By David Dayen, a lapsed blogger
I wasn’t entirely sure if the implosion this week of Third Avenue Management’s Focused Credit Fund was an elaborate advertisement for the release of The Big Short or what, but it certainly feels like a familiar early data point, not for mortgages this time but for something we’ve been tracking for a while: the high-yield bond sector.
Here are just the facts from Bloomberg:
A $788 million mutual fund is blocking clients from pulling their money so its holdings can be liquidated in an orderly fashion.
Martin Whitman’s Third Avenue Management put some of the assets in the Third Avenue Focused Credit Fund in a liquidating trust that will seek to sell them over time, the New York-based firm said in a statement on its website dated Dec. 9.
The step is unusual for a mutual fund, which typically offers daily liquidity to investors, and comes after regulators raised concerns that some mutual funds are investing in assets that could be hard to sell in a market rout. David Barse, Third Avenue’s chief executive officer, said blocking redemptions was necessary to avoid fire sales. The fund, which had $3.5 billion in assets as recently as July of last year, suffered almost $1 billion in redemptions this year through November.
The buried lede is the 77 percent drop in assets in just 18 months, from $3.5 billion to $788 million. That’s kind of the very fire sale that Third Avenue belatedly took evasive action to prevent.
I did a long exploration into leveraged loans for The Progressive in mid-2014 that they never put online – maybe I’ll post it this weekend. Here’s a taste:
Since March 2009, the junk bond market has doubled to $2 trillion, as worries about risk have flown out the window. Got an idea for a vegan restaurant on a cow farm or a lingerie shop in a nunnery? No problem, some investor will lend you lots of money…
Loans… are often “covenant-lite” leveraged loans, a type of junk bond that offers fewer safeguards for investors. Given the desperation for higher yields, investors foolishly accept higher risk to get their hands on low-grade corporate debt. So under the terms of these loans, investors do not get informed when the underlying companies run into financial trouble, making it harder to avoid losses…
Smaller and smaller firms were the beneficiaries of these loans, like Learfield Communications, a media group with $40 million in annual revenues that received an incredible $330 million in covenant-lite loans last October. It’s correct to call this the “subprime of the corporate world.”
More recently, Naked Capitalism has had Wolf Richter walking us through the coming carnage for over a year now. The basic story: the junk bonds are losing altitude, thanks mostly to losses in high-yield energy debt, with oil prices flatlined. Third Avenue’s FCF had some energy but also a number of companies acquired in large leveraged buyouts, so this is a private equity issue as well.
More and more corporate debt has become distressed, and the vultures lured into buying the wounded animals are taking their own hits now, as these companies default. Standard & Poor’s counts 102 defaults among corporate debt issuers, the most since 2009. S&P’s “distress ratio” is up to 20 percent and rising; for energy debt that’s up to 50 percent.
Late Friday, the next shoe dropped: distressed-debt specialist Stone Lion Capital froze redemptions in their oldest fund. I should note that Stone Lion is a major player in the Puerto Rican debt crisis, and this trouble, especially if it spreads to other vulture funds, could impact that situation, though I’m not certain in what direction.
These are really just shadow bank runs. And for a mutual fund that allows investors complete liquidity, that’s fatal. Wolf notes that there’s a big short going on here, too:
When an “open-end” bond fund starts losing money, investors begin to sell it. Fund managers first use all available cash to pay investors. When the cash is gone, they sell the most liquid securities that haven’t lost much money yet, such as Treasuries. When they’re gone, they sell the most liquid corporate paper. As they go down the line, they sell bonds that have already lost a lot of value. By now the smart money is betting against the fund, having figured out what’s happening. They’re shorting the very bonds these folks are trying to sell.
The longer this goes on, the more money investors lose and the more spooked they get. It turns into a run. And people who still have that fund in their retirement account are getting cleaned out.
I don’t know how many retail investors are exposed, but I’d bet they don’t know either. Wolf estimates the junk bond market at $1.8 trillion, so it’s sprinkled everywhere. Even Valeant’s debt is distressed.
Liquidation of Third Avenue’s Focused Credit Fund will take over a year. But it’s investors in similarly situated funds, and whether they panic, that will determine the course of this event. So far it looks pretty bad: Wolf reports that $3.5 billion in retail cash fled US junk-bond funds over the past week, $2.8 billion of that from mutual funds.
I think asking “will this be the next crisis” is in a way besides the point. All crises are not created equal. But if anything, the experts and pundits are underpricing the risk. For starters, a lot of this debt was securitized, packaged into collateralized loan obligations that were privately traded, so we have no clue of the level of risk. Many CLOs were synthetic, too, and a good number of hedge funds bought CLOs with borrowed money. So Third Avenue, and like-minded distressed-debt specialists, are one thing. The real question is how the CLO holders hedged themselves, and who else has a piece of this crap.
Traders trying to minimize the damage are moving into options, but that may not hold out. And of course we’ll have a Fed rate hike, in all likelihood, interacting with this next week.
In a sense, this is a real-economy crisis – the slow, inevitable crash of the energy sector during an oil glut – magnified by financial engineering. If you think of it that way, you can envision the battle in Congress right now over whether to lift the oil export ban as a pre-emptive bailout, as if there was a bank bailout back in mid-2006. But even lifting the ban appears to be more like applying a band-aid when you need a tourniquet. Even with the ability to export, U.S. energy producers will still have to sell into a global market, probably with even lower prices if it gooses production in the short term. That’s not going to solve the problem. And it’s not going to unwind the toxic debt instruments.
Martin Whitman, Third Avenue’s founder, literally wrote the book on distressed investing. But their investing strategy – putting high-risk investments into a mutual fund – seems like exactly what not to do, especially if a systemic downturn hit any portion of the corporate sector. I already see people trying to blame Dodd-Frank for this, and not just the usual dumb money gambling to chase returns. Brace yourselves for the next couple months as this begins to shake out.