Perspective on Risk - March 4, 2024
Evolution of the Financial System; Private Credit; Counterparty Risk; Mark To Myth; Regulatory Interest; Loan Review; Endowment Risk & Return; Happiness (Get Up & Dance)
Since credit decisions are almost always delegated to agents … any effort to analyze the pricing of credit has to take into account not only household preferences and beliefs, but also the incentives facing the agents actually making the decisions. And these incentives are in turn shaped by the rules of the game, which include regulations, accounting standards, and a range of performance-measurement, governance, and compensation structures. (Stein 2013)
Evolution of the Financial System
I read a lesser reported paper Evolution of Debt Financing toward Less-Regulated Financial Intermediaries in the United States. The paper is a very good summary of developments and changes and is recommended. Below I summarize the principal conclusions:
Nonbank lending in the US is growing fast across all the debt markets, ranging from small direct loans to corporate bond markets. This growth has been an unintended consequence of tighter bank regulation
Nonbank lenders suffer from the excess volatility of their capital supply, which worsens during bad times, especially for those institutions subject to runs. As a result, the capital constraints of nonbank lenders adversely affect the access to liquidity for borrowing firms, as was the case during the COVID-19 episode.
On the other hand, nonbanks are faster and more efficient … [and] often include more innovative features in their loan contracts. Thus, financial innovation has also played a substantial role in the increasing influence of FinTech in credit markets.
The critical questions are what should be done about the possibility of runs on nonbanks, such as mutual funds, and the consequent threat of fire sales. Another concern is who will lend to smaller and riskier firms, which shifted their borrowing toward nonbank lenders, if these lenders disappear or become traditional lenders over time.
[Mutual fund families] cash holdings are insufficient to fully mitigate any price impact externalities that funds may exert on other market participants.
Acknowledging the vulnerability of mutual funds, the SEC adopted a new regulatory framework … requiring mutual funds and ETFs to classify and monitor the liquidity of individual portfolio holdings … and also permitted open-ended funds to use “swing pricing,” [In] 2022, the SEC proposed to significantly tighten the regulation of open-ended funds regarding liquidity risk management.33 Among the proposed changes are the mandatory implementation of swing pricing and maintaining a minimum cash reserve equal to 10% of their net assets for all mutual funds, except for money-market funds and ETFs.
[The] cyclicality of nonbank loans and show that it is the main driver of the decline in syndicated loan originations (and increase in loan spreads) during the credit tightening of both the Financial Crisis and the COVID-19 pandemic.
It comes back to the source of financial fragility is the run-risk associated with large institutional pools of money.
Private Credit
Fed Board Report
Fed Board economists have written an overview piece: Private Credit: Characteristics and Risks. The paper provides a nice overview of the growth and players.
Reading the paper, we mostly see that this market is substituting (or supplementing) traditional bank-led syndicated lending, and perhaps is recreating an element of the old junk bond market. The article also points to the fact that supervised banks are not the efficient holder of these sub-IG credits.
The sector is heavily concentrated in a few large fund managers such as Oaktree, Ares, Goldman Sachs, HPS Investment and Blackstone.
Comparing private credit loan spread with spreads observed in institutional Term Loan B in the leveraged loan market, we observe that the spread on private credit loans is generally higher, and the gap in spreads between the two types of loans declined in recent years to below 200 basis points before widening again in 2023. The difference in spreads is consistent with the riskier profiles of private credit borrowers relative to syndicated loan borrowers.
… mean interest coverage [ratio] of around 2.0x … For comparison, ICR in leveraged loan borrowers is slightly higher at around 2.7x …
Based on a very small sample size: lower default rates, but higher loss-given-default
year-to-date default rates have generally been low, compared to the broadly syndicated loan market or HY bond market, particularly in direct lending.
Despite this seniority in debt structure, private credit loans have relatively low recovery rate upon default (or equivalently, exhibit high loss given default) compared to syndicated loans or HY bonds, as shown in Figure 15. Post-default value of a direct loan is around 33 percent, while those in syndicated loans and HY bonds are 52 and 39 percent respectively.
The key reason for the low recovery rate upon default is that more than half of all value-weighted private credit is provided to borrowers in sectors with relatively low collateralizable or tangible assets such as software, financial services or healthcare services (Figure 16), and thus have lower recovery rate for every dollar of defaulted loans.
They discuss, and do not find, significant systemic risk. I image when (if) a recession occurs, we will see this form of credit extension significantly retrench.
Two Papers From 2024 BEAR Conference: The Prudential Framework
Insurance Companies and the Growth of Corporate Loans' Securitization (NY Fed)
Insurance companies nonupled1 their CLO investments in the post-crisis period. This growth has far outpaced that of loans and bonds and is characterized by a strong preference for mezzanine tranches over triple-A tranches. Conditional on capital charges, insurance companies invest more in bonds and CLO tranches with higher yields. Importantly, they prefer CLO tranches because these carry higher yields relative to bonds. Preferences increased following the 2010 capital regulatory reform, resulting in insurance companies holding 40 percent of outstanding mezzanine tranches. Insurance companies contributed positively to CLOs’ equity returns and played a critical role in the rise of loan securitization.
Nonbank Market Power in Leveraged Lending
Banks sell loans to nonbank investors to finance lending to risky firms. Among these investors, collateralized loan obligations (CLOs) provide the bulk of funds. Is how that CLOs have market power, which enables them to extract lender-friendly loan terms. I use hand-collected data on CLO mergers to identify this effect. In that process, I provide the first analysis of mergers in the CLO industry. CLO market power results from switching costs faced by the bank. One source of switching costs is information asymmetries across CLOs that arise during underwriting. My results help explain the price differential between loans and corporate bonds.
Counterparty Risk
As we’ve discussed, the evolution of the financial system has been towards the development of a tranched financial system, with banks at the core in a ‘super-senior’ type position, and much of lending occurring in ‘private credit.’ Combine this with ‘private trading’ dominating markets through hedge funds (with leverage provided by banks) and counterparty risk rises to the forefront.
Fed. Gov. Barr has now given this speech: The Importance of Counterparty Credit Risk Management at a Basel Committee conference on counterparty risk hosted by the NY Fed.
I'll focus my remarks on three themes.
First, banks should know their customers exceedingly well, both at onboarding and throughout the evolution of the relationship.
Second, banks should have tools to identify the unique risks they face as these risks materialize across products, business lines, and clients and use these risk measures to maintain appropriate margins through the credit cycle.
understanding a counterparty's risk profile through a range of risk measurement tools.
banks should conduct risk aggregation within and across products, business lines, and clients.
banks should have capabilities for timely and accurate risk measurement given the dynamic and complex nature of trading activities.
banks maintain appropriate levels of margin to insulate them from loss.
Third, banks should set prudent risk limits and respond to signals of risk appropriately.
The Fed has recognized that individual firm efforts may not be enough to limit systemic risk:
… alongside this year's stress test results, we will publish the aggregate results of several exploratory analyses, including analysis of the resilience of the globally systemically important banks to the simultaneous default of their five largest hedge fund counterparties.
What will be interesting is that I imagine many of the ‘five largest hedge fund counterparties’ will likely be subject to portfolio margining through VaR-type models, rather than the more traditional margining regime discussed under the principles he articulated. It will be very interesting to see HOW they chose to disclose the results here.
Mark To Myth
Of course, valuations here are opaque. Flawed Valuations Threaten $1.7 Trillion Private Credit Boom (Bloomberg)
… a prime virtue of private credit — letting these funds decide themselves what their loans are worth rather than exposing them to public markets — is looking like one of its greatest potential flaws.
Data compiled by Bloomberg and fixed-income specialist Solve, as well as conversations with dozens of market participants, highlight how some private-fund managers have barely budged on where they “mark” certain loans even as rivals who own the same debt have slashed its value.
Yeah, duh. If you are a sophisticated investor, or a prime broker extending leverage, you better not be relying on the dealer’s marks. Same problem with derivatives; need a good independent valuation process.
Mismarks can contribute to systemic risk (see Lehman’s marks on their CRE) but it is not a real problem if there are not runable funding.
Continued Regulatory Interest/Concern
So let’s bring together private credit and counterparty risk.
Oversight of Non-bank Lenders
Bank of England deputy governor calls for more research into non-bank lenders (FT)
A shift in the willingness of market-based finance to lend to corporates, particularly those perhaps that are highly leveraged, would have significant implications for the real economy — a credit crunch sourced in market based finance rather than bank lending, Breeden said on Monday
In discussing Barr’s Counterparty speech above, we note that the Fed is conducting ‘exploratory analysis’ by obtaining information on the effects of the failure of the large banks top 5 hedge fund counterparties.
The Bank of England is taking a somewhat different approach (given their broader supervisory remit and authorities):
The BoE is currently working on its inaugural review of how financial markets function under stress, dubbed its “system-wide exploratory scenario”. The assessment aims to examine 50 institutions to assess how they would respond to potential shocks.
Loan Review
Loan review is one of the most unloved aspects of risk management. It’s not sexy, but it is vital. Witness NYCB’s disclosure:
Separately, as part of management’s assessment of the Company’s internal controls, management identified material weaknesses in the Company’s internal controls related to internal loan review, resulting from ineffective oversight, risk assessment and monitoring activities. Although assessment of the Company’s internal controls is not yet complete, the Company expects to disclose in the 2023 Form 10-K that its disclosure controls and procedures and internal control over financial reporting were not effective as of December 31, 2023.
When it rains, it pours.
[Full disclosure: I own some NYCB shares at a significantly higher price than it currently trades.]
Collateral Cycles
Collateral Cycles (Bank of England)
Using supervisory data from UK central counterparties (CCPs), our paper uncovers persistent collateral cycles in which cash goes back and forth from financial markets to CCPs. In the onward phase of the cycle, clearing members provide cash to CCPs to meet margin requirements. This pattern is procyclical as the pledged collateral increases with market volatility and places upward pressure on repurchase agreement (repo) rates. In the backward phase, CCPs return the cash to the financial markets via reverse repos and bond purchases, in compliance with regulation that requires CCPs to invest their cash holdings in safe assets. The cash given back by CCPs generates downward pressure on repo rates in a countercyclical manner.
Excellent paper
Endowment Risk & Return
I wasn’t smart enough to go to any of these schools covered in FY2023 Ivy Report Card: Volatility Laundering And The Hangover From Private Markets Investing. Yale has the best Sharpe.
Happiness
My Happiness Is On An Uptrend
By this metric, my kids will be happier than me for only about three more years.
Depressed? Get Up and DANCE!
I may need to add dancing to my weekly routine.
A combination of nine of a kind