Chances are, when you think of the repo market you think of banks and broker-dealers and the craziness that went down in 2008. This column, based on an amazing research paper by Zoltan Pozsar, suggests that’s a mistake.
(Bonus: It calls out Pimco on window-dressing its balance sheet)
Here’s an excerpt:
I’m not an energy person. So I was delighted to learn about reserve-based lending and the semi-annual “redetermination of the borrowing base” procedure that oil companies undertake with their bank lenders.
It’s no secret that energy companies have borrowed heavily from Wall Street to fund their shale exploration. With the price of oil halved from its peak last year, those companies are under pressure. One place this is showing up is in the world of bank credit lines to energy firms, and also junk-rated bonds they sold.
There is lots of information in the below article, including talk of the hedge funds and private equity firms waiting in the wings to “rescue” energy firms on potentially punitive terms. One thing I would like to stress is a rather unsavory dynamic at play here. If energy companies have to turn to second-lien financing to plug holes in their bank loan facilities, the claims of existing unsecured creditors – i.e bondholders – get pushed further down the payment hierarchy. Because so many of these bonds have been issued on a cov-lite basis, subordinating them becomes even easier. In short, there are interesting times ahead for the high-yield energy sector.
April in Texas traditionally marks the start of the spring thunderstorm season. This April, the tempestuous weather looks set to be accompanied by an additional financial squall for the state’s oil and gas companies as banks begin cutting back on the reserve financing on which these firms rely.
Such financing is typically re-evaluated twice a year, usually in October and April, and is tied to the value of the borrowing firms’ oil and gas reserves and related assets such as pipelines.
With the price of US crude now less than 50 per cent of its recent peak of $107 a barrel, the likely consequence is that banks will significantly reduce their lending to energy firms across the US, forcing companies to look for alternative sources of financing on more punitive terms.
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Energy bondholders at risk as bank loans ebb
Energy bondholders could lose out in refinance deals
A dozen ways to stretch your borrowing base
We know that banks and hedge funds a traditional sellers of volatility. But low interest rates and somnambulant markets have also encouraged asset managers (or “tourists” as the banks and hedgies sometimes call them) to take up the strategy as they seek to juice their returns. It seems … risky.
This story has a lot of stuff in it, including a smallish dive into the events of October 15.
Long the domain of professional speculators like big banks and hedge funds, “selling volatility” — as such wagers are known — became one of the most popular trades of the year as a much wider range of investors piled into bets that asset prices would remain stable.
Now, as the prospect of the Federal Reserve raising interest rates draws increasingly near, the concern is that market volatility will return with a bang in 2015 and those investors caught on the wrong side of the revival will suffer badly.
“Volatility is a zero-sum game — for every buyer there is a seller. But what has changed is the type of sellers,” says Maneesh Deshpande at Barclays.
…
Here’s an analysis of how some corporate accounting shenanigans are playing out in credit markets, where aggressive earnings adjustments known as “add-backs” can make companies appear more creditworthy than their historical cash generation might otherwise indicate. The effect can be pretty darn substantial.
In the competitive world of online dating, men and women will embellish their profiles to attract the best mates. Salaries are engorged, ages are diminished and heights increased as singles seek promising partners.
In credit markets a similar trend is playing out as companies flatter their bottom lines to attract the best financing deals from investors who are willing to play along in order to get a shot at a debt product with juicy yields.
And here’s the key quote:
“Beauty – or the lack of beauty – is in the eye of the beholder,” says Scott McAdam, portfolio specialist at DDJ Capital Management. “In the late stages of a credit cycle where capital is cheap and there’s a lot of money chasing deals, companies will kind of get away with this.”
I interviewed Jacob Frenkel, chairman and CEO of the G30 and former Bank of Israel governor, for Markit Magazine.
The full interview is available for free here, but I thought his thoughts on the limits of macroprudential tools in the face of low interest rates are worth noting.
“Let’s not kid ourselves,” [Dr Frenkel] says bluntly. “Interest rates are the most efficient instrument of monetary policy, period. If the use of the interest rate instrument is limited due to the zero bound constraint, can you still operate with macroprudential policies? The answer is probably ‘yes’ but it will be less efficient. In order to be effective you will need to use macroprudential measures in a draconian way.”
Wall Street banks are encouraging the use of derivatives including total return swaps (TRS), credit index options (swaptions) and variants of the synthetic collateralised debt obligations (CDOs) that proved so disastrous during the previous financial crisis in an effort to serve investors the yield they so desperately crave.
(The crucial difference this time around, is that these are tied to corporate credit rather than residential home loans).
Read the following, and weep/laugh as you see fit.
Boom-era credit deals poised for comeback (December, 2013)
Last month Citigroup placed an unusual job advertisement. The bank was seeking an analyst able to crunch the numbers on an obscure financial security: synthetic collateralised debt obligations. Four weeks later, job applicants would find the position filled. Such has been the clamour among investors for the higher yields from higher-risk products that big banks including Citi, JPMorgan Chase and Morgan Stanley are turning again to the more esoteric parts of the financial markets.
Turning to total return swaps (July, 2014)
A type of derivative known as a “total return swap” has become a hot ticket item on Wall Street as investors seek out new ways of playing booming credit markets, while banks – including Goldman Sachs – find fresh methods to finance their assets.
Investors dine on fresh menu of credit derivatives (August, 2014)
The renewed boom in credit derivatives is being powered by yield-hungry investors and Wall Street banks looking for new revenues. The two instruments helping investors play booming corporate credit markets at this juncture include total return swaps (TRS) and options on indices comprised of credit default swaps.
Updated: October 17, 2014 given recent market events and sudden interest in all things liquidity-related. To be clear, the lack of liquidity just exacerbates market moves. The underlying problem is that complacent investors have been in the same (long) positions for the past five years, selling volatility and levering up to boost returns.
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A by-no-means-extensive list of my work on the changing structure of the bond market.
Goldman eyes electronic bond trading (March, 2012)
Finance: Grinding to a halt (June, 2012)
Dealer and investor talks over liquidity fears (June, 2012)
Goldman launches bond trading platform (June, 2012)
Bond trading model shows signs of stress (October, 2012)
Banks tout idea of sharing bond data (November, 2012)
Slow-drip bond sell-off masks a problem (November, 2012)
Markets on edge as investors seek exit (June, 2013)
ETFs under scrutiny in markets turbulence (June, 2013)
Markets: the debt penalty (September, 2013)
Digging into dealer inventories (September, 2013)
Verizon’s $49bn bond sale whets appetite for larger issues (September, 2013)
ETFs: Tipped as liquidity source (November, 2013)
Global liquidity: Buyers struggle to find a safe landing (November, 2013)
Big US banks back new bond trade venue (November, 2013)
Investors turn to ‘shadow’ bond market (January, 2014)
Banks are a proxy for credit bubble fears (March, 2014)
Taper tremors fail to deter ETF investors (May, 2014)
Checking out of the ETF hotel could be costly (May, 2014)
‘Patient capital’ ready to exploit bond market sell-off (June, 2014)
Fed looks at exit fees on bond funds (June, 2014)
Bonfire of the bond funds (June 2014)
BlackRock’s Aladdin: Genie not included (July 2014)
Investors in junk bonds face a Matrix moment (August 2014)
Finance: The FICC and the dead (August 2014)
Investors dine on fresh menu of credit derivatives (August 2014)
Yield-hungry markets overlook credit risk (September 2014)
US corporate bond traders go electronic (September 2014)
Gross exit from Pimco tests bond market (September 2014)
Wall St sheds light on Bill Gross reign after Pimco departure (September 2014)
At the risk of sounding like a broken record, expect more on this.
I was in Dallas to cover the annual shareholders meeting of Goldman Sachs. I thought I would take a detour from the plush surroundings of Goldman’s offices to a rather different locale; the site of one of the first – and largest – CMBS 2.0 loans to have defaulted. My cab driver eyed me nervously when I said I wanted to stop by this place in North Richland Hills (he later confessed that he thought I was planning to strike a drug deal in the parking lot).
Here’s the story: