Leveraged Loans and Liquidity Risk
New York | This past week, readers of The Institutional Risk Analyst awoke to see that banking exemplar Bank of the Ozarks (OZK) had taken a loss on two legacy loans on regional mall properties in the Carolinas. First and foremost, this event shows that commercial real estate many parts of the US have still not recovered from the 2008 bust. Bank OZK, as it is now known since shedding its bank holding company, had previously reserved for the write-down. Our friends at Kroll Bond Ratings, who rate Bank OZK “A-“, summarized the situation nicely:
“While reiterating that we consider these two credit issues to be largely idiosyncratic, KBRA notes that OZK’s core business strategy, which is centered on underwriting large commercial real estate loans, certainly offers the potential for some asset quality volatility even in generally favorable economic environments. Notwithstanding these unexpected charge-offs, Bank OZK’s ratings continue to be supported by its long and consistent record of solid risk-adjusted returns, which, in no small part, stem from disciplined underwriting and an effective risk management framework.”
So, no, we do not see the earnings miss at Bank OZK as a sign that a wider apocalypse is impending in the world of commercial real estate -- at least not yet. Yes, multifamily and CRE properties are overbuilt and there is a rising glut of luxury properties in many urban areas. But the credit consequences of this latest round of irrational exuberance are probably a couple of years away in terms of bank earnings results.
Indeed, we see the near term risks to financials coming from ebbing liquidity rather than festering credit. Writing in The Wall Street Journal, Rachel Louise Ensign reports that the levels of non-interest bearing deposits at US banks are falling. We discussed same in The Institutional Risk Analyst several months ago (see chart below) and in the most recent edition of The IRA Bank Book.
While Ensign correctly notes that rising interest rates are driving the secular decline in non-interest bearing deposits, that is certainly not the only reason. Among the largest components of bank transaction deposits is escrow balances for residential and commercial mortgages. Figure about $1 trillion annually in non-interest bearing float for the $11 trillion or so in outstanding single family mortgages.
As large banks such as JPMorganChase (JPM) and Wells Fargo (WFC) have sold distressed servicing and withdrawn from low-FICO lending, the related deposits naturally decline as well. Indeed, we hear that WFC is preparing to follow the example of JPM and withdraw entirely from the Federal Housing Administration market. A sale of all of WFC's GNMA servicing portfolio is also said to be in process.
The key insight in the WSJ report is that funding costs are rising – and quickly. How long will it take the financial media and investors to figure out what this means for bank earnings? As we told Grants Interest Rate Observer (October 19):
“The average cost of funds for the whole industry right now is a little over 1%. The average earnings on total earning assets is barely 3%. You’ve got about 2 points of spread. If funding costs keep rising faster than earnings, then you will see net interest margin start to contract by Q1. How do you think the Street will react to that?”
We have opined previously that the Federal Open Market Committee is not only going to squeeze bank earnings by raising short-term interest rates, but the Fed may very well cause a liquidity crisis in the world of non-bank finance. A year or two hence, we fully expect to see over-leveraged developers of luxury multifamily properties hanging from lampposts – figuratively speaking, that is.
A key bellwether to watch is the net loss rate on CRE and multifamily exposures, which at present is deeply negative. That means that when a rare default event actually occurs in the multifamily sector, the bank gets its money back and then some, as shown in the chart below. When you see loss given default back into positive territory, that will be a signal that the period of artificially boosted asset prices is at an end.
Meanwhile, our friend Ralph Delguidice has been sending a steady flow of commentary about the hottest spot in the world of credit risk, namely the increasingly rancid world of collateralized loan obligations or “CLOs”. Remember this acronym. Tomorrow’s headlines about credit risk exploding in the face of investors will originate from this little-known corner of the financial markets. How? As credit spreads eventually start to widen with rising interest rates, the flaws in this deeply overbought institutional market for CLOs will become apparent.
But for now the overall tightness in the credit markets is actually causing spreads in CLOs to tighten. Think of this as the melodic prelude to the final, disastrous finale of credit misallocation. The astute folks at TCW wrote:
“CLO triple A liabilities are still widening while we see loan collateral prices tighten. The arbitrage is already stressed and every time we see rates go higher, the asset class seems to get incremental inflows from retail funds and SMAs, which only further pressures the arbitrage. Something will have to give. We will either see triple A CLO liabilities begin to tighten again or we will need to see enough outflows in loans that it restores the supply/demand relationship necessary to print new CLOs. However, when CLOs have represented roughly 60% of the loan demand, it is hard to craft a scenario where SMAs and retail funds can replace that demand for a prolonged period of time.”
Many late vintage CLOs are indeed headed for credit problems, but the first act in that tragedy will be a massive and relatively sudden reset in credit spreads. The tightness in asset prices due to the FOMC’s twin idiocies of “quantitative easing” and “Operation Twist” will transform overnight into a buyers market. The low-quality leverage buyout and acquisition loans that make up more than half of CLO issuance and have been sold at high-investment grade spreads will suddenly be no bid.
A number of observers have noted that the quantity and quality of debt issuance in the US over the past five years suggests troubling similarities to the 2008 credit bust. As was the case a decade ago, mis-pricing of risk thanks to the market manipulation of the FOMC is at the root of the mounting problem in CLOs. Delguidice offers some insights:
“The torrential demand for leveraged loans — institutional and now increasingly retail—comes down to two things: 1). The loans float. This gives way to the proposition/myth that they offer protection against an increasingly aggressive Fed. 2) The EBITDA interest coverage is currently solid given the (12%) revenue growth in 2018 YTD. That said, the base line effects of 2015/16 will fade into next year even as the FOMC goes five more times and the fiscal impulse fades. This will (would) require 50%+ of the leveraged loan universe to post the same (12%) EBITDA growth in ALL the coming quarters just to keep coverage ratios from slipping. The red-hot demand for CLOs has also eroded covenants on the deals. This is impossible to quantify but critical to credit recovery and thus cycle dynamics of the structure) to the point where every new deal pushes the limits. Some 75% of the credit stack in leveraged loans is now 'covenant lite.'”
Slipping coverage ratios? Mis-pricing of risk? Does that sound familiar? The good news is that the credit quality of US bank portfolios is very strong. The bad news is that many bank customers are leveraged up to their ears and more. When EBITDA coverage ratios start to slip as the FOMC withdraws liquidity from the system, these mis-priced risk exposures in the leveraged loan market will cause a terrible slaughter among fixed income investors who have blindly purchased these toxic exposures.
The contagion of credit losses that starts in the market for leveraged loans and CLOs will slowly but surely impact the banking system as well. Early stage companies and leveraged buyouts will fail, causing a cascade of credit losses throughout the economy. Credit rating agencies will scramble to downgrade heretofore investment grade CLOs. And once again, the FOMC will be called upon to solve the problem of collapsing assets prices, a problem that its previous policies have caused.
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