I wrote a week or two back about my expectation that significant economic dislocation awaits us. I still think that. The morning after I published, hordes (ok, maybe not hordes) of PhD Villeins were outside my house with pitchforks and burning torches, loudly asserting that I had wildly overstated the likelihood of material distress in the marketplace. “No, no, no, the White House has assured us of a soft landing and a soft landing we’ll have.” (The Council of Economic Advisers, not surprisingly, if professionally embarrassing, seem to think so, too.) And, while inflation is bad, it’s not that bad. (I don’t yet need a wheel barrel to buy bread!) No recession, they perorate loudly and insistently. We’ll be back to 2% inflation, sub 4% unemployment and 2% GNP growth by Q4 of 2023!
But from the trenches, where those abide whose opinions are backed by actual money at risk as opposed to bloviated hot air, there is a sense that the butcher’s bill is coming due.
We are in the riptide of a risk-off storm. The Fed is fully engaged in its war with “transitory” inflation, with a “make my day” cavalier disdain for the country’s economic pain. At inimically cross purposes, our executive branch continues to push easy money and liquidity. Student loan forgiveness, the absurdly named Inflation Reduction Act, money for CHIPS, the last blast of Mr. Biden’s Build Back Better Plan and the leftovers from the Covid goody bag are adding liquidity into a market that has been bloated by liquidity for a decade. Talk about a cage match between monetary and fiscal authorities (think Biden and Powell in those cute little WWE leotards…there’s a visual for you).
Fiscal excesses make monetary constraint more compelling and will keep the Fed on the barricades, increasing the already near certainty that the Fed will overshoot, deepening the looming recession.
Thinking about that all led me to noodle on (I knew the answer before I started) whether any elements of our government, executive or legislative, were doing anything remotely useful to ameliorate the coming financial distress. Nope. Regrettably, they’re acting to the contrary. Our Congress and regulatory apparatchiki are intent on pushing a number of policy initiatives that are having the effect of suppressing capital formation, diminishing the ability of lenders to lend, and diminishing animal spirits, things required for a thriving marketplace.
I know, I know, after four years of our adventure in Trump-land and recognizing that elections matter, the fact that the current masters of the heights are intent upon righting perceived wrongs and rebalancing perceived imbalances, is entirely understandable. Notwithstanding, when circumstances change (to channel our inner Winston Churchill), policy should adjust, shouldn’t it? One might have hoped, that when a macroeconomic storm is upon us, the pace of regulatory change, best suited for a robust and growing economy, might have abated a bit. Pursuing with fervor and purity, a commitment to Mr. Biden’s suite of campaign promises and Bernie and Elizabeth’s most ardently-held fever dreams in this time and place seems, at best, risky.
What mischief is afoot? How much time do you have? To keep this commentary to one slim volume, let’s just look at a sample of the mischief roaming around the regulatory landscape. The banking regulators have now gifted us with CECL (Current Expected Credit Losses). With CECL in place, all lenders will soon be required to add to loan loss reserves on a quarterly basis based upon complex, barely understood by most lenders, and controversial models. (Beware of geeks bearing models?) Will these models set loan losses right? Almost assuredly not.
When CECL is imposed, at a time when the economy is contracting and liquidity is shaky, you know what’s going to happen, right? It will be strongly procyclical. Lenders are going to book more losses, adding to capital buffers and consequently reducing their ability and willingness to lend just when we actually need them to step up and provide liquidity. Remember, this is on top of a multi-year wave of bank regulatorily imposed capital increases (FRTB, CCAR stress tests, other fun with Basel III, etc.). All this was sold as being “countercyclical,” an ant versus grasshopper sort of thing. While that might have been true when markets were on fire, given current market conditions, this larding of capital on capital will turn out to be badly procyclical.
There is more (of course…there’s more.) Don’t forget the revised CRA requirements and the CFPB’s expanded Home Mortgage Disclosure Act (HMDA) reporting. Each focused on fairness and equality (and there’s nothing wrong with that) but expensive. The word is also out there that the eye of Sauron the Bank Examiner, being regularly flogged by our political elites, continues to focus substantial energy on a virtue campaign across the banking sector, chasing foot faults, reporting errors, policy and procedure failures and other alleged bad behavior far from the distant past and or far removed from the core business of lending. A campaign is pursued with considerable fervor as evidenced by a week in and week out litany of fines and the imposition of ongoing new compliance obligations. It can sometimes seem a bit asymmetrical, a bit retributive.
I hope that everyone gets it that increasing the price of a product means the cost of it will be concomitantly higher and the supply will be concomitantly diminished.
Our banking regulatory friends are not alone. Add to this the SEC’s regulatory word salad of proposed rules imposing new duties, obligations and responsibilities on private funds and fund managers regarding disclosure of vehicle ownership, additional financial disclosure and a new and thoroughly unvetted cohort of disclosure around ESG. As a considerable share of capital formation is occurring in the non-bank market, this matters a lot.
So, to recap, at a time when capital formation is already being suppressed by macroeconomic conditions, the regulatory estate is making it more expensive and riskier for lenders, both bank and non-bank, to do their basic job of lending. More capital, more limitations on trading, more headcount devoted to reporting and compliance as opposed to lending. More anxiety over complying with often inconsistent, contradictory and opaque rules. More anxiety about striving, innovation, straying from the herd? The psychological and emotional penumbra on the financial sector participants of all this is meaningful. That will only exacerbate institutional instincts to be cautious, perhaps even a bit timid. This penumbral impact itself will impair capital formation as a first derivative of the actual regulatory actions.
Cliffs Notes summary; this regulatory environment is inconsistent with our expectation that the financial sector can be relied upon as a critical engine of growth.
It’s all rather distressing, isn’t it? But, playing the cards dealt is the only option. Remember, a lack of revenue can be as highly correlated with severely diminished bonus pools (and indeed unemployment) as realized losses. Distressed conditions will ease eventually and markets will repair, just not soon enough to allow us to hunker down and wait.
We need to find stuff to do. So, here’s what I’m thinking about.
First, find borrowers willing to borrow at spreads consistent with the new price of risk and new cap rates. Eventually, reconciliation will be attained and the entire market will reprice in terms of both the value of fixed assets and the price of debt and fresh capital, but, in most cases, not for a while. If, however, this works well for you now, please feel free to ignore the rest of this note. You’re good.
Be a buyer when scale and risk aversion bite. The increased regulatory pressure on the banking and lending world is likely to cause disintermediation of commercial loans (mortgage loans and others) and indeed parts of loan platforms. Loans will trade. Pools of loans will trade. While reconciliation will only slowly penetrate the borrower community, the financial marketplace will have gotten the joke. To the extent business realities and regulatory burdens impact many shops, there will be willing sellers in the marketplace.
The coming distressed debt wave will turbocharge this trend. Trepp, this past week, identified $52 billion in CRE loans maturing in the next 24 months with DSCR below 1.25. This stuff won’t refinance without significant equity or sub debt. The same will be true for all other asset categories.
For the non-bank market (where the regulatory future might be considerably worse than the regulatory present), the increased cost of compliance with the panoply of new regulations will put a premium on scale. Small platforms will simply be stressed. They will be stressed by the enhanced regulatory disclosure burden that is in place and growing, they will be stressed by the withdrawal of liquidity from the warehouse marketplace, and they will be stressed by the diminished velocity of transactional activity writ large.
Buyers with free cash will occupy the catbird seat. Creative destruction, baby!
Consider providing liquidity in the warehouse space as the regulated bulge bracket banking market retreats a bit. Liquidity will be increasingly dear and warehouse lending at a significant premium to what the market has experienced recently might be the only game in town. Some users of capital might literally tolerate negative arb on legacy portfolios in order to refresh capital. Loan on loan is again becoming a thing. Provide the leverage. Wider spreads, higher fees, co-investment opportunities, kickers, etc. All will be on the table.
Be a buyer of high yield, first loss tranches of existing loans. This is really straightforward. Regrettably, however, using participation structures, which is the only way to do this easily, has a limited appeal as, from a GAAP point of view, selling subordinate participations doesn’t really accomplish much for a GAAP-sensitive seller. This is also a hard process to scale. Restructuring loans with the borrower and slicing off a mezz or a B note will certainly work and might scratch what itches, but is mechanically rather burdensome. There’s not a borrower on the planet that will not use that as an opportunity to extract a pound of flesh.
Consider the power of credit risk transfers. Under federal banking law, credit risk transfer trades can be done if properly structured, can transmogrify commercial real estate exposure into securitization exposure with an 80-90% reduction of risk-based capital. Go read Reg. Q. It may also get a bank out of 100/300/600% hell. For the regulated bank marketplace, this could be a powerful tool to help banks improve their regulatory posture through risk-based capital management.
Buy a platform. There’s an awful lot of public companies in our space that will be trading below book and arguably trading well below reasonable asset valuations, and we’re also likely to see some small platforms be willing to sell as an alternative to closing the doors. (Okay, the people walk out the door each night, but brand, counterparty relationships and existing liquidity might all make this interesting). Going private, tenders and other organic M&A transactions at this time might be an enormously powerful tool for acquiring value.
Consider joint ventures. As Ronald Reagan famously said, “Half a loaf is better than none.” Spread the risk, improve the quality of management, use the balance sheet where others are struggling. Joint ventures might be a powerful device for acquiring AUM.
Finally (finally? I doubt that), where the government is socializing risk or subsidizing returns, go there. ESG looks to be such a place. Certain types of multi-family, workplace housing, tax credit plays and infrastructure all sort of leap to mind.
As we always say, there’s a pony in there somewhere. If regular way, down the middle of the fairway, lending for fee income, lending for spread and lending for securitization profit is no longer working, other things will. So put the thinking cap on, embrace the new reality, embrace the chaos and find the next deal.