Tuesday, May 18, 2010

History Repeats Itself

Cliche:  History repeats itself because no one was listening the first time.

This morning's Bloomberg story of interest involved the continued acceleration of ignorance of risk and potential pitfalls, even though we just went through this scenario.

"Two years after suffering $213.2 billion of losses when debt markets froze, investors in junk bonds are accepting what Moody’s Investors Service calls the weakest creditor protections since 2007. 

Even with housing starts hovering at their lowest levels on record, Beazer Homes USA Inc. managed to sell bonds this month on terms that allow it to add more debt. The Atlanta-based builder couldn’t even do that when it issued debentures at the height of the housing bubble in 2006 and its credit rating was seven levels higher. In a report last week Moody’s singled out CF Industries Inc., Standard Pacific Corp., AK Steel Corp. as borrowers offering debt on terms historically available only to higher-rated companies.

“We got ourselves in trouble with that in the past and here it is again,” James Kochan, the chief fixed-income strategist at Wells Fargo Fund Management in Menomonee Falls, Wisconsin, said of the trend toward looser debt covenants. “It’s not that surprising, but it is disturbing,” said Kochan, who helps oversee $179 billion. "

Beazer Homes is issuing debt with investor-unfriendly covenants that it couldn't even issue at the peak of the bubble!  Shocking.  I mean - ignorance of risk is one thing, but ignorance of risk in a home builder?  Really?  I must be living on another planet.  

"Lenders are letting down their guard just as worsening government finances raise doubts about the sustainability of the global economic recovery. Money managers say they have little choice but to go along. They need to find a home for the record $29.4 billion that has flowed into high-yield bond mutual funds the past 16 months from retail investors seeking to join in a rally that has produced an average 69 percent return since the market bottom in March 2009."

Oy vey.   And THIS is why I blame the Federal Reserve's zero interest rate policy (ZIRP) for the current situation, folks - the bastardization of risk pricing and asset prices.  "Money managers say they have little choice but to go along" ??? Really?  And if/when it goes bad, what happens?  We blame the banks who underwrote it, right?  (that's where I need my SARCASM font!)   This is also what I meant when I explained to a commenter on a  previous thread that the Fed can indeed effect the entire corporate risk curve, not just the treasury curve - ZIRP forces investment, even where rational investment wouldn't be made.

It's a well known fact that there are cycles of risk appetite and avoidance on Wall Street - I'm just shocked at how short those cycles have become.  We JUST concluded the biggest orgy of debt consumption in our nation's history, which I'd dare to say ended badly,  and it's almost like it never happened.  Even though we saw the results of covenant-lite loans, they're back with a vengeance already!

“This trend represents more than an episode of ‘back to the future,’” Moody’s analysts including Alex Dill, the firm’s senior covenant officer, wrote in their report. “It reflects a weakening in covenant protections even below those existing at the peak of the market, in 2006 and 2007.” 

Weaker covenants than at the peak - the peak of the bubble of all debt bubbles!  WTF?

Well, at least we can offer on explanation, after we get to the details:

"Beazer sold $300 million of 9.125 percent bonds due in 2018 on May 4 that carry lighter restrictions than its 2006 issue on the amount of debt the builder can add and how it can use money raised from selling assets. The terms also allow Beazer to double its capacity to pay dividends to shareholders even after a 90 percent drop in its stock, according to Covenant Review."

"The company’s senior unsecured bonds are rated Caa2, which Moody’s defines as “judged to be of poor standing and are subject to very high credit risk.” Beazer was rated Ba1, one step below investment grade, in June 2006, when it issued $275 million of 8.125 percent 10-year notes."

Ok - so Beazer's credit rating is lower, and they're paying a higher interest rate than they did at the peak of the bubble - that much makes sense.  Why, though, are buyers of the debt making concessions?  The buyers should be the ones in control.  Ah - but it gets back to the Fed and ZIRP, and should give us an idea of exactly how powerful the Fed's effects are:  there is so much capital out there looking for a positive yielding home that even companies like Beazer, a troubled company in a troubled industry, can get investors to make concessions.

Capital re-deployment is precisely what the Fed wanted - I'm guessing ignorance of risk is NOT what the Fed wanted, but it's a side effect nonetheless, and will bring me back to the word I've often used to describe the situation:  PONZI.

A closing quote:
“In 2008, all the companies that we said would screw the bondholders did it,” said Cohen of Covenant Review. “Now, it feels like 2007 to me. We’re telling them they’re going to get screwed and they’re not paying attention.”

Note: related, via Paul Kedrosky:  "The Triumph Of the Stupidly Optimistic."



Byrne said...

Wow, that really makes no sense. I can understand foolish optimism, but I can't the covenant-lite kind; this as close as you can get to asking to be screwed by the borrower.

Is there enough data to backtest a strategy of just buying credit default swaps on covenant-lite products, and selling CDSs for the less-lite ones? Obviously 2008 will distort things a bit.

Ken said...

I am not really sure why people would be bothered by the story.

"Two years after suffering $213.2 billion of losses" is how the article begins.

Key words being investors actually suffered losses. Isn't that is what is supposed to happen when I make poor decisions?

If people or firms choose to lend money with few convenants on generous terms to iffy borrowers, well, ultimately they will reap what they sow when the borrower cannot make the payments.

Besides, I would rather see investors pour money into junk bonds and suffer huge losses than to see that same money pour into commodities and drive up the price of oil to $150 a barrel or drive up copper to $4.50 per pound which effects each and every one of us when we fill up at the pump or purchase a manufactured component.

Anonymous said...

You know what else is interesting, Paulson just reported a 6.7% stake in BZH—now biggest holder.

Kieran McCarthy said...

On this point, I am in complete agreement with you. ZIRP creates an institutional imperative for money managers to seek yield, which leads to money managers directing cash into the riskiest assets, which leads to defaults, which leads to more ZIRP. Little good comes from a society that allocates its resources to the least worthy stewards of capital.

And so it goes.

getyourselfconnected said...

On a related note I am working this article tonight which says what I have been saying for a long time, only better:
U.S. Solvency Contingent on Low Interest Rates
I don't agree with everything in the pice but the low rate problem is a real one.

kinkistyle said...

Someone once said: As long as the musics you have to keep dancing.

kinkistyle said...

Sorry, make that: "As long as the music is playing, you've got to get up and dance"