A version of this article was published in the November 2012 issue of The NMS Exchange, an investment bulletin for the endowment and foundation community.
The 30 years preceding the financial crisis were a time of unprecedented deregulation and consolidation of financial intermediaries across the globe. Now, four years after the crisis peaked, global banks are working to adjust to a very different set of rules governing their regulatory capital and liquidity standards. Although there is wide disparity in the health and preparedness of financial institutions for this new world, there is little dispute over the wake they have collectively left in the capital markets. Scores of individual borrowers, and some corporate borrowers, who routinely accessed cheap funding pre-crisis, now look for new lenders, with little success. Not only are banks hesitant to lend, they are also actively shedding legacy credit risk. PIMCO estimates that over $2 trillion of assets need to be sold or restructured in the coming years – and the buyers/restructurers are simply not that large.
Institutional investors are undoubtedly presented with countless alternative investment strategies every year – from a wide variety of hedge funds, real estate, residential credit and direct lending, to a mix of distressed strategies. Most of these are things that banks used to routinely do: Lend. Take risk. Provide liquidity. These activities are capital-intensive and generally undesirable for banks now. Although the macroeconomic negatives of bank deleveraging need not be reiterated, the silver lining of the banks’ retreat is quite simply more return for non-bank investors. The cost? Less liquidity, more volatility, and longer holding periods.
In the pre-crisis era, few markets drew more support from big debt than residential real estate, commercial real estate and corporate credit. Largely because of the retreat of large financial institution balance sheets, we believe segments of these asset classes will continue to offer opportunities to earn attractive returns. Below, we highlight the critical changes in these markets and the opportunities they present.
The residential credit markets in the U.S. may require many more years to repair. U.S. housing is currently stabilizing with the aid of unprecedented government support from the Federal Housing Administration, Fannie, Freddie, and the Fed’s aggressive battle against higher rates. Most banks aren’t taking residential credit risk – the Federal Housing Administration (read U.S. Treasury) is. Only the highest-quality borrowers have access to credit. About 90% of all residential loans made in the U.S. in the last two years were originated specifically for immediate sale to Ginnie, Fannie or Freddie. Why won’t banks make more loans at attractive rates to marginally riskier (but still high-quality) borrowers? Because loans require much higher capital charges than the same loans packaged into Agency-guaranteed MBS. And would-be new mortgage lenders want clarity on a labyrinth of new regulations (Dodd Frank), on the rules-of-the-road for loan servicing, and on the ability to foreclose in cases where all other means to work out a loan fail.
The result is a relatively uncrowded landscape for mortgage risk-takers. Private capital has filled some of the void in legacy mortgage securities in the last three years, but the opportunity remains robust in less liquid forms such as non-performing loans, single family housing and restructured legacy cash flows.
The commercial real estate (CRE) market, by contrast, is relatively free from the web of regulation that surrounds lending to consumers. Private lending has recovered more quickly in this sector, but our theme persists. Banks want to lend now only to the cleanest, best-protected new deals with significantly higher equity than pre-crisis. Large global banks continue to liquidate non-performing loans and complex securities created during the go-go days, because they are both labor- and capital-intensive. We also anticipate that many regional banks will be sellers of CRE-related positions over the coming years; they have come under pressure from shareholders and regulators to exit these businesses as stakeholders recognize that carrying values are based on significantly overstated appraisals. These asset sales will not be limited to U.S. institutions; European institutions hold CRE exposure via subordinate debt positions and legacy CMBS or CDO positions. These sellers typically create attractive return opportunities for investors when liquidity needs are high.
Within the corporate credit markets, again, we look to the void in financing and liquidity that the withdrawal of banks and other traditional lenders have created. The high yield market has shown an increased aversion to smaller, less liquid issues due to the decline in market-making from the banks – yet another repercussion of the increased regulatory environment. This has inflated the borrowing spreads that middle market issuers are forced to pay in the public market or has forced them to rely on capital from private market providers. These trends have been exacerbated by a decline in demand for corporate syndicated loans due to the shrinkage of commercial banks’ balance sheets as well as the sharp decline in CLO formation. The result has been staggering – nonbank institutions now provide 70% of middle market loans, according to recent studies.
So where have the best opportunities arisen from these disruptions in the corporate financing market? We believe middle market financing can offer investors an opportunity for attractive risk-adjusted return, either by investing in high yield bonds or by direct lending. Investors in middle market companies are typically very experienced and sophisticated in conducting extensive due diligence and structuring transactions that accurately price corporate credit risk and a premium for illiquidity.
European corporate distressed markets may present an opportunity over time. While corporate asset sales from the European banks have been relatively muted over the past 18 months, we expect these sales to accelerate over time now that there has been some improvement in pricing generally for risk assets. We believe that this opportunity will be quite broad and include non-performing loans, non-core business lines, non-core asset divestitures and banks returning to their home markets (particularly in Europe).
Given the variety and complexity of these opportunities, we feel investors are best served by a manager that has the expertise to source, perform due diligence and structure complex loan pools where pricing can be less efficient than the public markets. The manager should have a global platform with broad access to various public and private markets and established relationships with source opportunities. With the public market’s aversion to illiquidity and complexity, this premium should persist for the foreseeable future.
The build-up to the financial crisis took decades. Although four years have passed, it will likely take many more to unwind a financial system built on debt and leverage. It’s a process that will likely create higher return opportunities for many years to come.
Want the opportunity for higher returns? Do what the banks won’t do.