In the theatres of Ancient Greece, when dramatists brought a god on stage, they set him down with a hand-operated crane, expecting to produce the desired effect of awe within the audience. Aristotle criticized the device in Poetics, his c. 335 BC work on dramatic theory, arguing that the resolution of plots should come from the characters not the machine. Any rigged resolution to a plot, according to Aristotle, would lead to an unlikely ending.
The monetary machine of global central banks, led by the U.S. Federal Reserve, unleashed an unprecedented and radical amount of stimulus to prevent the world from falling into the abyss during the financial crisis. This “wall of liquidity” successfully surmounted the “wall of worry” caused by the crisis but the Fed’s continued zero-interest rate policy has artificially preserved investors’ preference for risky assets. The massive rally in risk since 2009 has in turn caused investors to chase returns, which like any desperate pursuit, can result in complete exhaustion.
Ben Bernanke, the former Chairman of the U.S. Federal Reserve, sided with Aristotle during recent conferences in Toronto and Washington where he reflected on his actions during the financial crisis. “In the fog of war there are many things we did that were imperfect”, he said, referring to the ad-hoc interventions to bail out certain non-bank financial firms (like AIG, Morgan Stanley, and Goldman Sachs). “The Fed should be out of the business of weekend emergencies”. Bernanke seemed to concede that many of the characters of the crisis drama should have been left to their own devices. Broker dealers played a leading role in the tragedy, who through unbridled leverage made obscene profits through speculative bubbles but were extraordinarily vulnerable when the crisis hit. The biggest survived due to the Fed’s bailout of counterparties, lender-of-last resort support, permission to convert to a bank holding company, and access to TARP funds. These broker dealers, now banks with the option of using FDIC-insured deposits, are back in business pursuing the same risky strategies that brought them close to annihilation. However, moral hazard, the willingness to take risks knowing the Fed or government will assume whatever negative consequences follow, has made them so big, leveraged and connected to the global financial system that their collapse could have systemic and catastrophic effects. This is the unlikely ending that Aristotle warned interveners about in Ancient Greece.
The overabundance of liquidity has driven up asset prices on investments in every risk category. On a global basis, stocks are up more than 40% from 2012 and have gained 150% from the 2009 lows. In the first quarter of 2014, U.S. bonds outperformed the stock market: the S&P 500 posted a total return of 1.8% while long-term U.S. Treasuries rose 7.5%, and corporate bonds and high yield each advanced 3%. Gold was one of the best performing asset classes of the quarter, rising 7.5%. With higher prices come lower yields, and the total yield on high yield and leveraged loans are near all-time lows. Many bond investors expect U.S. Treasury rates to rise as the Fed begins reduce its monetary stimulus, which will further compress spreads in the high yield and leveraged loan markets. The marginal buyers of traded credit are now large ETFs and mutual funds, which investors (especially retail) are treating like money market funds and driving massive inflows into the sector at a pace exceeding primary supply. To compensate, investors are loosening underwriting standards and even encouraging shareholders, especially private equity investors, to take money off the proverbial table. Between January and March of this year, PE-backed issuers tapped the loan market for $16.9 Billion of dividend-related recap loans, the largest sum since the second quarter of 2013 and up nearly $10 Billion from the fourth quarter of last year. Covenant-lite structures represented 60% of new-issue flow during the quarter, continuing last year’s trend and bringing the benchmark S&P/LSTA Index to be dominated by covenant-lite loans. This supports a benign default outlook but also poses danger signs for a future crisis. Investors in traded credit should be very concerned above the flagging quality of deals coming to market.
We have been warning about the high-yield and leveraged loan markets for nearly two years (see our 2012 Annual Investor Letter) and we risk becoming a “Credit Cassandra”, but the data is frightening. Loans with debt-to-EBITDA ratios of more than 6X grew to a six-year high of 37.5% in the first quarter of 2014, according to S&P Capital IQ Leveraged Comps Data.
Cumulative default experience by leverage ratio
This is lower than the pre-crisis high of 60% until you dissect the debt stack and notice that the amount of first-lien leverage was a record 4.2X in the first quarter, which will inevitably lead to higher defaults and lower recoveries in the future. Traded credit has been rigged by a liquidity machine. Aristotle was concerned about preserving the identification of the audience with the actions depicted in the tragedy. Investors would be foolhardy in believing that today’s credit market story will end any differently than before.