Matt King: "We Are More Reliant On Central Banks Holding Markets Together Than Ever Before"

Two weeks ago we summarized the stunning impact that ECB Predit Mario Draghi"s "whatever it takes" efforts have had on European capital markets in one simple chart...

... which as Wolf Richter showed on Friday meant that European junk bond yields are now on top, if not lower than 10Y US Treasurys, indicative of a market that has "gone nuts" largely thanks to the ECB"s daily intervention, which as reported moments ago, now holds €103.39BN in Europe"s corporate bonds, or nearly 13% of the total outstanding.

Today, perhaps troubled by the ongoing distortions in the European bond market, Citi"s global credit strategist Matt King also looks at the European bond market and in a note titled "Partying like it"s 2007", he looks at recent development in the Investment Grade bond market and writes that "after the rally in recent weeks, the 53bp z spread on € iBoxx Corp is 20bp wide to the 33bp it reached in June 2007. However, he noted that a straight comparison of the index spread level now with then is misleading."

King points out that a huge decline in index rating quality means that, on a like-for-like basis, spreads would only be 41bp: just 8bp shy of the tightest € IG spreads ever.

This means that the upside is very limited: "Even if we do rally back to the all-time tights, that would equate to less than 0.5% of excess returns from here."

We won"t go into the details of the breakdown of the adjusted credit spread, but we will highlight a key thing in King"s observations, namely what is the true level of European leverage, and what is prompting this market distortion (spoiler alert: central banks).

Sceptics may argue that the system is much less levered now than in 2007, and (insofar as it goes) this is true. Back then, the response to tight spreads on what was believed to be low-risk assets was to lever up – by taking exposure through a hedge fund buying on margin and benefiting from European banks’ lack of constraint on leverage ratios, or by buying a structured product which leveraged the underlying assets.

Still, even if the growing back then leverage may have been a source of risk, King is not so sure that it all led in the direction of spread tightening, and as he adds "we are doubtful that today’s one-way reach-for-yield, in which many investors have almost despaired of relative value as a concept, is as much safer as regulators like to think."

To the extent that higher gross CDS notionals (Figure 14) are a crude reflection of this increased leverage, much of the trading being done involved relative value relationships – shorts as well as longs – in a way that simply doesn’t happen today. Indeed, it feels to us as though markets were much more two-way back then than they are now. In some sense the additional leverage clearly did add to systemic risk – it is impossible to look at the 2008 liquidity squeeze and argue otherwise – but we are doubtful that today’s one-way reach-for-yield, in which many investors have almost despaired of relative value as a concept, is as much safer as regulators like to think.

Another difference between 2017 and 2007 is CDO issuance, a product which remains largelly dormant in the current market:

Probably the biggest source of “artificial tightening through leverage” back in 2007 was the volume of synthetic CDO issuance. Synthetic CDOs (CSOs) effectively created negative net supply, as net protection selling by investors forced dealers to buy bonds to hedge their books, dragging both CDS and cash spreads tighter in the process. From 2003-2006, global delta-adjusted CSO issuance ran around $300bn/year; in 2007, this increased over $600bn.

As for today...

But the comparable number today is the buying from global central banks. This too produces an “irresistible force” driving spreads tighter, which investors feel powerless to resist. And the volumes are much larger still, averaging around $1.2tn/year (Figure 15) relative to CSOs’ $3-600bn. Admittedly this is spread across asset classes, with the CSPP in isolation amounting to only €80bn – but to take the latter number would to our minds grossly understate the additional demand created in credit. While it’s essentially impossible to isolate an undistorted credit spread in either case, the fact that the increasingly finite demand of central banks is what has facilitated such tight spreads in the first place is hardly reassuring.

In other words, the same thing verbalized as the chart shown up top shows in very simple terms: it"s all frontrunning the ECB"s corporate purchases/

What does this mean for returns?

The post-adjustment 8.5bp of additional spread on the current index relative to the 2007 tights equates to less than 0.5% of index return – from the point where spreads are back to the tightest level on record. And that was a level that with hindsight was driven by leverage and unrealistic assumptions about credit quality – of banks, of corporates and of sovereigns. The aftermath was not a pretty sight.

The conclusion for both the economy, and market, is troubling especially at a time when central banks are preparing to reduce their balance sheets:

With asset prices displaying a high degree of correlation with central bank liquidity additions in recent years, that feedback loop makes the economy, upon which both corporate profitability and bank net interest margins depend, more reliant on central banks holding markets together than almost ever before. That delicate balance may well be sustained for the time being. But with central banks beginning to move, however gingerly, towards an exit, is it really worth chasing the last few bp of spread from here?

Between record high valuations, FOMO, and confidence that central banks will come to the rescue once again, not to mention the MSCI World Index and the DJIA both hitting yet another all time high, the answer appears to be a resounding yes.

Structured Credit Bubble 2.0: Asian Investors Binge On "Boom-And-Bust" CLOs; Issuance Up 97% YoY

Back in 2006, some of the wall street banks (ahem, Goldman) managed to layoff quite a bit of their mortgage risk to unwitting European and Asian investors who, in their desperate "search for yield", had no idea they had just been conned into stepping in front of a freight train.  Now, it seems that the same thing may be happening yet again with another favorite wall street structured product, Collateralized Loan Obligations (CLOs).

According to Bloomberg, money managers in Korea, Japan and China are piling into CLOs, and often into the most junior tranches no less, at an alarming rate which has resulted in a staggering 97% increase in YoY new issuance volume.

Faced with near record-low interest rates at home, money managers in Korea, Japan and China have been piling into complex and increasingly risky structured loan products in America. Their investments in collateralized loan obligations -- including the high-yield “equity’’ tranches most exposed to defaults -- have helped drive a doubling of issuance in 2017.

The bets have performed well so far. But some observers worry that Asian buyers are overlooking risks. Headwinds in the retail and energy sectors have raised the specter of defaults, while Moody’s Investors Service has stopped evaluating one type of CLO product amid concern that buyers will end up holding less creditworthy positions than they anticipated.

“CLOs are a difficult investment universe, and CLO equity is a boom-and-bust product,’’ said Mike Terwilliger, a New York-based portfolio manager at Resource America Inc., which oversees more than $9 billion and invests in CLOs. “Investors need to make sure they’re being adequately compensated.’’

“U.S. CLO equity is starting to look a little less attractive,” Tyler said. “Investors may want to lighten up on this space before there’s a turn in the credit cycle given the illiquid nature of CLO structures.”

Meanwhile, non-U.S. money managers’ share of American CLO tranches with single-A credit ratings more than tripled to 21% last year, mostly due to surging demand from Asia, according to Citigroup Inc.

Korea Post, which manages about $102 billion of savings and insurance products, said in March it had been adding to CLO holdings. Japan Post Bank Co. has made plans to boost exposure to the safest tranches, people familiar with the matter said in January. Gopher Asset Management, a Chinese investment firm that oversees $17.5 billion, is currently raising money for a second global credit fund that may invest in CLOs, said Chief Investment Officer PV Wang.

Some “super-aggressive’’ Korean funds are buying equity tranches, according to Eugene Chun, who helps manage about $100 million of CLOs as a Seoul-based executive managing director at HDC Asset Management. Others are purchasing what’s known as combination notes, Chun said. The products blend investment grade and equity tranches to deliver higher yields while still maintaining adequate credit ratings.

Helped by strong Asian demand, CLO issuance has totaled about $32 billion so far this year, up 97% from the same period in 2016, according to data compiled by Bloomberg.

Of course, the reasoning is fairly simple and quite familiar for those of us who lived through the "great recession".  With all-in yields on even the riskiest U.S. debt hovering at just over 5.5%, much lower than even the 2006/2007 bubble levels...

...wall street has a convenient product that takes "safe" levered loans, packages them up in a nice little bundle and then sells them to folks all over the world with juicy yields and an investment grade rating.  It"s a win-win-win...lower risk, higher yield and IG rating...

Haven"t we seen this movie before?

The Other Shoe Drops: Prime Auto Loans Losses Surge As Recoveries Tumble

When we looked at subprime auto delinquencies most recently, we found some troubling trends: first, in February, we showed that 61+ day delinquencies in General Motors" subprime securitization book would support a rather bleak thesis for future auto sales, and specifically the demand side of the equation, with January 2017 delinquency rates soaring to the highest levels since late 2009/early 2010. 

Ironically, this hasn"t stopped lenders from providing financing, and according to Morgan Stanley since 2010, the share of Subprime Auto ABS origination that has come from deep subprime deals has increased from 5.1% to 32.5%, suggesting that yield-starved buyside will put "other people"s money" into anything as long as it provides a slightly higher yield.

Meanwhile, the subprime shock has already impacted the broader market, observed with the latest monthly auto sales data which declined four month in a row heading into May. An even bleaker picture of the subprime market emerged a month later when looking at the latest securitization analysis from Morgan Stanley which revealed that 60+ day delinquencies at 266 subprime auto ABS deals were surging - despite low unemployment, high consumer confidence and debt-to-income ratios at 30-year lows - back to "great recession" levels. Meanwhile, loss severities were also shooting higher just as used car prices were sliding.

 

In part, this tied in with the overnight look at the "flood of off-lease vehicles", according to which by the end of 2019, an estimated 12 million low-mileage vehicles are coming off leases inked during a 2014-2016 spurt in new auto sales, which is set to put even more pressure on used (and new) car prices for the foreseeable future.

As Reuters noted, a computer search for available used vehicles within 150 miles of Reel revealed an eye-popping figure: 668 Escapes. That"s enough to put more than 40 percent of the inhabitants of this small northeastern Ohio town, population 1,600, into the popular crossover. A search for the Chevrolet Equinox, a comparable crossover, showed 461 available.

"The automakers have flooded the market," said Reel, owner of Reel’s Auto in Orwell, Ohio, about 40 miles east of Cleveland.

The above trends validate a recent bearish Morgan Stanley analysis, which forecast that the plunge in used car prices is just getting started, and in a bear case, the bank sees used car prices dropping by up to 50% over the next 5 years.

 

* * *

However, in an even more troubling development for US consumers, it now appears that the other shoe for the US auto market has finally also dropped, and according to analyses by both Morgan Stanley and S&P, losses on prime auto loans are also surging.

In the latest note by Morgan Stanley"s Jeen Ng, the analyst reports that "fundamental performance deterioration has not been confined to Subprime. Both 60+ day delinquencies and default rates in Prime ABS pools have nearly doubled from their post-crisis lows."

A slightly better picture - at least according to MS data - emerges in terms of loss severities. Still, while subprime losses are far worse, the deterioration among prime loans is unmistakable: compared to peak levels, 60+ day delinquencies in Prime auto loan pools are roughly 65% of the way back, whereas Subprime pools are close to 95% of their peak levels. On the default rate side, the deterioration is somewhat more subdued, with Subprime over 80% of the way back to prior peaks while Prime has yet to reach the 45% mark.

One troubling observation, as confirmed in the recent Fed Senior Loan Officers Survey is that credit standards have continued to ease: as in Subprime, some of the ongoing Prime deterioration can be attributed to a relaxing of credit standards.

Aggregate credit scores have decreased by about 5 points, which while easier is not even half as much as the 10+ point deterioration in Subprime. The same is true for longer origination terms. Most Prime issuers have extended loan terms by 3-4 months over the past 5 years. In Subprime, extension in most cases has been longer than 10 months. These easier standards can help explain both why delinquencies and defaults are higher, according to Ng. Also, keep in mind, there is a limit as to how far Prime issuers can expand their credit box in the form of lower credit scores before the deals become Subprime.

Some more observations from Morgan Stanley, which finds a particular deterioration in recent loan issuance at Huyndai and Mercedes:

As auto lenders expand their credit box to weaker credit borrowers, we should expect to see poorer credit performance among more recent deals relative to the more seasoned ones.

Across the OEM originators above, we see a very consistent shift in lending standards over time - marginally longer loan terms, higher credit scores and lower used car composition. Overall, the longer loan terms and higher credit scores have offsetting effects on fundamental performance. If we look at the 60+ delinquencies and 3-month CDR curves by vintage, we don"t necessarily observe performance  deterioration over time, and for some issuers we even see relative outperformance among recent deals. However, we do see higher severities among recent vintages, which we can at least partly attribute to the decline in used car values.

HART (Hyundai) and MBART (Mercedes Benz) serve as exceptions to the above, with a higher % of used vehicles and FICO migration of less than +10 points over the last 7 years. They are also the two shelves which show the most pronounced performance shift. TAOT (Toyota) also extended their credit score by less than 10 points, but their change in origination loan terms has been minimal and they have a lower  composition of used vehicles over time.

Additionally, in terms of loss severities, the bank finds that all originator types appear to be trending higher in similar fashion, with non-bank originators printing the lowest recovery values. OEM originators overtook bank originators to see the highest recovery values last year.

* * *

In a separate, and even more downbeat report, S&P Global Ratings analyst Ann Matin noted that losses in bonds tied to "prime auto loans have surged surged in recent months from a year ago, hurt by falling recoveries" and notes that prime net losses rose to 0.73% in February from 0.57% in same month last year. According to S&P, bonds from some issuers that have become a larger share of the index, including Mechanics Bank’s California Republic and TCF Financial Corp., and both are contributing to those higher losses.  Additionally, the rating agency referred to the abovementioned loan losses at Huyndai, stating that “we’ve increased our expected cumulative net loss levels for certain issuers, including Hyundai’s most recent transaction, HART 2017-A."

Margin also wrote that prime asset-backed deals issued in 2015 seem to be performing worse, comparatively, than those sold between 2010 and 2014, and the deterioration in loans made to strong credit borrowers has forced S&P to revise its net loss expectations for various bonds.

* * *

To summarize: subprime loan losses have been surging alongside loss severities (with the buyside happy to soak up any and all issuance, regardless of underlying fundamentals), as recoveries slide, and in recent months this deterioration has finally shifted over to prime loans. Meanwhile, used car prices are tumbling, while new car sales have declined for 4 consecutive months as auto loan demand among tapped out consumers has tumbled. Meanwhile, millions of used cars are about to hit the market as they come off lease, which in turn will further pressure used car prices and new car sales.

So what happens next?  Here, we"ll repeat what we concluded last night:

Unstable used car prices will almost certainly reduce OEM reliance on leases as the implied 3-year depreciation (or residual values, if you prefer) will make them all but completely uneconomical: remember, Americans only care about that monthly payment.  Meanwhile, the relative value between used and new cars will tilt heavily in favor of the used market.  Thankfully Americans will still be able to buy that Mercedes they require to get back and forth from their minimum wage jobs, while maintaining a monthly payment of $500 or less, but it will just have to have 30,000 miles on it.

Of course, the OEMs of the world won"t admit that their game is over until it"s way too late.  So, they"ll keep right on producing new cars to cover a 17-18mm SAAR environment up until the point they face an outright revolt from their dealer networks.  At that point, however, dealer inventories will be so high that Detroit will be forced to shutdown for months on end while new car prices are slashed to reduce the massive inventory glut.  Tanking new car prices will put even more pressure on used car prices which will mark the beginning of the death spiral that will result in a new round of inevitable auto bankruptcies, catalyzing the next economic contraction... assuming one hadn"t started already.

Meet The New, "Safe" Synthetic CDO's That Could Spell Disaster For The European Banking System

So what do you do if you"re a European banking regulator faced with the task of maintaining a safe, sustainable financial system amid a concerning growth in bank leverage.  Well, if you said sell down risk assets then you"re just being silly or completely ignoring your implicit obligation to engineer higher banking profitability at all costs.

If we can get serious for a moment, like in the early 2000"s, when all else fails you turn to synthetic CDO"s which, courtesy of some magical, if completely incomprehensible, math, slashes the risk of bank balance sheets while having a negligible impact on profitability.  It"s called the Synthetic Collateralized Loan Obligation and it"s all the rage in Europe.

Here"s how it works:

In a synthetic securitisation a bank buys credit protection on a portfolio of loans from an investor. This means that when a loan in the portfolio defaults, the investor reimburses the bank for the losses incurred on loans in that portfolio up to a maximum, which is the amount invested. This amount therefore provides credit protection for a slice of the portfolio, which is often called the ‘first loss tranche’. The size of this tranche is typically chosen in a way to cover at least the expected losses on the portfolio as well as a share of unexpected losses. The bank usually retains the rest of the risk, which is called the ‘senior tranche’.

Before closing, the bank and the investor agree on the terms of the transaction, such as the amount the investor is at risk for, the duration of the contract and the loans that are eligible for inclusion in the portfolio. Choosing which loans are eligible can be on a disclosed basis, where the investor knows the exact names of the borrowers of these loans, or on a blind pool basis, where the investor does not know the identities of the borrowers. In the latter case the loans are chosen based on criteria, such as the type of loans, sector, geography, credit risk, et cetera.

The term ‘synthetic’ comes from the fact that, unlike in a true sale transaction, the loans being securitised are not sold by the bank but are referenced, which means they remain on the bank’s balance sheet. This way, the bank reduces the credit risk on the securitised loans and remains in charge of managing the loans and the lending relationship with their client itself. Synthetic securitisations are often used for hedging the credit risk on loans that cannot easily be sold.

As Bloomberg points out, from the regulator"s perspective the logic is that these deals are usually fully funded, with investors posting the full amount that they"re on the hook to cover should a lot of a bank"s loans go bust. They"re not highly leveraged wagers similar to the pre-crisis synthetic collateralized debt obligations, which were backed by who knows what and sold to whomever.

Of course, the problem with that perspective is that it views the risk profile of the synthetic CLO in a bubble and completely ignores all other possible second derivative implications. 

One such second derivative implication can by linked back to the primary demand for these structures, hedge funds. 

Per the graphic above, hedge funds are all too willing to post the collateral required to backstop losses on a bank"s loan portfolio but only if they can juice their returns somehow.  So how do they do that?  Well, they borrow money from banks, of course.  Yes, you read that correctly, banks are lending money to hedge funds which use that leverage to backstop losses on the bank"s loan portfolio...effectively the bank is issuing loans to backstop loans.

We vaguely remember similar shenanigans occurring roughly 10 years ago when most of wall street"s modern day titans were still watching Power Rangers in their PJs...as we recall, in the end, it didn"t work out well.