Sunday, July 29, 2018

Casino Capitalism is Back. Brace Yourself.

Who can forget the global crunch of 2007 when America's housing bubble burst?

It was the advent of Casino Capitalism, liars loans, collateralized debt instruments and credit default swaps. It brought America low and the contagion spread to European banks in turn. That was never going to be allowed to happen again. And yet it has.

The Business Times posits it as "The junk debt that tanked the economy? It's back in a big way."

Banks are writing high risk loans to heavily indebted borrowers and they're doing it for one reason - because when those loans are collateralized (blended) there's a thriving market waiting to buy them. Sound familiar?

This time the term is "collateralized loan obligations" which is a fancy way of saying "IOU."
LIKE most people, you probably assume that the level of lending done by banks at any moment is largely driven by how much demand there is from borrowers. But in the world of modern finance, that's only part of the story. For just as important is the level of demand from investors - pension funds, hedge funds, mutual funds, sovereign wealth funds and insurance companies - to buy the loans that banks make. 
Indeed, there are times when there's so much demand for loans from investors and the profit from selling them is so lucrative that bankers are only too happy to go out and make bigger and riskier loans than they would if they were keeping them on their own books. 
That was the situation back in 2006 when investors were so keen to own "mortgage-backed securities" that Wall Street was begging lenders for more and more "product." You know how that turned out.

Now it is happening again, as investors and money managers scramble to buy floating-rate debt - debt offering interest payments that will increase as global interest rates rise, as they are expected to over the next few years. A big new source of floating-rate credit is the market for "leveraged loans" - loans to highly indebted businesses - that are packaged into securities known as "collateralised loan obligations," or CLOs. Because the market seems to have an insatiable appetite for CLOs, leveraged lending and CLO issuance through the first half of the year are already up 38 per cent over last year's near-record levels.
Bloomberg, meanwhile, focuses on what it calls the Titans of Junk whose ranks include Elon Musk and Michael Dell.

Masayoshi Son and Elon Musk leveraged their dreams to the hilt. Patrick Drahi stockpiled debt to build a global cable empire. Michael Dell loaded his computer company with risky loans to buy out activists threatening his control. And a group of Chinese developers borrowed big to expand in the nation’s booming property market.
Call them the titans of junk.
They’re the headliners in a decade-long, $11 trillion corporate borrowing frenzy, fueled by central banks that flooded the global financial system with ultra-cheap money. Investors have been lending to virtually anyone willing to pay a decent yield. But now the easy money is coming to an end. Policy makers, after driving interest rates to unprecedented lows, are hiking those rates for the first time in 10 years. For many companies, it will bring new financial pressures. And for some of them, those pressures could trigger disaster.
...While many are household names like Dell Technologies Inc. and Tesla Inc., others are privately held entities that avoid the scrutiny of the S&P 500 crowd—companies such as specialty-chemicals maker Avantor Inc. and IT firm BMC Software Inc. 
But chances are that anyone who socked away cash into a retirement account during the past five years has lent them money. Investors have parked trillions of dollars in mutual funds and exchange-traded funds that buy junk bonds. Pension funds in Canada have started leveraged-finance lending operations. Insurance companies have helped bankroll leveraged buyouts. And, in an echo of the subprime mortgage bubble a decade ago, investors from Sydney to Seattle snapped up hundreds of billions of dollars in AAA rated securities known as collateralized loan obligations that are actually backed by the debt of junk-rated companies.
...there are few signs that the borrowing is slowing down. But there are plenty of signals that its only getting riskier. In the past 18 months, institutional investors have snapped up $1.6 trillion of leveraged loans in the U.S. alone, data compiled by Bloomberg show. That’s more than the three previous years combined. What’s more is that private-equity funds, which typically use junk debt to fund the bulk of their buyouts, are sitting on record amounts of money earmarked for such deals. In other words, more junk-debt titans are likely to emerge before it’s over.
The next Day of Reckoning.

Moody’s has already started to warn that investors could end up recovering substantially less in bankruptcies than they have historically. One of the reasons leveraged loans have attracted so many buyers is that they have always been viewed as the safest type of debt you can buy because they are the first in line to be repaid when a company goes bust. Problem is, as companies increasingly tap that market for their borrowings, those lenders are finding that there’s no one left behind them to cushion the blow. 
“The effect of that when it happens will be larger than people expect because it’s like a coiled spring,” said Dan Zwirn, chief executive officer at Arena Investors, which manages about $1 billion in investments including loans to small-to-mid-sized companies. When yield-chasing investors “finally feel that shock, whatever that shock is, they’ll be surprised about the actual underlying credit quality of what they own—and then realize that what they thought was liquid actually has no bid. Then we’ll see fire and brimstone.”

More from Business Times.
It is no coincidence that the decline in loan quality has occurred as there's been a shift in who is doing the lending. Back in 2013, 70 percent of the loans were made by major banks whose lending is closely scrutinised by government bank regulators. That figure is now down to 54 per cent, according to Bloomberg, as hedge funds, private-equity firms, insurance companies and non-regulated lenders have entered the market in a big way. This shift in market share away from banks mirrors what happened to mortgage lending in the run-up to the 2008 crash, when competition from unregulated lenders led banks to lower lending standards in an effort to maintain their market share. 
There's also been a shift in how the loans are being used. Some of the debt is being used, as it always has been, to finance expansion or refinance old debt. But more recently, a growing portion of leveraged lending has been used to buy back stock, pay special dividends to private-equity firms cashing out of their investments or to finance richly priced mergers and acquisitions, which are now running at a pace that exceeds the bubbles of 2000 and 2007. In other words, it has been used to reward investors rather than grow the business.

Trump Looks the Other Way.
Although financial regulators have taken passing notice of the increased volume and declining quality of corporate credit, they haven't done much to discourage it - just the opposite, in fact. 
Earlier this year, after complaints from banks and dealmakers reached sympathetic ears in the Trump administration, the newly installed chairman of the Federal Reserve and the Comptroller of the Currency Office declared that previous "guidance" against lending to companies whose debt exceeded six times their annual cash flow should not be taken as a hard and fast rule. 
Whether intended or not, however, the market read the regulators' announcement not only as a green light to the banks to step up their leveraged lending but also as an indication that regulators would be more responsive to industry pressure than during the Obama years.

America's conservative/corporatist judges weigh in.
 The CLO market got an even bigger boost this year when an appeals court in Washington struck down a regulation issued under the Dodd-Frank financial regulation law that required all securitisers - the firms that bundle loans of any kind and sell pieces of the packages to investors - to retain 5 per cent of a deal. 
The regulation's rationale was that if the securitisers had "skin in the game," they wouldn't have an incentive to make or buy questionable loans and peddle them to unsuspecting investors. For Dodd-Frank's authors, this was a central feature of the architecture of financial reform.
...The appeals court opinion is a model of legal and etymological hairsplitting by activist, conservative judges who were clearly looking for a way to ignore the explicit intent of Congress, which was to make risk retention a feature of all loan-backed securities, no matter who made the original loan.
And so it goes. Take it from Hyman Minsky.

Or if you prefer your economics doom and gloom with a little humour there's a fine documentary, "Boom Bust Boom."


Anonymous said...

The appeals court opinion is a model of legal and etymological hairsplitting by activist, conservative judges who were clearly looking for a way to ignore the explicit intent of Congress...

One of those activist, conservative judges is being richly rewarded for this work - Brett Kavanaugh is Trump's latest nominee to the Supreme Court! He'll make out just fine, even if his decision tanks the economy.


The Mound of Sound said...

I'm waiting until the backstory about Anthony Kennedy's abrupt resignation comes out, Cap.

Anonymous said...

Yeah, the story they put out doesn't make any sense. Why would Kennedy, a swing vote on the court, insist on being replaced by a former clerk who makes Scalia seem like a bleeding-heart liberal? My bet is that Kennedy's son at Deutsche Bank is in Mueller's sights over his loans to Trump and dad decided to git before the excrement hit tbe rotary blades.


The Mound of Sound said...

That's my guess too, Cap.

Anonymous said...

Aww but Canada will be a-okay. Stephen Harper is hankering for the position of Finance Minister in the next election. He will work diligently to make everything right with the world. Say What? Anyong. Just an aside.