At the CI Leadership Forum in October I spoke briefly about increasing interventionism in the capital markets. I believe we are still in the early innings of secular change in the regulation of the capital markets. I can make the argument this is a rejection of the laissez-faire economic policies associated with Reagan, Thatcher, and even Greenspan. This is, without a doubt, reaction to the pre-2008 excesses brought to light and the taxpayer capital put at risk to bailout poorly regulated and poorly managed banks and broker-dealers.
Earlier this year, the Office of the Comptroller of the Currency (OCC) – the principal regulator of large American banks – sent letters to numerous institutions operating in the U.S. The purpose of this letter was to prevent banks from making exceedingly risky loans. For now, bonds seem to be exempt. The OCC sought to limit the amount of credit risk that banks could take with their lending books. Specifically, the intent was to put a ceiling on the amount of credit extended to customers to four times leverage (i.e. debt-to-cash flow) on a secured basis, and to six times on a total, unsecured basis. Additionally, the OCC wanted to ensure debt levels could be managed and amortized under “reasonable assumptions”. This was the first time regulators have explicitly outlined what constituted prohibitive “risky lending”. This has become a little fuzzy as the regulators allegedly changed from “prevent” to “deter” and realized the “reasonable assumptions” qualifier is open for abuse.
No one seems to know what the consequences are for not following these rules. Policy compliance, or lack thereof, could impact each bank's annual Comprehensive Capital Assessment Review (e.g. "stress test") conducted by the Fed. The inability to increase dividend payouts or share repurchases could be at risk for non-compliance. For lack of clarity, a number of U.S. banks have found themselves turning down new loan business including leveraged buyout financings, and fees associated with syndicating this risk, to ensure they are compliant.
Why does this matter to anyone outside of the banks and why I am telling you this?
Well the banks factor prominently in risk taking in the real economy by borrowing money from depositors and bondholders and then lending it out. On aggregate, the banks extend multiples more in commercial loans than the bond market. Now the Fed has a shiny new macro-prudential tool in its growing unconventional monetary policy toolkit and it could be a bit of a bazooka. Yes, the Fed can manage risk taking by controlling short-term interest rates. It can now also manage the aggregate risk in the real economy by adjusting the amount of leverage it will allow the banks to extend to customers.
Actually, the Fed can now (attempt to) manage the economy like never before. For example:
- Is the unemployment rate low, capacity utilization high, inflation ticking higher, and are leveraged buyouts (LBOs) being done with excessive leverage? Well, the Fed can raise overnight rates and lower the acceptable amount of leverage in the loan market.
- Does the economy need stimulus? The Fed can lower rates and raise the leverage ceiling.
This could be the most significant development in credit markets. Although, to be fair, there are a lot of moving pieces and we are still in the early stages. It could negatively affect credit assets for companies experiencing cash flow deterioration to the extent that leverage is now above the limit and they are restricted from refinancing their loan debt. This could put additional supply into the bond market as bank loans are refinanced with public bond market debt. This could also cause companies to deploy cash earmarked for growth-to-debt reduction instead, and cause shareholders to bear the brunt of additional dilutive equity raises. Borrowers may be forced into bankruptcy for not being able to refinance their debt. However, I have trouble believing this was the intent of the Fed's policy.
Alternatively, this may be a very credit positive situation, especially in the parts of the market where leverage can be four to six times (i.e. high-yield bonds and leveraged loans). The extent that companies are fearful of being unable to refinance or de-lever with cash or equity is credit enhancing. Also, the extent that we are seeing leveraged borrowers being bought by less-leveraged borrowers (i.e. investment-grade rated) is encouraging for credit markets. Private equity sponsors have to contribute more equity to their LBO purchases to keep the leverage lower, and that is credit positive. Another promising market development is the limited future supply of highly levered bonds and loans.
The impaired liquidity environment in all asset classes (including high-yield, foreign exchange and U.S. Treasuries) is a side effect of quantitative easing and new regulations stemming from Dodd-Frank and the Volcker Rule. There will likely be unintended consequences of this leverage policy as it is amended and implemented. It will be exceedingly important to monitor this policy and its impacts of the high-yield bond and leveraged loan markets as well as the real economy.
This does not put us in the “top-down” portfolio management category here at Signature. However, it does demonstrate how deep, bottom-up fundamental credit analysis and portfolio construction can be married with both an informed macroeconomic view and risk management, from awareness of seemingly un-related technical developments in other parts of the markets.