This is our final installment of the notes from iGlobal's Distressed Investing Summit. Our contributor, Josh Nahas, of Wolf Capital Advisors did an amazing job on this series - and tonight, with a more macro bent, is no exception. Later this evening, I have a post on David Einhorn's view on levered equities, and this weekend a comprehensive post on the RMBS market, using material penned by Canyon Capital. Enjoy!
In the third installment of our coverage of the iGlobal Distressed Investing Summit we are going to focus on the Risk Management panel. This panel represents and interesting counter point to the views expressed by the Leveraged Loan panel which given the current technicals in the HY/Leveraged Loan markets is quite bullish about the prospects for those markets. While it is hard to dispute the current technical factors driving spreads tighter, the question really is whether the underlying economic fundamentals can support the cash flow needed to support a deleveraging of the many broken capital structures out there. If you look at the data presented by the Risk Management panel the answer is decidedly negative without serious impairment to creditors and existing equity holders. A note of disclosure, the charts in this article are not from the presenters but are based on topics referenced by the presenters. Many of the conclusions are extrapolated from the panelists’ remarks and therefore represent the author’s own opinion.
Tepid Economic Recovery
The panel kicked off with an interesting way to look at risk defined as Risk = Exposure + Uncertainty. Uncertainty and corresponding volatility has plagued the markets since the credit crisis ended in 2009. Since then there have been periods of exuberance, the first 6 months of 2011 and the last 3 months , along with violent sell offs in July and September/October of 2011. This lead one panelist to observe that the “The pain of uncertainty is ALWAYS greater than the certainty of pain”. The tepid the economic recovery, uncertainty regarding regulation and increasing negative public sentiment towards the financial sector has created a great deal of uncertainty in the markets over the direction economy has caused sharp turns in the market. These types of rallies and sell-offs are more reflective of secular bear markets which can see large rallies followed by steep sell-offs and prolonged stagnation.
The economic fundamentals paint a bleak picture indicating that these market rallies are likely technical driven and unlikely to be sustained. Some startling facts include that 72% of GDP is driven by consumption while 10% of Americans are responsible for 40% of that consumption. With a great deal of that 10% employed by the financial sector which is under increasing pressure, the ability to sustain growth in GDP is limited at this point. Moreover, the outsized attention paid to manufacturing vs service by politicians distorts resources away from the areas that will drive growth in the future.
Weak Underlying Economic Fundamentals
Given that manufacturing accounts for such only about 12% of GDP, it is mathematically impossible for it to drive GDP growth. During every previous recession since the Great Depression household net worth grew on average 4%, however, in this previous recession house hold net worth fell almost 25%. The consumer represents almost 150% of GDP including debt, combining this with the drop in net worth portends badly for the fundamental economic outlook. According to the panel, the US consumer has experienced 13 consecutive quarters of income decline. Which begs the question of how we can have a sustained rally in the credit and equity markets with such weak underlying fundamentals?
Moreover, the unemployment statistics based on the U3 calculate by the BLS and frequently cited in the press and by politicians arguing that the economy is improving are misleading. These headline unemployment numbers do not include those who have stopped looking for work, those who have been out of work over 6 months, or those who are under employed. Moreover, headline monthly unemployment numbers are subject to revision as the result of the birth/death adjustment which attempts to estimate how many jobs were created as the result of new businesses being formed as well as those lost by firms going out of business.
These estimates tend to overstate the number of jobs created and are subject to big downward revisions in later months. The BLS’ U6, which is a much broader measure of and includes those who need work but have given up the search, and those who have taken part-time jobs while still seeking full time employment. In February, that figure rose by 0.6% to 16.0%. The U3 unemployment numbers have been further distorted due to adjustments made as a result of the 2010 Census. The BLS has indicated that the current series is no longer comparable to historical data as a result and has not supplied what the adjustment is.
Compounding the already strapped consumer are demographics which are going to be a drag on growth over the next couple decades as more baby boomers retire. The dependency ratio, or those who are out of the labor force (usually over 65 ) vs those in the labor force 65 is steadily increasing indicating that there are more retirees than workers. This is going to cause significant tension with respect to entitlements and taxes between those in the work force and the retired population.
This will put additional strain on workers in the form of additional taxes or force retirees to take less benefits. Neither one of these are politically attractive and at this point we seem to have found a third option which is called quantitative easing, or more accurately printing money. This will ultimately result in inflation, which the panel expects to see an outbreak of at some point. The panel also mentioned that current government statistics do not accurately capture inflation. This is the result of changes to the CPI’s calculation during the 1990s by the Boskin Commission (See ShadowGovernmentStats.com for a complete explanation). As a result CPI no longer accurately reflects the cost of a basket of goods used by the average consumer, but is now distorted by econometric adjustments. Under the old method of calculating CPI inflation would is running almost double the official statistics.
Short-Term vs Long Term Factors
Short term technical trends favor leveraged credit instruments in 2012. At the end of the 2011 and to start 2012 we saw managers begin to put cash to work that has been sitting on the side lines for some time. Given that large inflows into HY/Leveraged Loan funds, managers were going to have to start putting money to work. Banks then pounce with as many new issues in their pipeline while the window is opened. We saw this same pattern in 2010 and 2011. Furthermore, election years tend to be good years and spending will be in excess of $2bn.
While technicals will dominate in the near terms, given the longer term fundamentals the panel has highlighted indicates that there still needs to be a substantial deleveraging. Wall Street is focuses on the balance sheets of fortune 500 companies, but it’s the balance sheet of middle market companies and consumers that drive GDP at the margin. Since growth by definition is at the margin, it appears that the US economy is facing at best prolonged economic stagnation or another contraction. As evidenced by the chart below the spread on Middle Market loans to large corporate loans are trading at significant premium to their historical average.
On the plus side the banking system does appear to be on sounder footing and far less leveraged to exotic instruments such as conduits, arbitrage CDOs and subprime. Nevertheless, given the large stack of maturities between 2015-2017, particularly for middle market borrowers who have not been able to refinance, there will be significant restructuring activity as these companies are forcibly deleveraged. Compounding matters is the fact that by 2016-2017 all of the vast majority of CLOs will be outside their reinvestment window, which has been a major drive of the current A&E cycle. Moreover, many of these CLOs will be approaching their own legal final maturities and therefore will not be able to extend even if they wanted to. New CLO activity is running at a fraction of its historical highs seen in 2007 at $150bn annually. For 2012 CLO issuance is expected to be about $12bn. Not nearly enough to replace the lost supply.
Sovereign Debt Effects
Europe appears to have pulled back from the abyss with ECB now embracing the US approach of monetizing the continent’s debt problems. During the 2001-2007 credit boom European banks were large investors in CLOs and other leveraged US credit products. Now European banks are investing in sovereign debt which the ECB is accepting as collateral for ECB loans and capturing the spread. The recap of southern rim EU countries is essentially being financed by the ECB who is providing the banks with cheap loans secured by sovereign debt. This is why sovereign spreads in Italy and Portugal have been tightening in their latest government bond auctions. With this money no longer flowing into the US market, and CLO activity no where near its historical levels in the boom years, HY and Leveraged loans will need to find new sources of demand to meet the 2015-2017 maturity wall. Moreover, given that the US’s large budget deficits are being financed with Treasuries, might produce a “crowding out effect” on the HY market and lead to much wider spreads.
Given the poor underlying economic fundamentals and potential supply demand imbalances at the onset of the 2015-17 maturity wall, there will likely be substantial opportunities in the distressed market. The effects will be most pronounced in the middle and lower middle markets where distressed hedge funds and distressed PE players will be competing for control of the choicest deals