaying their loans at an early stage and was once a basic feature embedded in the majority of “leveraged loans” made to companies below investment grade. Investors generally like the call protection since it means they do not have to reinvest their money.
But in recent months the balance of power has tipped further in favour of corporate borrowers who can dictate the terms of loans. With demand for loan securities high, investors have been willing to buy higher-yielding loans with fewer safeguards – known as covenants – and with shorter call protection periods.
Kroll rates Invitation Homes $1B single-family securitization Housing Wire, last Friday. Key section of the story on the latest Blackstone rental securitization:
There are also two distinct differences related to tenancy in the IH 2014-SFR1 as compared to the prior SFR transactions, Kroll said.
For starters, all three prior SFR [single family rental] deals had fully occupied collateral at the time of the related securitization’s closing date; however, 5.1% of the properties in the IH 2014-SFR1 portfolio are currently vacant. Vacant homes create a burden on the borrower because these homes generate no income to offset fixed expenses such as real estate taxes, insurance and HOA fees, if applicable. However, KBRA’s analysis assumes that the portfolio will operate with some level of ongoing vacancy, which is typical for income-producing commercial real estate, including multifamily. In performing its analysis, KBRA applied a 10% vacancy rate assumption to the in-place gross revenue generated by each property, which is approximately double the actual vacancy rate of the portfolio.
Secondly, in all prior SFR transactions, each tenant was required to satisfy the requirements for an “Eligible Tenant”. The concept related to tenant quality and the criteria included, in the case of IH 2013-SFR1, the satisfaction of a minimum rent-to-income ratio and confirmation that the tenant was not subject to a current bankruptcy action prior to the execution of the lease. Failure to comply with the eligible tenant requirement would cause the related property to become a “disqualified property” that must be removed from the collateral through prepayment or substitution (unless the borrower deposited 100% of the allocated loan amount for such property in a reserve account).
“In the current transaction, the eligible tenant concept was removed; however, the property manager continues to employ a screening process that includes a review of credit and income, rental history and prior evictions and a background check for criminal activity,” the report states.
Translation: First, unlike the 3 previous rental securitizations, not all homes are rented in this one (5% are vacant at the start). Second, the deal no longer has an “eligible tenant” requirement, effectively a promise that current and future tenants would be credit worthy.
Land Rush into Novel, Untested Products. Jumping on the peer-to-peer gravy train FT Alphaville, Wednseday:
Hey, how would you like to invest in US credit card debt, via the UK’s tax free regime of individual saving’s accounts? You can’t yet, but the hedge fund Marshall Wace and broker Liberum are aiming to raise £197m for a investment trust listed in London to do just that.
For possible catches, you might turn to the 96 page prospectus that dwells on the risks at hand. But the chief pause for thought might be that this will be an expensive way to lend money to consumers and small businesses, offset by the use of some leverage to juice the returns back up.
Now, of course, this is all completely rational and in fact what we predicted. Blowing up the world economy was a very profitable exercise for the bankers involved. They got record bonuses in 2007 and even higher bonuses in 2009 and 2010. And the surviving firms emerged politically more powerful and too bigger to fail. Admittedly, while ZIRP and QE initially provided a lot of juice to bank earnings, a fairly flat yield curve, the absence of profit on float, and diminished volatility have over time taken away some easy and important financial firm profit sources, which has in the last year led to less robust bonuses and some headcount trimming. Nevertheless, as widening income and wealth disparity statistics confirm, the financiers came out well, which means they have no incentive not to revert to their old, successful strategies.
Now that central banks have improves their rescue playbooks, a September-October 2008 outcome seems unlikely. But the diversion of resources and profits from potentially productive real economy to the credit market casino has only become more deeply institutionalized. It’s hard to see how this resolves, but the ending is unlikely to be happy for ordinary citizens.