Market report: April 2019

06.05.2019 * reading time: 15min.


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      At the beginning of our April market report, let’s step back in time. It is the beginning of 2007. The American subprime loan market (loans of higher risk to persons with low creditworthiness) is flourishing, initiated in the 90s of the previous century. Among the factors determining the development of this market are the demand for real estate from less affluent US citizens, high level of competition in the US mortgage market, which translated into low margins on standard products and market niche exploration, including the subprime segment, legislative changes in the USA carried out in the 1980s, including on the permission of the lenders to grant ARM-type loans (ie adjustable-rate mortgage, variable loan interest rates, initially low fixed interest rate after a few years a variable market interest rate).
Since 1997, there has been a continuous increase in property prices, and credit institutions ignoring the basic principles of financing and assessing the creditworthiness of borrowers have granted loans to people who do not have a regular source of income. In order to ease the monetary policy, the FED started a three-year cycle of interest rate cuts, from 6.5% in mid-2000 to 1% in mid-2003. This factor has increased the activity of banks and credit institutions in providing low-cost mortgages and consumers, encouraged by the prospect of easily obtaining housing loans and paying off lower installments of these loans.
The situation changed from the second half of 2003. Since mid-2003, the Federal Reserve System FED has raised interest rates 17 times (from 1 to 5.25%) to limit the inflationary pressure accompanying the rapidly growing US economy.
For many borrowers (USD 376 billion subprime type ARM), the time has come to change the terms of interest rates on loans. Loans servicing costs have become too high in relation to the income possibilities of some borrowers. As a result, more and more of them began to go bankrupt, and banks increasingly began to struggle with the problem of bad loans. In mid-2007, the number of problematic subprime loans stood at 13.5% (more than twice as many as in 2005). In 2007, approximately 1.3 million households ceased to repay loans. Another factor was the securitization of subprime loans (at the end of 2007, the total value of mortgage bonds securitized, secured with the proceeds from loans on the US market amounted to USD 4.5 trillion, while the US mortgage market value amounted to USD 13 trillion), which in the face of an increase in non-performing loans and rising market interest rates has led to the collapse of the securitization market. Expensive mortgage loans (as a result of raising the interest rates by the FED), a sharp increase in the number and value of unpaid loans, emerging information about the decline in the value of assets of an increasing number of financial institutions (due to turbulence on the stock exchanges), as well as the increasingly occurring phenomenon bankruptcy or loss of liquidity of credit institutions (and other companies in the financial sector) caused a dramatic drop in trust in credit institutions in the banking sector (playing a key role in the financial and economic systems of individual countries). The value of equity of a number of financial institutions listed on the stock market dropped significantly, due to their location in financial instruments, the value of which was related to the information on the involvement of these institutions in unprofitable subprime loans, holding own deposits in other bankrupt credit institutions and general very emotional behavior investors. Thus, it suddenly turned out that their equity was insufficient in relation to their liabilities. Institutions being forced to increase their equity as soon as possible, restoring solvency and security ratios to the appropriate level, immediately tried to get rid of their financial instruments (so-called deleveraging). As they acted under time pressure and supply far outstripped demand, the value of their instruments rapidly decreased. As a result, financial institutions faced the sudden need to obtain a financial injection to avoid bankruptcy.
As a result of the large involvement of a number of European banks in the process of subprime mortgage securitization in the US mortgage market, the bursting housing bubble has caused the demand for bonds that were previously acquired by European credit institutions secured by financial flows from relevant mortgage tranches to drop sharply. In the situation of a deep demand-supply imbalance, the market of securitized bonds and structured credit instruments collapsed. As a result, a number of institutions operating on these markets were unable to sell their assets. Banks reported increased demand on the interbank money market, but due to the fact that the level of involvement of individual banks in the subprime market was difficult to estimate, in the face of panic, the interbank market offered little opportunities. Among the private and institutionalized clients, there were more and more frequent symptoms of distrust of credit institutions which resulted in the crisis widening to other financial institutions, not related in any way to the mortgage market. The credit crunch turned into a liquidity crisis.

Heard on the street:

Have you insured bonds financed with cash flows from individual mortgage tranches with a swap?
No? Why not?

23:08 short position. Please. You’re welcome.

Do you really think that car insurance or a scam proposal are sufficient in this situation?

Let’s go back to today.

In 2018, the global value of Lavereged Loans, described more broadly in the March Market Report, reached the pre-crisis level close to USD 800 billion. About 80% of issues are so-called loans leveraged in the “covenant lite” – in which investors do not require borrowers to maintain certain financial ratios. Most new issues of leveraged loans are used to refinance corporate debt, buy-back equity financing, dividends paid, instead of financing new production investments. The leverage of borrowers has also increased, and the available statistical data on the level of indebtedness of enterprises to their EBITDA are, according to our assessment, understated. The most probable cause of this underestimation is the securitization of leveraged loans and their purchase by non-banking entities, a market segment that has become larger than the junk bond market. We are dealing with a situation of shifting lending from the banking sector (of strategic importance) towards non-banking financial institutions.

A few facts:

– approximately 80% of the USD 800 billion issued in 2018 are loans leveraged in the “covenant-lite”, which does not require the issuer to periodically achieve threshold levels for financial ratios, such as net debt / profit before interest, taxes, depreciation and interest. The convention imposes certain requirements on the levels of indicators achieved as a result of activities such as debt issuance, dividend payments or acquisitions.

– around half of the enterprises using this type of financing have a debt to EBITDA ratio in the range of 4.99-6.99. – about 57% of enterprises financed in this way in 2018 are American enterprises (followed by Japan – around 7%), about 52% of issue value in 2018 are emissions intended for financial institutions (industry – in the second place – around 26%)

– in around USD 491 billion of issues from 2018 the 10 largest US banking institutions acted as underwriters.

In the period preceding the crisis in 2008, the demand for structured credit products came largely from investment vehicles created by banks with an off-balance sheet structure. These vehicles depended on short-term wholesale financing to finance illiquid mortgage portfolios with a longer maturity. When this unstable funding source froze in August 2007, the banks had to finance the SIV (structured investment vehicle) directly. Losses incurred by SIV had to be covered by sponsoring banks – and ultimately by the taxpayer. Currently, most of the demand for leveraged loans comes from managers of collateralised loan obligations, which are bonds issued in several tranches with several-year maturity, corresponding to the period of loans for which they are secured. It reduces to some extent the risk of exceeding the acceptable indebtedness at the enterprise level. It lowers but does not eliminate. It lowers at the current level of interest rates and current economic growth. What if these variables change significantly in terms of the ability of enterprises to service debt?

Debt and credit risk premium are correlated: the higher the debt to EBITDA ratio, the higher the spread between BAA profitability and the yield on US government bonds.

In order for the debt to EBITDA ratio to be close to 4.6, the spread for BAA-rated bonds should now be around 120 basis points more (we are talking about the debt of non-financial corporations in the US because this, according to our assessment, presents the most reliable picture of the real situation). After adjusting the corporate debt to be consistent with the EBITDA interest rate, the Markov switch-model estimation fits the actual spread better than without an adjustment.

The debt to EBITDA ratio close to 5 is high by historical standards. In recent history such a level was achieved in 2001 and 2009. Private suppliers of stock indices and financial data confirm the observation that the debt to EBITDA ratio is at the level usually achieved during the recession. Consequently, the BAA-to AAA spread should be around 120 bp higher than currently observed (~ 230 bp today) if hidden debt is taken into account.

We carefully observe the market for overnight financing in the US.

Let’s recall, the Federal Reserve System implements the monetary policy using the corridor within which the effective interest rate moves. The bottom is limited by the interest rate reverse repo overnight (ON-RRP), in which FED sells US Treasury securities to its dealers (takes out a loan under pledge of treasury securities). The upper part of the corridor is IOER (interest on excess rate), i.e. interest on the excess reserves maintained by banks on the account in FED. The effective interest rate on funds should, from a theoretical point of view, move within the corridor.

It should, but we see after March 20, 2019 that the effective interest rate (Effective Fed Funds) increased above the IOER rate (2.44% vs. 2.40%).

We decided to take a closer look at this market anomaly and found that from the beginning of April this year. the balance of approximately USD 2.28 trillion of government money-market funds decreased by approximately USD 108 billion, of which about USD 49 billion in the period March 29-April 3 this year.

There may be several reasons for this phenomenon. These may be payments of tax liabilities made by Investors that drain the level of bank reserves (which would suggest a temporary nature of anomalies). Another reason for this phenomenon (closer to us) may be the fact that the growing effective interest rate on funds is the result of the fact that the level of bank reserves maintained on the FED account is for many banks, let’s call it uncomfortable, which means that banks are willing to pay a higher percentage in order to maintain the current level. In other words, the USD 1.5 trillion surplus liquidity created by the FED is no longer sufficient for banks that are seeking liquidity. This would mean that even a modest liquidity crisis at any time in the future can have very negative consequences.

We read comments and reports of large institutions dealing with asset management, covering both the first quarter of 2019 and the month of April 2019. Most of them agree that long-term economic growth remains unthreatened. We are skeptical about this, we think that the global economy will slow down and we will be witnessing it in the second and third quarter of this year. It is very likely that we are near the top of the mountain of the global economic climate and the current 10-year credit cycle has ended. We see many threats, market valuations are high, investors’ expectations as well. The profit-to-risk ratio is at an unacceptable level.
In the report from October 2018 (S&P index at 2745) we found that the US stock market is undergoing the first downward impulse. Our opinion has not changed, we think that the last growth on the market has been used by “smart money” for stock distribution. We would do it.
According to our assessment of the situation, the transition to the risk-off phase is a matter of short time.

The anticipated program of temporary debt monetization by the FED through the Standing Repo Facility (SFR), allowing access to liquidity on demand to the main FED dealers while securing statutory pricing (not market-based), is treated more as a prelude to approaching trouble than the long-term growth management tool.

Risk management in the selection of shares, meaning something for those who want to have shares in the portfolio

The risk is perceived differently by different investors. For some, it’s just another word about volatility. For others, what the portfolio looks like compared to the benchmark.

The first step in effective primary risk management is to understand what may go wrong at the company level. Accurate research at company and industry level is necessary, for example, to determine how sensitive the company’s profits are to changes in the macroeconomic environment and to identify environmental, social or management risks that may affect performance.

It is important to question your own perspectives. In some cases, this can be done by working with short sellers, usually working in hedge funds. Because short sellers are trying to take profits from the drop in stock prices, they have negative opinion about the company’s prospects. When talking to them, investors can identify potential areas that can and need to be improved. This may lead us to look again at the key assumptions or to change our return forecasts to compensate for the risks we originally did not notice.

Innovation in understanding risk at the portfolio level

At the portfolio level, stock funds managers typically rely on a range of quantitative risk models from external suppliers to test the portfolio’s resilience against different threats. Models that analyze the likely response of the portfolio to different scenarios can help control exposure, but ultimately do not replace experience and proper assessment of the situation.

Asset managers usually also rely on risk models that test the exposure of the portfolio to known country, industry and various risk risks. They can assess how cheap or expensive or how big or small are the portfolio companies in relation to their broad investment universe. Risks that do not match these segments are then classified as specific risks.

Traditional risk models may need help. Although it is important to understand and control the exposure to risk factors, which can have a major impact on performance, the same approach may be too static and simplified. Many other threats are not related to specific stocks, but are not necessarily easy with standard risk categories. And the way in which different stocks are exposed to such risks can vary significantly over time.

Cluster analysis fills the gaps

Cluster risk analysis is a good complement to traditional risk tools. This technique looks for correlated risk sources that may not be obvious to quantitative risk models or core analysts. Cluster analysis is a technique of artificial intelligence that divides segments into groups whose returns have come together in the last few months. For example, it can help to separate stock groups in an industry or segment that will benefit from risk trading when markets reward more risky assets.

Rafal Ciepielski

Rafal Ciepielski

CEO RCieSolution

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all RCieSolution management teams. Are subject to revision over time.