The response phase to the complex health, economic and social crisis caused by the onslaught of the global pandemic is now behind us. What follows next is the flood and fractures phase as the collateral damage across each heading comes into sight.
At the epicentre lies the financial system itself, without which there is no organised society. There is a battle on to defend it from Covid-19 lockdowns if the pandemic doesn’t stop wreaking havoc and instead lingers well into 2021.
It is that simple. Not everything can be saved by adding ever more debt, and the belief that this can be done on an open-ended basis and without consequences is fanciful.
The financial system is only as strong as its weakest parts. It came close to fracturing after subprime mortgage defaults, a situation amplified when the undergrowth of opaque financial leverage went up in the Lehman mushroom cloud. System fragility isn’t just a theory, it is also recent history.
This time the weakest part of the system is not from securitising dodgy US housing loans but uncontrolled detonations at the base of the corporate debt pyramid. Here lies a species of subprime business debts called leveraged loans (see explainer below). This is debt added to already highly indebted companies, which fails the Fed market support test because of being an inferior loan class.
Depending on how you define high-risk loans, the global total amounts to $5 trillion, 80 per cent of which is in advanced economies, according to the International Monetary Fund (IMF). Think of mergers and acquisitions, share buy-backs, management buyouts and refinancing at airlines, hotels, cruise liners, restaurant chains, shopping centres, casinos, airports, office blocks, sectors now getting hammered by collapsed revenues, and ask what happens when they breach covenants or try rolling over their debt?
Nearly a quarter of leveraged loans are blended into securities called collateralised loan obligations or CLOs (see explainer below) which populate some of the balance sheets of the world’s most systemically important banks but are also, rather helpfully, diversified among insurance companies, pension schemes, investment funds and other non-financial organisations.
The exposure will be at its riskiest where investors have chosen lower grade debt in the hunt for higher yields and at its worst in so-called enhanced CLOs which contain much more junk, CCC and D-rated debt. Despite close examination by the international Financial Stability Board (FSB), the holders of one in every seven CLOs cannot be determined. Both the IMF and FSB are very concerned about the lack of oversight over non-banks and the unknown feedback loops into the banking system from indirect exposure.
The Federal Financial Institutions Examination Council (FFIEC), which does deep dives into US bank balance sheets, reports off-balance-sheet exposures from items such as bank guarantees, letters of credit and credit derivatives for big CLO players including Citi Group at $3 trillion and JP Morgan Chase at $2.9 trillion. These US banks were identified among the world’s most systemically important which hold CLOs on balance sheets, $20 billion at Citi Group and $35 billion at JP Morgan Chase. Together with Wells Fargo, they have over 80 per cent of CLO exposure among US banks.
Confidence remains among players in the resilience of these CLO debt portfolios – they believe all will be well – but it is grounded in laboratory models of normal default risk. These determine that there is no fragility, that the diversity across banks and non-banks, mixing junk and higher-grade borrowers coupled to spreads across industries and services, creates a robust lattice that can absorb default shocks during normal recessions. But this isn’t a normal recession – it’s global, it’s multi-sector and it’s not V-shaped as advertised.
Laboratory models that adopt the classic bell-shaped curve in determining probabilities confine black swans to extremes, but these are often wrong, because extremes occur with far greater frequency in the real world as we keep finding out to our cost.
One key study in 2017 by Griffin & Jordan determined that CLO models understate default correlations between three and six times the calculations of their creators and so their credit ratings were already overstated before lockdowns. Two thirds of borrowers in CLOs were B-rated or less, and one in seven were rated pure junk at CCC or less, but what shape are they in after six months of lockdowns and restrictions?
Already major brands are running to ground, seeking protection, leaving creditors facing wipe-outs or getting cents on the euro. Globally, airlines in trouble include Latam, Virgin Australia, Air Mauritius and Avianca. In Europe, government bailouts are already propping up Lufthansa, Air France-KLM and Alitalia but the wider casualty list so far includes Debenhams, Flybe, Virgin Atlantic, Noble Corporation, Victoria’s Secrets, FC Kaiserslautern in Germany and Fauchon in France. In North America it includes Hertz, JC Penny, True Religion Apparel, CMX Cinemas, Apex Parks, Gold’s Gym and Cirque du Soleil. It is just the beginning.
Others are hanging in by their fingertips, such as AMC, the world’s largest movie theatre chain forced to close 634 locations, putting at risk the servicing of $4.9 billion debt. AMC, owners of the Walking Dead TV blockbuster about a zombie apocalypse, has organised short-term finance to get through to 2021 but, like vast numbers of businesses globally, it is barely holding on, praying that Covid-19 can be beaten in time.
Banks, especially in the US, are better capitalised with bigger shock absorption capacity but a contagion of default in leveraged loans, including CLOs, amplified by unforeseen feedback loops from indirect exposures could test capital buffers, especially in the euro area where they are thinner and which carries $348 billion of drawn and undrawn leveraged loans.
It just takes one biggie to trigger a stampede to the exit, a sell-off of high-risk corporate debt opening up fresh and uncharted transmission channels that defy regulatory modelling. Beyond high-risk corporate loans lies the bigger beasts, commercial mortgage backed securities (see explainer below) and consumer debt as government forbearance and Covid-19 payments reach their limits.
That’s why sharp eyes are on the $2 trillion balance sheet of Wells Fargo, one of the world’s largest banks. Once the US’s most valuable bank brand, Wells Fargo was embroiled in a scandal four years ago after creating millions of fake bank accounts, this coming after it had paid $50 million to settle a racketeering lawsuit. In 2018 the US Federal Reserve Bank banned Wells Fargo from growing its assets any further, pending cleaning up its act.
Sitting on the Wells Fargo balance sheet on page 144 of its 2019 Financial Statement are CLO holdings of $29.7 billion, although this has since jumped to $38 billion. Percolating away in the opaque Cayman Islands, however, is a variable interest entity (see explainer below) valued last year at $1.12 trillion and noted without detail on page 177 of its financial statement. It is unknown what quality of debt this contains.
What is clear is that banks are facing substantial losses. What is yet unclear is for whom it will lead to chronic deficiencies in capital. Thankfully, the exposure to high-risk corporate debt is shared with non-bank players, yet still a contagion from indirect exposure through other lines of credit and the scope for amplified new lines of transmission under stress conditions cannot be determined. Not until it happens.
Not every business can be saved, and the longer the economic damage goes on, the greater the number of corporate zombies. These will be joined by consumer debt defaults, including residential mortgages, once government forbearance programmes run dry of powder.
The ultimate backstop is the Fed and the US dollar itself, neither of which is invulnerable. That is the truth of it.
That we must learn to live with Covid-19 is not just a sentiment about regaining personal freedoms but, at its heart, it is ultimately about saving the global financial system from zombifying and taking a headshot.
We are all in this together — just not in the way that policymakers on the public payroll grasp.
A loan to a borrower already heavily indebted, carrying higher default risk and priced at higher interest rates. Typically borrowers are below investment grade rating, with total debt over four times Ebitda (profits) that significantly exceeds industry norms. Arranged by a single lender, these loans can be sold on or syndicated to other banks or investors. The credit is often used to refinance debt, share buybacks, finance mergers and acquisitions or in leveraged buyouts where public companies are taken private.
Collateralised loan obligation
Single security comprising of a basket of loans, typically 100 or more, most often leveraged loans, it is actively managed and layered from highest to poorest grade with tranches sold to investors. Loan repayments cascade in a waterfall to investors prioritised in a pecking order from top through to bottom. Enhanced CLOs are securities containing much higher exposure to CCC and D-rated debt than normal CLOs.
Variable interest entity
A special purpose vehicle, where investors have controlling interest in parts of a business but not majority voting rights, used as a way of raising credit while reducing risk to other creditors or legal action, often used to ringfence credit to projects and sometimes to park it off balance sheet.
Commercial mortgage-backed securities (CMBS)
These are fixed income paying securities backed by mortgages on commercial property like hotels, office buildings, shopping centres, apartment blocks and business parks to facilitate investment liquidity in this sector of corporate debt and assist banks recycle loan capital through securitisation. The quality of the CMBS will depend on the loan profile.
Financial Stability Board (FSB)
Established 2009 in Basel Switzerland, the FSB has 68 member institutions including central banks and regulators. It monitors the global financial system, coordinates and sets international standards for members.
The practice of selling on loans by pooling them together and selling the income stream to investors as bonds, securities or collateralised debt obligations (CDOs). The total CDO market in 2007 was $640 billion, a figure now exceeded by the CLO market today valued $740 billion.
Eddie Hobbs is a financial advisor