News of the day: Minsky Moment 2.0, Real Estate, Sell Offs Revisited

Minsky Moment 2.0

Back in 2009 a New York Times article by John Cassidy titled “The Minsky Moment” made a lot of noise. Cassidy wrote:

Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to Minsky’s theory of financial instability have become commonplace on financial Web sites and in the reports of Wall Street analysts.

As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid.

Today might be a good time to revisit this article. In general Minsky’s theory groups borrowers in three fairly broad categories: hedged borrowers, speculative borrowers, and Ponzi borrowers. The three groups are essentially listed in order of their interest coverage ability where: hedged borrowers are capable of covering their interest and principal payments through operational cashflow, speculative borrowers can cover interest but need to roll-over on principal, and Ponzi borrowers, borrow based on the belief that assets financed by the debt will appreciate in value — enough to cover both principal and interest. The general theory states that financial instability is created when too many Ponzi borrowers enter the system and are unable to cover the payments, erasing liquidity and making it difficult for the other two groups to access credit markets in order to match their settlements. As Warren Buffet famously stated:

“Only when the tide goes out do you discover who’s been swimming naked”.

The recent downturn clearly wasn’t triggered by Ponzi borrowers; however, their predominance may exacerbate the problem. This distinction between types of borrowers should be recognized when it comes to inevitable bailouts and liquidity injections. With the build up of leverage across the system, two obvious places to start looking for Ponzi borrowers are: private equity and corporate debt markets. In particular, the idea of leveraging and banking on asset appreciation screams private equity circa 2008–2019. Last Thursday I wrote about dry powder in PE, however I might have severely understated the problem. In article from November of 2019 ft points out:

Many private equity deals are valued on Adjusted Ebitda (as opposed to the standard approach of using actual Ebitda over the past 12 months). Adjustments to Ebitda help private equity firms to sell their deals; just as some men exaggerate about their height in online dating apps.

These adjustments tend to overstate Ebitda by around 30 per cent, an S&P study found when comparing the actual Ebitda of private equity companies in 2016 and 2017 against the PE firms’ own projections in 2015.

Even on these fudged “adjusted” earnings, private equity valuations and debt levels look dangerously high. Yet institutional investors expect to pay the same or higher prices than the public markets for smaller companies with much lower credit quality and a likely 20 per cent default rate.

A classic sign of a Ponzi borrower is over leveraging in good times without truly grasping the risk associated with their own investment. More from ft:

More than three in four institutional investors polled believe their private equity portfolios have credit quality equivalent to bonds rated BB and above, while only 24 per cent of respondents believe their private equity portfolios are B or below. This is in sharp contrast with Moody’s, which rates 98 per cent of private equity portfolio companies B or below.

Even well established, reputable private equity firms will likely require governments to lend a helping hand. An obvious example here is ONEX. Their $3.5 billion acquisition of WestJet of which only $345 million was completed in December of 2019. With borders closed and travel restricted, airlines across the board will suffer immense loses. It is unlikely WestJet will be able to escape bankruptcy, barring some pandemic provision in their debt covenants or government bailout. As many other investments are going to be written down on PE portfolios, credit lines will dry up further causing cash crunches extending further into every credit market and worsening financial meltdown.

On the corporate debt market side defining Ponzi borrowers is a little more challenging. This market has been a major point of concern with alarms blaring year over year. A particular focus has been paid to the triple B rated corporate bonds which at the end of 2019 have made up over fourty percent of the $10 trillion market. This segment is larger than the entire corporate debt market was in 2008. The build up of leverage here stems from the same Allan Greenspan’s doctrine that has led to the original Minsky Moment. A prolonged period of easy monetary policy meant to spur growth, did exactly that through balance sheet expansion driven by leverage. The problem here is, lower interest rates pushing down borrowing costs even for junk debt as yield hungry investors took on more risk. Attracted by cheap debt corporates have used it to fuel stock buy backs as Jeff Cox points out:

U.S. companies are on pace to break another record for share repurchases in 2019, using a combination of cash and debt to push the total to close to $1 trillion.

For the first time since the financial crisis, companies have given back more to shareholders than they are making in cash net of capital expenditures and interest payments, or free cash flow, according to Goldman Sachs calculations.

The rise in buybacks has had a twin effect on corporate balance sheets, both drawing down cash and increasing leverage.

This has an unintended consequence of changing the correlation between equities and debt. Generally, the two asset classes are negatively correlated as investors move towards safety in credit in uncertain environments or flock to stocks during expansions in order to capitalize on growth. This trend has not held up for the last decade with both equity and debt rallying to new highs. In a way the Ponzi borrowers here are the triple B rated corporates themselves, using leverage to drive up the overall enterprise value of their firms looking to continuously refinance at cheaper levels. While some of have recognized the problem and vowed to go on a “debt diet”, many simply kept rolling over expecting cheaper and cheaper credit. Meanwhile, the Fed obliged by lowering rates. This interplay is especially dangerous for triple B tranche of borrowers as they are exposed to more technical risks associated with downgrading. In particular when the tide goes out, as many of them will be downgraded this will cause a sell off by institutional investment grade funds that are required to adhere to specific policies in regards to their holdings. An oversupply in the junk bond market will then depress the prices further triggering margin calls and market wide repricing while making the financing harder to come by.

These cascading effects are exactly the type of financial instability that Minsky has outlined in his theory. Fed is stepping in with additional lending facilities, venturing even into secondary markets, but it does not have the power to stop the domino effect. For that all eyes are on fiscal policy. Private equity and corporate debt might be good places to start.

Real Estate Needs help

Further drawing a parallel between the original Minsky Moment and today take a look at the Real Estate market. In particular focus should be on commercial real estate. Regulatory changes implemented after 2008 have restricted banks exposure to certain categories of commercial mortgages. In their absence REIT and debt funds have slid into the role of financing providers through repurchasing agreements. In essence banks agree to purchase a portfolio of commercial loans from REITs with an agreement that this portolio will be repurchased at a later date, thus providing liquidity to the real estate market. As Tom Barrack writes in his aritcle this allowed for the total commercial and multifamily related debt amount in US to grow to a record $3.66 trillion in 2019. Furthermore he points out:

Central to the fundamental credit structure of repurchase arrangements is each bank’s ability to “mark-to-market” the loans or CMBS the bank is financing and require the mortgage REIT or debt fund to satisfy any resulting “margin call” by partially paying down the advances on the affected loans, typically within only one or two days. Many repurchase arrangements also give banks the discretion to declare mandatory acceleration events based on the occurrence of certain loan-level events (such as defaults by underlying mortgage borrowers or the failure of the underlying property to satisfy minimum debt yield tests). In addition, repurchase agreements typically contain payment guarantees from mortgage REIT and debt fund sponsors that impose minimum liquidity requirements, the breach of which trigger cross-defaults connecting the sponsors’ other repurchase agreements, corporate credit agreements, and contractual obligations, creating a cascading effect that would spur a rash of mortgage REIT and debt fund insolvencies.

While these protective measures have become commonplace in the commercial real estate finance market given their effectiveness in curtailing the negative impact of isolated cases of non-performing loans, a systemic trigger of these measures across the entire market will have unintended but dire consequences. In the early days of the 2008 financial crisis, banks’ rushed and widespread use of “mark-to-market” remedies in order to rapidly reduce exposure to commercial real estate mortgage loans caused a systemic liquidity crisis in the commercial real estate lending industry, resulting in widespread economic distress and the drying up of credit markets.

That same panic has already resulted in significant margin calls over the past week on CMBS repurchase transactions, resulting in a severe liquidity crisis across the entire real estate finance market. If these actions continue in the CMBS market and spread to the broader commercial real estate whole loan market, the economic impact, magnified by widespread total industry shutdowns throughout the American economy, could be exponentially worse than the economic effects of the 1987 crash, September 11th attacks and 2008 recession, combined. The long-term impact on the economy could be catastrophic.

While the Fed is rushing to act to provide liquidity across the board through opening a broad range of lending facilities and promising “unlimited qe” there is a clear need for a massive fiscal stimulus. A key date to watch out is April 1st unemployment has risen and it is unclear what percentage of renters will be unable to pay rent on that day. This could potentially trigger a breach of covenants for a large swath of real estate actors leading to cascading defaults. Senate’s failure to pass the “corona virus” bill is simply unacceptable and the only valid reason for a delay in any stimulus bill should be related to expanding the amount of investment. Minsky Moment 2.0 has arrived and this time it is even larger, requiring more effort on the part of government to help the economy.

Sell Offs Everywhere

Last Friday I wrote about trading halts and the mostly detrimental impacts they have on the markets. However after listening to the most recent episode of Odd Lots I may have to revisit that position. Nafal Sanaullah essentially explained that trading halts may work but only if there is clear progress being made on the fiscal stimulus side during the time markets are frozen. If no such action is undertaken during the trading halt sell orders only end up piling up as people are desperately searching for liquidity with no asset class safe from exodus. A clear example of that are sell offs in generally counter cyclical commodities such as gold that have experienced a week full of volatility. With circuit breakers consistently being triggered across the globe it might be the time for a trading halt and international coordinated action.