For years, regulators have tried to make the financial system safer by blocking banks from taking on the extreme leverage that almost toppled the industry in 2008. Turns out, the risks just moved.
In a matter of days, a slew of trades unraveled to expose various forms of soured levered bets at their heart. Citigroup Inc. was among banks that tried to sell off US$1.3 billion of risky loans to unwind leveraged wagers by clients. Funds that borrow to load up on mortgage bonds fed a flood of liquidations. Large municipal-bond funds are selling billions of dollars in positions, too.
In 2008, the culprits were real estate speculators, investments banks that fueled the bubble while leveraging books about 40 to 1, and investors who failed to conduct their own due diligence. A wave of defaults caused that system to come crashing down.
This time, another long period of rock-bottom interest rates, most recently cheered on by U.S. President Donald Trump, has let companies go into record debt while showering cash on shareholders. The enablers are banks eager to facilitate deals and investors desperate for higher returns. They borrowed to multiply profits on mortgages, junk debt and municipal and government bonds. The leverage means losses are getting amplified too.
“Everyone knows you are playing with fire with leverage,” said Michael Terwilliger, a portfolio manager at Resource Credit Income Fund. “Response to the last panic has built the new panic.”
After years of relatively sedate markets, trades are suddenly getting tested by the COVID-19 pandemic. Emergency measures to contain the virus’s spread are slamming the brakes on commerce, shutting businesses and leaving millions of Americans jobless. The economic downturn is raising the prospect that consumers and companies will fall behind, defaulting on loans.
A slump in prices for risky debt is putting pressure on investors to pony up collateral or unwind leveraged trades. That feeds a vicious cycle, with rapid liquidations depressing prices further, potentially triggering more margin calls and sales. It’s contributed to violent drops in the market.
Still, there’s scant evidence to suggest the amount of leverage in the system now is as great as it was heading into 2008.
There are few if any public disclosures outlining the magnitude and structures of many leveraged trades. Market insiders and people with knowledge of transactions that unraveled agreed to describe what they have seen on the condition of anonymity.
Citigroup and Truist Financial Corp. had to sell off hundreds of millions of dollars in risky credit known as leveraged loans, after prices on the debt collapsed to 10-year lows. The loans were behind total-return swaps, a type of derivative that gives investors amplified exposure to a debt’s performance.
In a typical arrangement, the client pays the bank an agreed-upon rate and in return receives payments based on the performance of the asset without actually owning it. The swaps have mark-to-market triggers that enable banks to demand more collateral if prices fall below a certain level. Depending on how the deal is set up, the assets may be sold.
The sudden plunge in loan prices in March spooked banks. One multibillion-dollar hedge fund manager said the bank he uses put a hard stop on any more such trades because of worries about counterparty exposure in a volatile market.
Another strategy involves selling mostly short-dated credit-default swaps that insure investment banks against the initial losses on hundreds of investment-grade and high-yield bonds.
The initial outlay for an investment fund is a mere fraction of the total outstanding notional value of the bonds being insured, in some cases amounting to implied leverage of as much as 100 times. If the bonds don’t default by the time the protection expires, the firm providing insurance comes out on top. But such bets can be undone by just a small number of defaults on the underlying debts.
The drop in prices for leveraged loans is also hitting investment vehicles known as collateralized loan obligations that are packed full of them. The vehicles sell an equity slice and interest-paying bonds so they can buy up loans. But to get the deals off the ground, managers kick-start them with borrowing, typically drawing on a form of bank financing known as warehouse facilities. Goldman Sachs Group Inc. and JPMorgan Chase & Co. recently sent out demands to some managers of the deals to put up more cash against those warehouse lines after loan prices fell.
Within the tranches of securities sold by CLOs, the equity is the riskiest piece because it gets paid out only after the bondholders are paid in full. That essentially makes equity stakes another form of leveraged bet on the performance of the loans.
Some investment funds have levered up their bets on securitized debts with bank financing. They might, for example, put up cash as collateral to gain the ability to spend several times that amount on debt, such as highly rated CLOs. In relatively safe pockets of structured credit like AAA-rated CLO paper, investors might borrow at seven times from banks to fund their trades.
Investors can also put up a high-quality asset to borrow cash through the repurchase agreement market, using it to then buy illiquid but higher-yielding assets. In either case, the borrowing of money can magnify returns. Yet if the assets start to lose value, banks can demand more money up front or force liquidations.
Banks now have much higher capital requirements than in 2008. That makes securitized products more onerous for many dealers to hold as collateral, which encourages banks to make margin calls.
Across mortgage land, there are mounting concerns that a growing number of unemployed consumers may soon fail to make payments.
Mortgage real estate investment trusts rely on borrowed money to build their holdings. That leverage helps drive higher returns than what they would eke out by simply collecting interest coupons from the underlying debt. Counterparties are willing to lend because of the pledged collateral.
New Residential Investment Corp., a real estate investment trust focused on housing, has been selling off a portfolio of debt with a face value of US$6 billion at a discount in recent days as it seeks to reduce risks and improve liquidity. The REIT, managed by an affiliate of Fortress Investment Group LLC, has said it sometimes uses leverage in the form of financing from banks and securities sales to enhance returns.
Last week, AG Mortgage Investment Trust Inc. said it had failed to meet some margin calls from financing counterparties and that it didn’t expect to meet future margin calls with its current financing. The firm, which said it planned to talk with financing counterparties, didn’t elaborate on the transactions at issue.
Some, like Cherry Hill Mortgage Investment Corp. have also been dealt a blow on so-called credit-risk transfer trades. Such securities offer higher returns on a pool of residential loans because investors agree to take borrower default risk off the hands of Fannie Mae and Freddie Mac. The lowest-rated slices of that debt have plunged because they’re the first to take a hit if the loans go bad. That contributed to the troubles at Cherry Hill, which elected to pay half its dividend in stock last week, citing market volatility.
In the US$3.9 trillion municipal-bond market, large municipal-bond funds run by Nuveen, BlackRock Inc., Pacific Investment Management Co. and Invesco Ltd. unwound a leveraged investment strategy that backfired last month when short-term borrowing costs spiked.
The companies liquidated US$2.5 billion of tender-option bond trusts, contributing to a flood of debt unloaded during a record-setting selloff. The trusts issue floating-rate notes to money-market funds and use the cash to buy higher-yielding long-term bonds. Mutual funds seek to pocket the difference in yield between the two.
Even swings in prices on the most ironclad securities can catch wrong-footed investors.
Hedge funds got hammered by moves in the Treasury market last month that derailed a popular strategy. The maneuver uses money borrowed from repo markets to exploit differences between cash Treasuries and futures. Some firms had levered up wagers as much as 50 times, people familiar with the situation told Bloomberg. Leveraged funds’ exposure to the so-called basis strategy could be as much as US$650 billion, JPMorgan strategists said.
“There’s been an exogenous shock that’s exposing leverage in the system,” said Michelle Russell-Dowe, head of securitized credit at Schroders. “There will be winners and losers, and it will all ultimately come down to leverage.”
Regulators focused on banks when they set out after the 2008 financial crisis to rein in the excessive risk-taking that threatened to upend the financial system. But as the U.S. emerged from that wreckage, the Fed kept lending rates so low that companies across the country binged on borrowings, with U.S. businesses taking on US$16.1 trillion, up from US$10.2 trillion a decade ago. Investors lined up to lend, in part because U.S. rates were still higher than those in Europe and Japan.
In their enthusiasm, investors let borrowers strip protections, known as covenants, from risky loan contracts. The leveraged lending market expanded to US$2.1 trillion. Sales of CLOs, the biggest buyer of leveraged loans, more than doubled to around US$670 billion from 2010. A new borrowing complex known as private credit grew, drawing lending even further away from regulated banks to an US$812 billion world of non-regulated lenders operating largely out of the authorities’ gaze. Meanwhile, banks rebuilt their derivatives operations.
The overall result was a growing pile of risky debt and a variety of options to juice profits.
“You have junkier and junkier debt, and it’s super levered up,” said Stephen Blumenthal, chief investment officer at CMG Management Group Inc. “When you get yields compressed to record lows, it takes more leverage to generate return. It’s classic human and end-of-cycle behavior.”
To be sure, a number of elements of the market are safer now. CLOs sold after the financial crisis don’t have mark-to-market triggers forcing investors to sell when prices fall below certain thresholds, meaning there’s a very high hurdle to breach before liquidation is triggered. Most of the bank warehouse credit lines that CLO managers use also aren’t marked to market.
This time, authorities were quick to roll out measures aimed at putting a bottom under asset prices with corporate bond buying programs. And Congress and the Trump administration are about to hand money directly to people and businesses.
“This unprecedented US$2 trillion shock-and-awe fiscal stimulus has been conceived in a relatively thoughtful way,” said Stephen Ketchum of Sound Point Capital Management. Banks were the heart of the problem in 2008 and received much of the money directly, which was relatively simplistic. “Now we’re trying to get money to millions of individuals and thousands of businesses that are being affected by Covid-19. It will be a massive undertaking to get it right.”
The coming weeks will be telling. Unlike a decade ago, when regulatory filings gave the public some insight into the types of risk-taking by banks that contributed to the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc., it’s more difficult to see this time how much leverage has accrued, or which investment firms might be most exposed.
The answer will emerge with time, leaving the Fed to face the issues created by its decade of low rates.
“Post-crisis policies drove everyone to places where they shouldn’t have been,” said Larry McDonald, author of the book “A Colossal Failure of Common Sense” about Lehman’s demise. “And then the Black Swan hit.”