This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
This week The Institutional Risk Analyst takes a step back to look at the world of credit and banking 30 days before the end of Q2 2020.
Suffice to say that there are reasons for optimism as well as dread, depending of course on where you turn your gaze. Stick with dread for now. We see a second credit tsunami approaching on the horizon.
Those risk professionals who keep their heads and stay focused on value (or a lack thereof) in the next few months are likely to prevail in our view.
Indeed, this dynamic process in the credit markets is one of the reasons that the private markets in the US continue to reject negative interest rates despite the obvious threat of deflation.
A reader asks why money market funds are bottoming out at about 0.1% yields, but banks are still paying 1.6% for one-year money in federally insured deposits. Of note, dealers are also offering attractive, zero risk weight returns providing financing for dry agency loans. Treasury yields at 1 year are sub 0.2% vs 0.65% at ten years, but with an increasingly steep yield curve.
Meanwhile, Ginnie Mae 2% coupons closed Friday at 103 & 19/32s for June delivery, just above 1.1% yield.
The simple answer is that commercial banks and broker dealers have private financing opportunities that remain superior to the heavily manipulated rate for federal funds and US government bonds.
This is part of the reason that mortgage rates have not followed Treasury yields lower, even with the Fed standing on the end of the Treasury curve. And of course, not all money market funds are created equal.
Looking at the System Open Market Account (SOMA), it seems that Fed Chairman Jay Powell and the Federal Open Market Committee started to accommodate back in September of 2019 and just kept on going.
Readers will recall that last September saw the most serious liquidity crisis in the US markets since the December 2018. The FOMC has been buying bonds ever since.
Notice that the dreaded VIX volatility measure has been muy tranquilo in recent weeks as a result of the launch of the latest Fed bond buying surge. Shall we call it QE5? Sounds like a so-so rock band from Lincoln Park, MI.
Street pharisees talk about the Fed easily growing its balance sheet in magical fashion, but in fact the reality is more subtle -- especially when the Fed is trying not to inflict collateral damage on private market players.
Kudos to Chair Powell and Godspeed.
Fact is, the Fed’s reaction to the March market fade is about right. If you look at global credit spreads in the chart below, the impact of March Madness on corporate bond yields was subdued to say the least.
Indeed, many investors never fully had an opportunity to become uncomfortable because they already started getting comfortable with the new normal post-COVID19.
But while the credit markets are subdued and the equity markets are, well, silly as usual, the real world prepares for the reckoning of 40 million Americans unemployed. We suspect that bond spreads will adjust accordingly as and when the pound of flesh is cut away to fulfill the creditor's bond.
Vultures continue to gather on Park Avenue, mostly in a virtual sense, but the money is real enough.
PitchBook reports that KKR & Co (NYSE:KKR) raised roughly $4 billion to invest in the corporate debt of companies struggling due to the coronavirus pandemic, including a 10% GP commitment. The KKR Dislocation Opportunities Fund reportedly brought in $2.8 billion alongside an additional $1.1 billion-plus in SMAs.
We are struck by the number of funds and strategies surfacing to exploit “distressed” opportunities, but we suspect that few of the investors we’ve seen in the mix are looking to take a risk position in the debt of a bankrupt restaurant operator, for example.
Yet the appetite for risk on the part of global investors is certainly growing as the Fed and other central banks drain marginal duration from the markets.
For the more adventurous, how about lending to private equity startups in China? Nikkei Asia Review reports that “fund houses, distressed debt investors, hedge funds and pension funds” have billions in new money ready to lend to companies in China.
And the Vig? No more that you pay on a bad credit card. “Burgeoning demand has boosted yields on such loans to as much as 18% from about 12% at the end of last year,” Nikkei reports.
Distressed real estate funds are raising funds at breakneck speed, in some cases turning away investors, the Wall Street Journal reports. The investment thesis: Buy bad loans from banks, that want to jettison the detritus as fast as possible. Determining value amongst the proliferation of “opportunities” in the world of credit defaults is another matter entirely.
Perhaps one of the more reasoned views we’ve encountered in the past week comes from the world of European commercial real estate.
SitusAMC advises that there may not be easy pickings for vultures look to feast on busted real estate in the EU.
“Investors and lenders will take write-downs on their assets, but this will be sector-specific and could be limited if some parts of the market recover swiftly. One thing is clear, there is significant weight of capital out there and banks are willing to lend," SitusAMC opines.
Of course, we’ve never been particularly disposed to invest in European real estate, in large part because creditors in Europe don’t have any effective legal rights. Distressed debtors can take years or even decades to resolve, ensuring that any distressed opportunity may well turn into a multi-generational affair. In Europe as in the US, the debt grows and grows, but is rarely repaid.
Back in the US, banks have rebounded nicely, but are still trading below the 52-week highs. Part of the reason for this striking underperformance stems from the fact of known unknowns.
We know that banks are facing very large credit losses in coming weeks, but we still don’t know the particulars. We increasingly suspect that the most pain will be felt on the commercial side of the ledger as small and not so small businesses fail.
While the pool of ready buyers for distressed commercial properties has shrunk in recent days, the wall of money in the hands of modestly competent investment managers has already started to support property prices. Sadly, we suspect that this is a false bottom to the commercial property market.
At present, it still is not possible to assess the viability of many commercial properties. Loss given default is a metric we really won’t fully understand until later in the year or in 2021.
Beware the double dip as or after the full horror of Q2 2020 earnings becomes apparent to the raging bulls.
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington.
This piece does not necessarily reflect the opinion of Hedgeye.
