Tag Archives: leveraged loans

The Truth Behind The “Repo” Non-QE QE Money Printing

“The Fed first tried to justify the loans by saying they were a short-term measure to stem a liquidity crisis. But the so-called “liquidity crisis” has not prevented the stock market from setting new highs since the loan operations began on September 17. And the short-term operation has been running every business day since that time and is currently scheduled to reach into next year or last permanently. A cumulative total of approximately $3 trillion in overnight and longer-term loans has been funneled to unnamed trading houses on Wall Street without either the Senate or House calling a hearing to examine what’s really going on.”Wall St On Parade

The analysis below is an excerpt from my November 24th issue of the Short Seller’s Journal

“Credit deterioration is a typical symptom of the end of a cycle — and that is exactly what Credit Benchmark is finding, particularly in the industrial sector.” – Bloomberg News in reference to a report from Credit Benchmark on the deterioration in credit quality of the industrial sector globally.

Credit Benchmark offers data/analytic services which provide forward-looking insights into the credit quality and liquidity of companies and sectors globally.  Credit deterioration is a typical symptom of the end of an economic cycle. Credit Benchmark also noted last week that U.S. high-yield corporate credit quality has been crumbling since early 2019.

High yield debt sits below and props up leveraged loans held by banks, pension funds and CLO (collateralized loan obligations) Trusts. Leveraged loan credit quality is also declining, with many loan issues trading well below par and a not insignificant portion trading at distressed levels. Banks have been stuck with a lot of leveraged loans that were underwritten with the hope of sticking them in CLO investment structures. But big investors have been pulling away from CLO’s since mid-summer.

A CLO is a type of collateralized debt obligation. An investment trust is set-up and structured into tranches in order of “safeness,” with credit ratings assigned to each tranche ranging from AAA down to the “residual” or mezzanine/equity layer. Each tranche is sliced into bonds which are sold to investors, primarily institutional and wealthy investors, who invest in the various tranches of the CLO based on relative appetite for risk. Typically hedge funds and/or the underwriter of the CLO will provide funding for the mezzanine/equity layer.

Leveraged loans underwritten by Wall Street are pooled together and the interest and amortization payments are used to fund the interest and amortization payments of each layer of the trust. Each tranche receives successively higher rates of return to compensate for the level of risk. In addition each tranche is amortized based on seniority. If and when enough loans in the trust default and cash collected by the CLO trust is insufficient to pay off all of the tranches, the losses are assigned in reverse order from bottom to top. During the financial crisis, losses spread into the highest-rated tranches.

Invariably, as yield-starved investors grab for anything with a higher yield than is available from relatively riskless fixed income investments like Treasuries, agency debt (FNM/FRE) and high-grade corporate bonds, the underwriting standards of leveraged loans deteriorate. Wall Street requires loan product to feed the beast in order to continue raking in fat fees connected to this business. And, as you might have guessed, Wall Street opportunistically offers credit default derivative “insurance” products structured around the CLO trusts.

As I’ve detailed previously, credit rating downgrades in leveraged loans are mounting as the level of distress in the asset class rises. CLO’s purchase roughly 75% of all leveraged loans underwritten. In theory, CLO trusts are “over-collateralized” to account for a certain level of loan default and to ensure the top tranche receives the highest credit rating possible. But it would appear that many of these CLO trusts are starting to incur losses at the lowest tranches. This fact is reflected in the rececent performance of CLO bonds since June. As an example, through June, double-BB rated CLO bonds threw off a 10% ROR (interest payments and bond price appreciation). But by the end of October, this 10% ROR was wiped out, meaning the value of the bonds has fallen 10% since June including 5% alone in October.

The chart above plots the SPX vs an index of “generic” CLO triple-B rated bonds. The negative divergence of the CLO bonds reflects the escalating degree of distress in leveraged loans, which are underlying collateral funding the CLO trusts.

I am certain that part of the reason the Fed has had to start bailing out the banking system with its not-QE QE repo operations is connected to the rapid deterioration in the CLO/leveraged loan market. Chunks of thes CLO’s and leveraged loans are sitting on bank balance sheets.

The 2008 financial crisis was primarily triggered by the collapse of collateralized subprime mortgage CDO’s (these were the securities featured in “The Big Short”). I believe – and I’m not alone in this view – that CLO’s will cause the same type of systemic damage . The CLO market is roughly $680 billion just in the U.S. That was about the same size as the subprime mortgage market by 2008. Including the offshore market, the global leveraged loan market is now $1 trillion, doubling in size since 2010.

Most people think of the Fed when they hear the term “repo.” But the repo market primarily is funded by banks and money market funds. CLO bonds have been used as repo collateral for several years. As the credit quality of this asset class declines, banks are less interested in participating in repo market funding transactions to avoid the rising probability of suffering a counterparty default from use of CLO collateral, thereby reducing liquidity in the repo market.

In addition, many banks have been stuck with leveraged loans that could not be offloaded onto investors or CLO trusts. This inability to off-load loans into CLO’s started this past summer when the largest investor in CLO’s, a large Japanese bank, began to pull away from the CLO market. As the value of these loans declines, banks are forced to increase the amount of capital required to maintain reserve ratios – another reason for the Fed repo market intervention.

As the global economy, including the U.S. economy notwithstanding the insistence to the contrary by the Fed and Trump, continues to contract it’s quite probable that CLOs/leveraged loans will begin to melt-down Chernobyl-style. Referring back to the SPX/CLO bond price chart above, in my view there’s no coincidence that the Fed’s intervention in the repo market commenced at about the same time the triple-B CLO bonds began to take a dive. That price decline is even more pronounced for the tranches with ratings below triple-BBB.

To be sure, CLO’s are not the only financial wildfire outbreak targeted by the Fed’s money printing, but I would wager a healthy amount of gold coins that distress in the CLO market is one of the primary troubles right now. And the problem is magnified when you take into account the credit default swap transactions “wrapped around” these CLO trusts. These derivative trades also require an increasing amount of collateral as CLO tranche distress escalates.

To accompany the above analysis in my Short Seller’s Journal, I presented some ideas for expressing a bearish view based on the the eventual collapse in the CLO/leveraged loan market. You can learn more about this newsletter here:  Short Seller’s Journal information.

The Financial System Is Becoming Increasingly Unstable

Bloomberg posted an article this morning describing the Collateralized Loan Obligation market as “Wall Street’s Billionaire Machine.” But I seem to recall that the CLO market was one of the financial nuclear bombs that blew up and triggered the financial system de facto collapse in 2008. Well, it’s back – with a vengeance. Of course the taxpayers were once again sold a bill of goods never delivered when it was promised that the Dodd-Frank farce legislation would “protect” the system from the re-development of these financial weapons of mass destruction…

Bank stocks are in a bear market now and there’s a reason for that. Many of you have probably seen leveraged loan ETF charts that look like this:

The chart above shows an ETF operated by Blackstone that invests in senior secured leveraged loans. Typically these loans fund private equity leveraged buyouts. But any highly leveraged company with a junk bond credit rating is a Wall Street candidate for this type of loan.

What you’re seeing in the chart above is the beginning of an investor stampede out of this asset class. This asset flourishes in the type of money environment – Central Bank money printing and interest rate intervention – that has existed for the last 10 years. The loans carry a higher rate of interest than an investment grade corporate bank loan. This appeals to pensions and insurance companies, which need to find the highest risk-adjusted interest bearing investments possible. I like to call these: “c’mon in the water is fine” loans. These are the type of loans that get magically transformed in to CLO’s – like lead into gold – at least the for Wall Street scammers who do the transforming.

As I’ve mentioned previously, credit market investors tend to be more risk-averse than equity players. They also scrutinize financial fundamentals more closely. To this end, bank debt investors are the most conservative. They also get to see the non-public financials of the companies to which they lend. That chart above reflects the onset of fear of in the leveraged bank debt market. It means that these investors likely have been seeing negative trends in corporate financials develop.

When I showed that chart to a colleague of mine earlier this week, his response was: “it looks like parts of the stressed financial system are breaking at the same time – dominoes are falling.” He was referencing the leveraged loan, investment grade and high yield debt markets. The latter two had been showing signs of breaking down well before the leveraged loan market started to crater. Investors have been pulling pulling billions out of all three segments of the credit market. The deteriorating financial condition of corporate America is spreading its wings. This is part of the reason the volatility in the stock market has ramped up recently.

Bank stocks are in a bear market and bank liquidity is drying up – There’s a massive liquidity crisis developing and the chart of SRLN reflects that. The sell-off in the housing stocks – down over 30% since the end of January foreshadowed this, just like the sell-off in homebuilders preceded the onset of the last financial crisis. This time it will be worse. This crisis is beyond the banking crisis 10 years ago. It’s everything. You do not want to be a creditor or own stocks going forward.

Looks like the Spanish philosopher, George Santayana, was correct: We did not learn from the past and now we’re condemned to repeat it.