Credit

Dwight Cass

Uh Oh: Banks Turning to “Mark to Myth” Accounting for Massive CLO Market

​Dominoes are falling in the financial sector according to the pattern set in 2008. Only then it was mortgages driving the mayhem. Now it is zombie corporate credits, kept alive for years on cheap junk-rated loans bundled into collateralized loan obligations (CLOs), which investors were forced to buy because central banks kept returns on everything else artificially low. 

Once the belle of the ball, since the Covid-19 crisis there are evidently too few buyers to provide prices for the banks that peddled the CLOs to value them accurately. According to a piece today in Risk, German lender Commerzbank is in trouble, having been forced to categorize $5.2 billion of its CLOs as Level 3 assets in the first quarter,  meaning they are unable to be marked to market (valued using market prices) and requiring Commerz to use a “mark to model” approach.

That means it more or less makes educated guesses, none of which anyone else believes. In 2008, this was referred to as “mark to myth” accounting when applied to the toxic mortgage securities that torpedoed many banks and brought down Lehman Brothers.

According to the FT, which wondered aloud today if CLOs were “ground zero” for the next stage of the financial crisis, JP Morgan estimates that US CLOs alone totaled some $691 billion at the end of last year, double the amount from two years earlier. In the same time, the market for the junk loans backing the CLOs doubled to $1.2 trillion.

The FT article showed that the Covid-19 crisis has since sent investors fleeing: Yields (which move inversely to prices) on the junkiest BB tranches shot up from around 9 percent to over 16 percent when the crisis hit.

All the investors stuck with this dreck can’t sell it without big losses, meaning they’ll have to sell more liquid assets to meet redemptions, spreading the misery to other markets, if the events of 2008 are any guide. But hey, perhaps the Fed and its counterparts will snap them all up, leaving the banks to repeat their mistakes yet again, and setting the stage for the next crisis. Third time’s a charm.

hen structured credit markets froze up in March, Commerzbank could not find enough real quotes to accurately price its collateralised loan obligations (CLOs). The dearth forced it to shift €4.8 billion worth ($5.2 billion) into the mark-to-model category –reserved for complex, illiquid assets

When structured credit markets froze up in March, Commerzbank could not find enough real quotes to accurately price its collateralised loan obligations (CLOs). The dearth forced it to shift €4.8 billion worth ($5.2 billion) into the mark-to-model category –reserved for complex, illiquid assets.The move increased the German lender’s stock of Level 3 assets by 69% quarter-on-quarter to €9.8 billion. As of end-March, they made up 7.2% of all fair value assets, up from 5% at end-2019.

hen structured credit markets froze up in March, Commerzbank could not find enough real quotes to accurately price its collateralised loan obligations (CLOs). The dearth forced it to shift €4.8 billion worth ($5.2 billion) into the mark-to-model category –reserved for complex, illiquid assets

Dwight Cass

The Fed’s Credit Head Fake Imperils Yield Curve Policy Prospects

The Fed has still not acted on its promise in February to purchase essentially unlimited amounts of investment grade and junk corporate debt and ETFs. While a yield chasing frenzy has allowed marginally investment grade issuers – including Walking Dead extras Carnival and Boeing – to raise stonking amounts of debt without the central bank’s help, the Fed risks losing credibility. Given its hopes to manage its balance sheet bloat through a yield curve control (YCC) policy, its timing couldn’t be worse.

The Fed’s empty jawboning has not gone unnoticed. On Friday, Bank of America credit analysts wrote:

Note to Fed: a lot of investors (including non-credit ones) have bought IG corporate bonds the past two months. . . on the expectation they can sell to you. So would be helpful if you soon began buying broadly and in size. (H/T Grant’s Almost Daily)

On April 23, Wolf Richter wrote:

So over the past four weeks, the Fed has not done any of the things with these SPVs and Primary Dealers that the markets were raving about it would do. It didn’t buy junk bonds, it didn’t buy ETFs, it didn’t buy stocks, it didn’t buy old bicycles. But Wall Street sure loved raving about it.

The situation hadn’t changed as of last week’s Fed balance sheet report.

The Fed’s credibility, always crucial, is particularly important now, with central bank grandees considering using a YCC policy to control rates without further ballooning its balance sheet. In essence, this involves telling the market that it will buy Treasuries at a given price. No one sells lower than that, knowing they can sell to the Fed, so rates stay at the target level, even if the Fed doesn’t actually buy much. But for that to work, as it did during World War II, the market has to believe the Fed will support the peg.

Hence the need for credibility, which the Fed is now frittering away.

Dwight Cass

Credit is the Emerging Bogeyman for Debt Dystopia

The downgrades of Macy’s and Kraft Heinz hint that the next corporate debt catastrophe might not be caused by a wall, but a cliff. The Wall of Maturities that so worried leveraged loan, junk bond and CMBS investors at various times after the Global Financial Crisis turned out to be easily vaulted. The real problem, according to an OECD report out today, might be the massive amount of debt clinging to the bottom rung of investment grade. Macy’s and Kraft Heinz lost their footing. If others follow, things could get interesting.

Wall Worriers were concerned that the junk bond and loan markets would not be able to absorb the massive amounts of debt that had to be refinanced from around 2012 through 2014 – much of it loans used to finance the pre-crisis buyout boom. The CMBS reckoning was thought to be coming a few years later.

But the Fed, ECB and other central banks came to the rescue. By driving down yields on moderate- and low-risk investments, they forced pretty much everyone to slide down the credit spectrum in search of yield. Junk issuers found plenty of indiscriminate demand, the brains on which zombie companies feed.

The OECD report highlights another big problem, and one that central banks will not be able to solve. This is simply that the flood of nonfinancial corporate bonds – some $2.1 trillion was issued in the wake of the Fed’s dovish turn in 2019 alone – is near junk. “Just over half (51%) of all new investment grade bonds in 2019 were rated BBB, the lowest investment-grade rating,” the report states. This is even more dismal that before the financial crisis, when only 39% of investment grade issues were rated BBB.

The proportion of junk bonds has also increased, to 25% of nonfinancial corporate issuance last year, and over 20% since 2010. That’s the longest period of high volumes of low-quality issuance since 1980, and, the OECD says, “indicates that default rates in a future downturn will likely be higher than in previous credit cycles.”

If more economic stalwarts like Macy’s start to circle the drain, or the coronavirus so messes up supply chains and distribution lines that many marginally investment-grade companies run into trouble, large numbers of issuers could cross the line into junk status, forcing investors who cannot hold high yield instruments to sell. Large-scale forced selling of distressed assets – that has an unpleasant ring to it.