Securitised credit: Where we’re going, there are no roads (part 1)

With global central banks rapidly deploying balance sheet to ease a liquidity-strained market, and a US Federal Reserve Bank (Fed) balance sheet likely to hit $10 trillion, we are seeing stimulus of a "1.21 gigawatt" magnitude.

Sadly, however, we're fairly certain not even Back to the Future's flux capacitor could bring us back to where we were in January.

Though we’ve seen global financial crises before, this one certainly feels different. First of all, is it really just a “financial” crisis?

Let’s start there.

Entering this year, economically speaking, we were already late cycle, but not in the same way as in 2008. Following the last financial crisis, there was heavy regulation of the banking system, material consumer protectionism, and heavy regulation of mortgage lending and  securitization. As such, the consumer felt much better positioned from a debt (or leverage) perspective.

The limited re-leveraging of the consumer contrasted sharply with the expansion and quality deterioration in the corporate sector. However, for the consumer, wealth inequality has been increasing, and with it a profound difference between a prime consumer (one that owned a house and had seen more income stability), and the more leveraged or the non-prime consumer (with subprime auto loans, installment debt and student loans).

We see here in Figure 1, the evolution of the increases in mortgage and real estate delinquency rates, and their recovery to pre-crisis levels.


Next, we illustrate the contrast between the recovery seen in the prime or “bank card” credit card delinquency rates - which remain low versus the high and rising auto delinquency rates - and the
student loan delinquency rates, which are already above levels seen in 2008-2009. The difference between “prime” and “not prime” has been a factor in our investment allocations well before this
recent dislocation.


With the average consumer debt-to-income at 40-year lows, we felt that on average, the consumer was in a much better, earlier cycle, position than the corporate market. The fundamentals sitting behind the consumer were stronger as indicated by lower leverage; certainly much lower when compared to 2007.


So is this just a liquidity crisis, or is it a solvency, crisis?

There is now a massive exogenous shock to the economy. The speed with which economic activity has arrested is astounding. With the yield machine having fueled itself with the plutonium of debt (leveraged loans), we have very real concerns about the ability of more leveraged sectors, borrowers and corporations, to last through a period of decline.

The growth of leverage has created a different subset of problems that, at worst, may need a different playbook. At best, it will have a much different impact on the market if the timing to resolution is longer, as the presence of leverage, increases sensitivity to change and reduces “staying power”. Built-to-last cash flows are critical in an environment of uncertainty. No one should want to be too dependent on a recovery path in an environment that is not likely to be well referenced to another period in history. 

Indeed, the first symptoms we saw in March were those of a liquidity crisis, including “cash hoarding”. These symptoms were so significant they rendered markets - from commercial paper to agency MBS - dysfunctional. Central banks have responded with massive injections of liquidity, interest rate cuts and quantitative easing (QE), a so-called, “bazooka” or “double down and all-in”. The government has also responded with massive fiscal stimulus programs (CARES Act).

But, implementations take time, and problems are likely well beyond simply “liquidity”. We have credit problems of a magnitude that will significantly impact employment and they will test the consumer. This is where leverage is relevant. A lower leverage consumer, or business, will have a longer time frame to abide and navigate a decline in cashflow. In a market where timing is very uncertain, this underscores the importance of looking for this reduced sensitivity.


If companies have more leveraged balance sheets, they have a shorter runway, and can no longer withstand months of economic slowdowns, let alone stoppages. Support for businesses from
the fiscal package will be a government-driven effort in picking winners and losers, but ultimately winners and losers will come down to leverage.

’Furlough’ will likely be the most popular google search in the coming days and weeks. The impact of ‘temporary unemployment’ is at best, uncertain and at worst likely to have a longer lasting impact on the consumer psyche.

Confidence, spending, saving, all of these consumer aspects are quite important economically speaking. While most expect several quarters of an economic downturn, the certainty around that projection is low, and this could be a much longer downturn depending on the medium-term destruction of jobs. Like corporations, or pensions, cash hoarding is not uncommon, even for a consumer.

If you are uncertain about your employment, you may not make a payment on your mortgage, or your car, “just in case”. Moreover, spending is likely to be curtailed and savings are likely to go up, this can have a more lasting impact on markets. Consumer sentiment is dropping, and likely to fall more than in 2008-2009.

What has happened so far:



But the projections are eye popping:





‘Where we are going, there are no roads’

In looking, not back, but forward to the future, we would characterise the economic outlook as highly uncertain. That we have a serious recession on our hands, is not in doubt. But the depth and length of this recession is, in my view, very challenging to predict with accuracy. No one is a virus expert, nor is anyone likely to predict the impact of fear and quarantine on consumer behavior. 

So what do we do? 

We combine the truth of Tyson (Mike) and the wisdom of Eisenhower (Dwight) into the ’atomic throw’ of analogies. 

“Everyone has a plan until they get punched in the mouth” – Mike Tyson 

“In preparing for battle I have always found that plans are useless, but planning is indispensable.” – Dwight D. Eisenhower

With any new crisis, the steps or phases can be highly variable in terms of length. While selling and overshooting took four to six months in 2008, it seems to have taken about three weeks this time around.

Can that be true?


Navigating the steps in an uncertain environment

What is not uncertain is that we will have a recession and reconciliation of markets. It is, however, the depth, the timing and the pattern of this cycle that are highly uncertain variables. Given the uncertainty, we believe there are several critical aspects of investment strategy that should be a central focus.

  1. Flexibility is key - Opportunities will change as we progress through the phases of the cycle. The most attractive opportunities can be rare and impermanent. These are often asymmetric opportunities with limited downside and attractive upside and they can be promulgated by aligning with the largest balance sheets, such as the Fed, or through critical government programs such as the Term Asset-Backed Securities Loan Facility (TALF), or through forced selling, where leveraged hands cannot hold even their better-quality cash fl ows. Or even later in a cycle, when more information is known, and when defaults are priced in, there will be the distressed opportunities.
  2. The lens with which one looks for opportunity must be suitably wide - This is not the market for a single silo. Opportunities, even those driven by regulation, can often take different forms, or structure, for example securities or loans or funds.
  3. Conviction is an essential component for investors in a dynamic market - Without it, it can become difficult to move. Building conviction means finding cashflows that are more certain in the scope of the current information, and have a required tolerance to variability. Hope is not a strategy and in a market like today’s, the parameters related to the range of possible outcomes, or expectations, must be widened. Being right on your base case is unlikely, being tethered to that sort of analysis does not work in an uncertain environment. 

We believe in using the framework of flexibility, opportunity and conviction to move through the phases of a cycle. And our approach begins with another trinity: fundamentals, structure
and valuation.

Fundamentals, structure and valuation

Standing before a precipice is often a breath-taking and challenging moment, and surely we have all felt, in different ways, the swerve to the edge over the last few weeks. It is the “everything has changed, right now” moment and at these moments, that change feels quite permanent. Only time will tell how much will change, and how much will be ingrained as we move forward together, but in these moments the tendency is to be overly dark, or overly light.

Overly dark: we will never go to restaurants, movies, hotels or work in offices, ever again. Working at home with a spouse, three kids, and a’s a real treat.

Overly light: any time the index is over 900 OAS, you always win. It sure looks cheap at $80.  But $80 is cheap if the value returns to par, not if it goes to $0. 

It is because of these swings in sentiment, or psychology, or opinion, that we have a market in the first place. Within it, opportunities can be created, even opportunities that allow for us to factor in, or price for, a wide range of possible variability.

Final thoughts 

At its heart, leverage is a part of every crisis. This can be borrower leverage, corporate/operating leverage, asset leverage, or even financial leverage. It is important to understand where the leverage is within markets, and the course its reconciliation will take. Leverage can impact staying power, and with uncertainty, and today you likely want the luxury of time to allow for variability. 

The intersection of fundamentals, structure and valuation help us navigate different degrees of uncertainty. With strong positives in fundamentals, structure AND valuation, cashflows can tolerate a greater amount of variation and become built to last. Built-to-last cash flows are like the boxer in the ring that can take a number of chin shots and remain standing. 

This is what is necessary and desirable given the range of potential outcomes that are possible as we look to the future. We believe there are securities that currently offer the type of “uncertainty” protection that is desirable, while still retaining upside to the eventual recovery. These are more likely to be found either where the government is assisting private capital, through leverage, to aid in the recovery, like TALF, but also in areas where there is both a dislocation and fundamental or structural support, such as in mortgage securities, that have seen liquidity driven selling and forced selling.

This is an asset, that is not just a “risk on trade”, but one that represents a risk-managed exposure to the extent markets need more than a spoon full of sugar to help the medicine go down. So, while we are going where it feels there are no roads, we can still cut the trail.

Understanding that uncertainty need not create paralysis, nor should it result in rash bet making, or blind faith in old “rules of thumb”.

Maintaining an awareness for when uncertainty rises and falls is critical, and understanding that even through these phases opportunities with conviction can be identifi ed though an examination of fundamentals, structure and valuation.

Please check back for part two of our analysis, to be published soon.