JPMorgan, Citigroup and BofA explore arranging new financing
Funding would allow managers to put up less of their own cash
Wall Street is moving to prop up the $881 billion market for leveraged loans by helping the largest buyers of the debt overcome tougher regulations.
JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp. are among banks exploring ways to arrange a type of financing for managers of collateralized loan obligations that would help them comply with the rules, according to people with knowledge of the matter. The funding would allow managers to put in less of their own capital to conform with so-called risk retention rules that require them to keep some skin in the game to avoid excessive risk-taking.
The banks have a very good reason to help. CLOs purchased more than 60 percent of leveraged loans last year and if they aren’t able to get off the ground, that could jeopardize buyout deals that have relied on the backing of credit markets. CLO issuance has already plunged to its slowest pace in more than four years and making it easier for managers to comply may help revive the market.
“Risk retention and the financing solution is part of a bigger puzzle for the whole leveraged-finance universe,” said Maggie Wang, Citigroup’s head of U.S. CLO research. “If CLO issuance falls, it will have a major impact on the loan market."
CLOs pool high-yield corporate debt that are often sold to finance some of the largest buyouts. The bundled debt is sliced into securities of varying risk with ratings that range from AAA down to B. The new risk-retention rules, a part of the Dodd-Frank reform, require CLO managers to hold 5 percent of their deals.
A manager can do this either by buying up 5 percent of the junior-most portion, known as the equity tranche, or by purchasing a little bit of each portion of the CLO structure -- or the so-called vertical strip -- to make up its 5 percent holding.
The banks are offering to raise money from investors to help provide the vertical-strip financing for CLO managers, the people said, asking not to be identified as the information isn’t public. One option the lenders are discussing is arranging financing for the safest portion of the vertical-strip, leaving the CLO manager having to look after the rest, the people said.
Banks may be willing to provide financing for between five and 12 years, the people said. Longer-term financing that more closely matches the maturity period for the vehicles is better for CLO managers so they can avoid the risk of having to refinance before their fund matures.
Without the financing from the banks, the manager of a $500 million CLO might have to put in $25 million to comply with the rules. That’s five times as much as the $5 million the same manager may have to tip in if it can secure financing for most of the vertical strip, the people said.
“This is the path to the smallest check for a manager to write,” said Oliver Wriedt, co-president of CIFC Asset Management. “The reason this financing solution is a hot topic is because poorly capitalized CLO managers and their underwriters want to find access to market.”
Representatives for JPMorgan, Citigroup and Bank of America declined to comment.
New CLO sales plunged to $8.2 billion in the first three months of the year, its slowest stretch since 2012. That follows nearly $100 billion of CLO sales in 2015 and a record $124 billion in 2014.
Bank of America cut its CLO issuance forecast for the year to $45 billion, less than half the total in 2015. JPMorgan analysts said it could fall to as low as $35 billion, after loans last year suffered their first downturn since 2008 and as managers grapple with the new rules.
Funding discussions between banks and CLO managers come as firms including Leon Black’s Apollo Global Management LLC raise fresh capital to address the new rules.
“Financing will be a big part of the solution,” said David Preston, an analyst at Wells Fargo & Co. “It will certainly help CLO managers continue issuing deals."
"cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before"
- BofA High Yield strategist Michael Contopoulos
While not as quixotic as Morgan Stanley's Adam Parker piece on market-chasing cockroaches, BofA high yield analyst Michael Contopoulos has moved beyond merely bearish and is now outright catastrophic . That may be a little far fetched, but in his latest note - while he doesn't call rally chasers "cockroaches" (yet), he seems at a loss to explain the ongoing junk bond rally. His reasoning: fundamentals just keep getting worse by the day, while price action has completely disconnected from reality, and virtually nobody expects what is about to unfold in the junk bond space.
First, according to his assessment of deteriorating macro and micro indicators, the recent price move makes little sense:
Despite the strong payroll data the economy still appears to be headed in the wrong direction, as our economist’s tracking model now indicates just 0.6% Q1 GDP growth and a revised 2.0% (from 2.3%) for Q2. Should our team’s figures hold, the period ending March 31st will mark the 3rd consecutive quarterly decline in GDP and the second sub 1% quarter in the last 5. More importantly for high yield investors, however, is that earnings growth continues to be anemic. 2 weeks ago we wrote that too much emphasis has been placed on Adjusted EBITDA, an approximation of cash flow that doesn’t take into account “1-off” charges, working capital, capex, etc. Although we understand the allure of this measure, in our eyes it has the tendency to cover up late cycle problems; namely asset impairments. With the understanding, however, that this measure is likely to be used for some time to come, we highlight the following: Even with 1-off adjustments 6 out of 17 sectors realized negative year-over-year Adjusted EBITDA in Q4, with a 7th sector growing at just 0.5%. On an unadjusted basis, 9 sectors realized negative EBITDA growth for Q4.
Because one quarter doesn’t tell the whole picture of a company’s earnings momentum, we also calculated both Adjusted and Unadjusted EBITDA by weighting the last 5 quarters 30%, 25%, 20%, 15,%, 10% (Q4 2015 having the highest weight Q4 2014 the lowest). What we find is that the commodities sectors are clearly not the only industries to be experiencing troubles as Capital Good, Commercial Services, Consumer Products, Gaming, Media, Retail, Technology and Utilities are all under pressure. Additionally, on an unadjusted basis Healthcare also doesn’t look like the darling some firm’s spreads would suggest.
Then he looks at where in the credit cycle the market currently finds itself:
We’ve written on multiple occasions how the main question mark surrounding the end of this credit cycle is its shape, not whether we’re currently living through it. As mentioned above, fundamentals have been consistently deteriorating even outside of commodities, defaults are rising, new credit creation is becoming difficult, and illiquidity is still a problem. Although technical tailwinds in the form of retail inflows and supportive central bank policies can prolong the market unwind, they do not change its direction as ultimately fundamentals will prevail.
That is a bold assumption with every central bank having become an activist, but yes: ultimately fundamentals will prevail.
In terms of the shape of this cycle, absent a recession we expect the pace of defaults to be much closer to the 1998 experience than the 2007 one. In fact, we have coined the phrase “a rolling blackout” to describe the potential for a period of many years where the market experiences general weakness and moderately high defaults as individual sectors take turns realizing their moment of distress. Whether these moments are based on a deterioration of underlying fundamentals, an unwind of crowded trades, or some sort of series of macro-economic incidents is nearly irrelevant, as the uncertainty and consistent underperformance of the overall market will likely frustrate many investors and asset allocators. In our view this is not unlike the 1998-2002 experience, where the very same scenario could played out: years of high yield underperformance, poor returns and moderately high defaults. Recall in those years, high yield returned 2.9%, 2.5%, -5%, 4.4%, -1.9% (and 3 years in a row of negative excess returns) while the default rate slowly crept up from 2% to 8% over the course of 3.5 years before hitting double digits.
Next, he proceeds to the "apocalyptic part", stating quite clearly that "the losses over the credit cycle could be worse than we've ever seen before." One reason: central bank intervention that keeps kicking the can instead of allowing the disastrous fundamentals to finally reveal themselves.
Should the market realize a mid to high single digit default rate for years cumulative losses over the length of the entire cycle could be worse than we’ve ever seen before. A total of 33% of issuers defaulted over the course of the 1987 and 1999 default cycles, higher than the 25% in 2008 as the latter benefitted from unprecedented central bank intervention. But the very same policies which helped alleviate the pain in the last cycle will likely add to the severity of the next one. This is because many of the companies that should have defaulted 7 years ago but instead received a lifeline will likely shutter doors now. As risk premiums have caused yields to jump nearly 400bp, many of these firm’s business models will now likely be unsustainable; especially given the lack of EBITDA growth we have seen this cycle (Chart 1). When these issuers are then coupled with the newest crop of unsustainable businesses from this credit cycle, we could see cumulative default rates approaching 40% this cycle versus the traditional 33%.
It's not just the upcoming surge defaults. Contopoulos also e focuses on product-specific issues which we have discussed before, namely the already record low recovery rates, a unique feature of this particular default cycle. These are only going to get worse.
However, not only will defaults be higher than in past cycles, but credit losses are also likely to be worse than ever before. That’s because recoveries, even outside of the commodity space have been paltry in the post crisis years. Given where we are in the default cycle, prevailing recoveries are a full 10 points lower than where they should be. Chart 2 highlights historical time periods characterized by low default rates (inside of 4%). Whereas in the past, recoveries tended to surpass 50% in low default environments, the last few years have seen those averaging 40%. This is telling because it means the pressure on recoveries is not being caused by the abundance of assets for sale in the market, which increases as more companies default, but rather because of the quality of these assets as we have discussed in part 1 of our recovery analysis published last year.
One reason for the collapse in recovery rates: the extensively documented chronic underinvestment in replenishing the asset base, and instead "investing" in buybacks and dividends.
So why are today’s assets garnering less enthusiasm than before? One reason, of course, is that a large portion of defaults today are in the commodity space, which are finishing with sub 10% recoveries as investors try to grapple with a market which may not have hit its bottom. However, problems persist even outside of the commodity industries. Take a look at the YoY growth in capex for non-commodity HY issuers (Chart 3). It’s striking how CEOs have invested much less in their businesses this cycle compared to previous ones. In fact, most of the capex growth since 2010 has come from energy issuers on the back of the US energy independence story in the early part of the decade; and we all know not to count on that going forward. On top of that, asset impairments as a percentage of tangible assets are through the roof, chipping away at valuations of an already low asset base. Not surprisingly, non-commodity recoveries reflect the same extent of erosion post 2010 as does overall HY (Chart 4).
If that wasn't bad enough, it gets worse: "Given that HY companies have seen hardly any organic growth within last few years, it is of little surprise that recoveries today are so low. The bad news is that we think they are going to decline further."
Contopoulos then analyzes various fundamental trends to determine the shape of the upcoming default cycle, and concludes with the following bleak assessment:
So where does this leave us? According to our model, should the default cycle look similar to the 1999 experience (2yr cumulative DR of 25%), and debt-to-asset ratio touch the highs of that cycle (0.51x), recoveries can be as low as 16c on the dollar. There is also a case to made that if there is no catalyst to total capitulation, and we see a longer flatter default cycle, we could see 2yr cumulative default rates much less than 25%. While this is reasonable, one can also argue that debt-to-asset ratio which today already stands at 0.48x, could ultimately go much further past 0.51x. Additionally, as we have seen in the post crisis years, default rates matter less than debt-to-asset ratios, meaning recoveries even under a rolling blackout scenario could even be worse than we expect.
Table 3 presents a scenario analysis of the range of recoveries to expect in the next few years depending on one’s forecast of default rates and debt-to-asset ratios. In almost any scenario recovery rates stand to be well below 30% this cycle.
According to Contopoulos, investors are only slowly starting to appreciate just how bad the future will be for junk bond investors:
While most investors we have talked to appreciate that recoveries will be lower going forward, we think it’s just as important to highlight just how much. Because, 8% yield may sound attractive if your expected credit losses are 400bps (6% DR*70% LGD). But the picture suddenly becomes unappealing knowing these losses could accumulate to 500bps; suddenly leaving you with an unremarkable excess spread cushion.
And it appears that investors have begun to pay attention, at least as seen from the events in the primary market. It’s no surprise that CCC issuance has cratered in the last year as investors are unwilling to extend credit to low quality issuers. Now it seems they are even rewarding BB issuers for using their newly raised debt judiciously, as can be seen from the lower clearing yields for debt being earmarked for capex investment over anything else
Welcome to the brave new world of massive default losses and record low recoveries.
This new world will be one where investors should and will adjust their expected compensation higher to make up for rising defaults, dwindling recoveries, and declining liquidity, all of which are here to stay.
Come to think of it, we almost prefer Adam Parker's incoherent ramblings about cockroaches better: at least it gave some sense that there could be a happy ending. If only for the cockroaches that is....
TIPPING POINTS, STUDIES, THESIS, THEMES & SII
COVERAGE THIS WEEK PREVIOUSLY POSTED - (BELOW)
MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Apr 11th, 2016 to April 16th, 2016
TIPPING POINTS - This Week - Normally a Tuesday Focus
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates
Not to continue beating a dead horse, but I have a stick and the carcass is right in front of me. The entire supply chain inside the US economy is full agreement both on where the economy is right now and, perhaps more importantly, how it came to be that way. Such harmony is not atypical, as synchronicity usually defines the hard edges of any cycle. This, however, is something else entirely, especially as it stretches back years and confirms we are witnessing nothing like the usual.
As it is, this latest part or phase or whatever has already taken up nearly two years. In terms of wholesale sales, as noted this morning, overall sales peaked in July 2014 – meaning nineteen months (thru Feb 2016) of deceleration into sustained contraction. Worse and what is probably the most concerning is that after those nineteen months inventory is only just now starting to correct, and it is doing so ever so gently. That suggests again slowdown without yet any visible end. In that sense, recession might actually be the best case since it would greatly speed up the affair in at least the convergence and reversion of inventory to sales (though that would still leave questions about the economic trend after it).
By comparison, the Great Recession featured just nine months of contraction; the whole of the dot-com recession twelve. Those were both top to bottom, peak to trough, over and done with. In 2016, we are very likely facing two years and still only the beginning of reconciliation or balance, and no idea what that might mean further down in wider economic feedbacks and negative multipliers.
The supply chain, top to bottom:
One other noteworthy interpretation: to find the “goods economy” including the whole of the supply chain in such joined, steady dislocation cannot be anything but a negative comment on the whole of the economy, services included. That starts with the fact that a significant portion (as much as half) of the “services economy” directly addresses the “goods economy” (retail, wholesale, transportation, etc.). Beyond that, if there is total breakdown in growth and advance in goods that can only mean a serious problem with US consumers. It has already forced economists and policymakers to completely abandon what was in late 2014 and early 2015 inarguable recovery and success. Just because it has not, so far, acted like recession does not propose a clean bill of health (just like it did not, last year, recommend this was all some temporary slump worthy of nothing but dismissal). Instead, that it has continued on for so long suggests quite the opposite, and, again, likely worse than just recession prospects in the long run.
MACRO News Items of Importance - This Week
GLOBAL MACRO REPORTS & ANALYSIS
US ECONOMIC REPORTS & ANALYSIS
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES
Market Analytics - WEDNESDAY STUDIES
STUDIES - MACRO pdf
TECHNICALS & MARKET ANALYTICS
TECHNICALS & MARKET ANALYTICS
Q1 SECTOR PERFORMANCE
COMMODITY CORNER - AGRI-COMPLEX
THESIS - Mondays Posts on Financial Repression & Posts on Thursday as Key Updates Occur
“The only way every currency can get cheaper at the same time, is not against themselves, but against Gold!”
James Rickards, Chief Global Strategist at West Shore Funds and a widely renowned author is interviewed by FRA Co-founder Gordon T. Long in which they discuss Jim’s just released book The New Case for Gold. They also delve into issues concerning the false perceptions of the world switching back to a Gold Standard and the reasons for a suspected G-20 stealth “Shanghai Accord”.
THE NEW CASE FOR GOLD
James Rickards suggests that there is a new case for Gold and points out that everyone thinks that what they own currently, in terms of stocks, bonds and other financial securities, is actually only “electronic digits” representing claims on assets. The new reality of Cyber war and Cyber attack suggests the real possibility of a single group of people or political regime hacking U.S servers. The potential exists today for investors to lose wealth and there will be almost nothing any one can do to bring back that money, at least in any realistic period of time. Physical Gold cannot be hacked nor simply be erased from the world’s ledger. It is the most tangible and secure way of preserving wealth and James recommends a portfolio with at least 10% being allocated to physical Gold.
Being outside the system, and being non-digital are the two main reasons that smart investors economists suggest will ensure having some sort of security for your wealth. Gold meets both these requirements and in the next big financial crisis will provide you with insurance for the rest of your portfolio.
“They’re not going to bailout the system; they’re going to lockdown the system”
OUTSIDE THE BANKING SYSTEM – The Best Kind if Insurance
The financial system is inherently unstable based on:
1-Complexity Theory and
Gold acts as an insurance policy no matter what happens:
3-Bank failures, and
Gold is always gold – It’s outside the banking system, can’t be reproduced by fiat, It cannot be “hacked”.
“It is one of the few asset classes that perform well in both inflation and deflation. That is the best kind of insurance,”
Jim talks to FRA about methodically dispelling the decades old arguments and fallacies associated with going back to the Gold Standard. He additionally dispels myths such as:
That John Maynard Keynes Called gold a “barbarous relic” (he didn’t),
That there is not enough gold to support finance and commerce (there is, it depends on the price),
That the gold supply does not grow fast enough to support world growth (it does if we are looking at real growth),
That gold caused the Great Depression (it didn’t, it was the Fed in charge of managing the money supply),
That gold has no intrinsic value (it doesn’t but neither has the theory of intrinsic value).
GOLD IS STILL A MONETARY ASSET & REAL MONEY
Rickards feels that over 40 years of “un-education or mis-education” has resulted in the new generation of economists and youth not understanding the importance or the value behind why gold is so important for our economy. We cannot blame the new generation for this gap inn their knowledge. We have not been teaching Gold as money in university curriculum and along with myths created about gold have virtually disowning it from economic thinking.
“The only way every currency can get cheaper at the same time is not against each other, but against Gold.”
Gold is the one form of monetary value that can’t fight back which is why they have completely stopped educating the U.S public on Gold as a whole.
A POST MONETARY RESET – Gold after the Next Crisis
The current financial system is inherently unstable and may soon have to be reformed. Gold will play a prominent role, if that happens.
China is not only acquiring vast quantities of physical gold, it is also going through the hassle of infiltrating the London gold market and simultaneously setting up its own clearing mechanism in Shanghai. Russia has boosted its gold to GDP ratio to 2.7 percent, higher than the United States percentage of 1.7 percent.
All powers are acquiring gold to have some bargaining power when the international financial system will be reformed.
“The gold to GDP ratio will be critical when the monetary system collapses because it will form the basis for any monetary reset and the new ‘rules of the game.’”
Why? After redistributing the official gold holdings and having monetized everything from bonds to stocks, the world’s governments and central banks won’t have a choice left other than to devalue paper money compared to gold, the same trick President Roosevelt used during the great depression and with the same objective of getting rid of an unsustainable debt burden.
In a monetary reset, gold will be the chips that are used to play a game of poker. Russians, Chinese and even the Iranians are stock piling gold because of this fear. If Gold has a role in the future monetary system, Gold’s price has to go up. Gold cannot multiply at the alarming rate that we will need it for. But we can always increase the price which is why the current monetary system will fail in terms of Gold in the future and will still hold the parity between money supply and demand. James expects a price target of $10,000 for the future if this falls in line.
“You want some assets in TANGIBLE ASSETS!”
James new book The New Case for Gold is available in stores and online now and provides an in-depth analysis on the old and new reasons for why Gold is a necessity in our upcoming monetary system. As always for more analysis and interviews follow us on twitter @FRAuthority or Subscribe to our YouTube channel, Financial Repression Authority for weekly interviews.
The systematic destruction of the American way of life is happening all around us, and yet most people have no idea what is happening.
Once upon a time in America, if you were responsible and hard working you could get a good paying job that could support a middle class lifestyle for an entire family even if you only had a high school education. Things weren’t perfect, but generally almost everyone in the entire country was able to take care of themselves without government assistance.
We worked hard, we played hard, and our seemingly boundless prosperity was the envy of the entire planet. But over the past several decades things have completely changed.
We consumed far more wealth than we produced, we shipped millions of good paying jobs overseas, we piled up the biggest mountain of debt in the history of the world, and we kept electing politicians that had absolutely no concern for the long-term future of this nation whatsoever. So now good jobs are in very short supply, we are drowning in an ocean of red ink, the middle class is rapidly shrinking and dependence on the government is at an all-time high.
Even as we stand at the precipice of the next great economic crisis, we continue to make the same mistakes. In the end, all of us are going to pay a very great price for decades of incredibly foolish decisions. Of course a tremendous amount of damage has already been done. The numbers that I am about to share with you are staggering. The following are 19 signs that American families are being economically destroyed…
#1 The poorest 40 percent of all Americans now spend more than 50 percent of their incomes just on food and housing.
All of us know people that once were doing quite well but that are now just struggling to get by from month to month.
Perhaps this has happened to you.
If you have ever been in that position, you probably remember what it feels like to have people look down on you. Unfortunately, in our society the value that we place on individuals has a tremendous amount to do with how much money they have.
Want to see a look of pure hatred? Pull out an EBT card at the grocery store.
Now that my kids are grown and gone, my Social Security check is enough to keep me from qualifying for government food benefits. But I remember well when we did qualify for a monthly EBT deposit, a whopping $22 — and that was before Congress cut SNAP benefits in November 2013. Like 70 percent of people receiving SNAP benefits, I couldn’t feed my family on that amount. But I remember the comments from middle-class people, the assumptions about me and my disability and what the poor should and shouldn’t be spending money on.
Have you ever seen this?
Have you ever experienced this yourself?
These days, most people on food stamps are not in that situation because they want to be. Rather, they are victims of our long-term economic collapse.
And this is just the beginning. When the next major economic crisis strikes, the suffering in this country is going to go to unprecedented levels.
As we enter that time, we are going to need a whole lot more love and compassion than we are exhibiting right now.
As a nation, we have made decades of incredibly bad decisions. As a result, we are experiencing bad consequences which are going to become increasingly more severe.
The numbers that I just shared with you are not good. But over the next several years they are going to get a whole lot worse.
Everything that can be shaken will be shaken, and life in America is about to change in a major way.
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
THE CONTENT OF ALL MATERIALS: SLIDE PRESENTATION AND THEIR ACCOMPANYING RECORDED AUDIO DISCUSSIONS, VIDEO PRESENTATIONS, NARRATED SLIDE PRESENTATIONS AND WEBZINES (hereinafter "The Media") ARE INTENDED FOR EDUCATIONAL PURPOSES ONLY.
THERE IS RISK OF LOSS IN TRADING AND INVESTING OF ANY KIND. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
Gordon emperically recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, he encourages you confirm the facts on your own before making important investment commitments.
Information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities.
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