peer-to-peer lending, the next big banking innovation

the demise of the department store

The story of the big commercial banks over the last forty years is sort of like that of the department stores, only in slow motion.  In the case of the latter, entrepreneurs targeted the most profitable “departments” of the cumbersome retailing giants and competed against them with freestanding specialty store chains offering a wider selection, trendier products and lower prices.  Toys, consumer electronics, jewelry, household goods, cosmetics, and, of course, various types of apparel were all targeted.

The financial world, for some bizarre reason known only to itself, calls this process “disintermediation.”  It has been underway for almost a half-century.

Consider what a bank does for a living:

in the simplest terms, it borrows money from some people, paying, say, 2% interest, and lends it to others at, say, 8%.  It uses the difference (the spread) to cover costs and make a profit.

money market funds

The first big disintermediation came in the 1970s, with money market funds.  These substitutes for bank checking or savings accounts take deposits from customer and make short-term (meaning a few months) loans to governments and corporations.  The entire spread, less expenses, goes to the money market shareholder.  So in normal times, money market funds pay considerably higher interest than banks.  The banks’ only advantage has been government deposit insurance.

The emergence of the money market fund produced a massive shift of customer deposits away from banks.

junk bonds

The second was  junk bond funds.  The first junk bonds were “fallen angels.”  That is, they were issued with low coupons by companies whose businesses subsequently deteriorated.  As a result, their bond prices had dropped sharply (and therefore the bonds’ yields had risen to high levels).  Careful credit analysis would turn up either companies that were on the cusp of a favorable turn in their fortunes or others where the market had considerably overestimated the chances of default.

As they become popular, junk bond funds soon faced a shortage of suitable bonds to buy. This led to the creation of an original-issue junk bond market–or junk bonds as we know them today.  These bonds were direct competitors to the corporate lending operations of banks.  However, junk bond issuers offered lower interest rates plus fewer restrictive covenants to borrowers and they delivered the entire spread, less expenses, to the fund shareholders.

Again, there was a massive shift of profitable business away from banks.

peer-to-peer lending

We’re in the early days of a third big disintermediation.  Peer-to-peer lending is, I think, will end up replacing banks as makers of small personal and commercial loans.

As things stand now, P2P lenders are simply internet-based intermediaries.  They do credit analysis to determine an interest rate for a given loan, put potential lenders and borrowers together and take a fee.  As I see them, they’re very much like the creators of money market funds or junk bond funds, only targeting a different “department” of the banks.  In the junk bond case, though, the “department” quickly morphed into something else.  That could easily happen with P2P, as well.

What’s most interesting about peer-to-peer to me is that the leading firms are preparing to go public by issuing common stock.

More when IPO dates are closer.

 

exit fees for junk bond funds?

contingency planning

The SEC is doing contingency planning for the time when the Fed will declare the current five-year+ economic emergency over and begin to raise interest rates back to normal.  What “normal” is in today’s world is itself a subject of debate .  The official Fed view is that overnight money should carry an annual interest charge of 4% vs. the current zero.  Even if the right number is actually 3%, that’s still a huge jump (more on this topic in a couple of days).

According to the Financial Times, the SEC is worried about what will happen to junk bond funds/ETFs when rates begin to rise.

the problem

The issue is this:

–investors wary of the stock market but searching for yield have put $1 trillion into corporate bond funds since the financial crisis.  Such funds now have about $10 trillion in assets under management.

–the charm of mutual funds is that the holder is entitled to cash in any/all of his shares at any time before the market close on a given day, and cash out at that day’s net asset value.

–junk bonds are relatively sensitive to changes in interest rates and go down when rates go up, and

–many junk bonds trade “by appointment only,” meaning they’re very illiquid and basically don’t trade.

So, the question arises, what happens if/when holders see their net asset value eroding and decide to all withdraw at once?  Arguably buyers will disappear when they see an avalanche of selling coming toward them.  The initial selling itself will tend to put downward pressure on bond prices.  A falling NAV can conceivably generate even more, panicky, selling.

If a big no-load junk bond fund is hit with redemptions equal to, say, 25% of its assets over a period of several months, will it be able to sell enough of its portfolio to meet shareholders demands for their cash back?  Maybe   …maybe not.

operates like a bank…

Put a different way, a junk bond fund is a lot like a bank.  It takes in money from depositors and lends to corporations.  In the pre=-junk bond days, a bank would lend at, say, 10%, pay depositors 2% and keep the rest for itself.  That opened the door to junk bond funds, which reverse the revenue split, keeping a little for themselves and paying the lion’s share of the interest income to shareholders.

…but no FDIC or Fed

If there’s a run on a bank, the government steps in and stands behind deposits.  If there’s a run on a mutual fund, there’s only the fund management company.

a real problem?

How likely is any of this to happen?  I have no idea.  Neither does the SEC   …but it’s apparently thinking it doesn’t want to find out.

Allowing/requiring junk bonds to charge exit fees would do two things:  it would decrease the flow of new money into the funds from the instant the fees were announced–and maybe trigger redemptions in advance of the imposition date; and it would make holders think twice before taking their money out.

footnote-ish stuff

Historically, there’s a sharp difference between the behavior of holder of load and no-load funds.  In experience, load funds that I’ve run have experienced redemptions of maybe 5% of assets in bad times.  Similar no-load funds might lose a third of their assets.

Mutual funds typically have tools they can use to deal with high redemptions.  They can usually buy derivatives that will hedge their portfolio exposure; they have credit lines they can use to get cash for redemptions immediately; in dire circumstances, they can suspend redemptions or meet redemptions in kind (meaning you get a junk bond instead of your money ( ugh!)).

Junk bond ETFs are a tiny portion of the whole.  They’re a special type of mutual fund.   Holders of ETF shares don’t deal directly with the management company.  They buy and sell through designated market makers, who have no obligation to transact at or near NAV.  Therefore, they can staunch selling simply by swinging the market down far enough.  At the bottom of the stock market in March 2009, for example, I can recall specialized stock ETFs trading at over 10% below NAV!

This issue is part of a larger government debate about whether large investment management companies are systematically important to the financial system and, as such, should be more highly regulated.

 

 

fixed income speculation and tapering

One of the earliest attempts by technical analysts in the US to link their work to economic variables was in charting the relationship between growth in the domestic money supply and stock market advance.

This wasn’t Milton Friedman.

This was–and is–a common sense attempt to create a barometer to measure the degree of speculation inherent in the stock market.  The idea is that the economy needs a certain amount of money to grease the wheels of commerce–to keep factories humming, meet payrolls, build inventories.  Anything in excess of that amount will inevitably find its way into financial speculation in equities, real estate and commodities.  Speculation, in turn, will lead to intervention by the Fed , “to take away the punch bowl,” as William M. Martin, a former Fed Chairman put it.  (Or, in the most recent case, where the punch bowl was heavily spiked and stayed out forever, a near-meltdown of the world financial system.)  So it’s an early warning indicator of a market decline.

Although still used by at least one famous hedge fund, this simple rule has lost much of its usefulness in a globalized world with supply chain management systems, ubiquitous, but only semi-visible derivative contracts and the increased prominence of businesses based on intellectual property.

I think, however, that the Fed is using this rule, but has reversed the inference, as part of its rationale for tapering.  I think the Fed sees increasing speculative activity in fixed income markets as evidence that there’s too much money sloshing around in the world.  (I know I am.)

Three areas worry me:

pik bonds.    Pik stands for payment-in-kind.  It’s a type of junk bond where the issuer has shaky cash flows and may not be able to afford to make interest payments on its debt.  So lenders allow the firm to pay interest “in kind,” meaning issuing more junk bonds to cover the interest expense.  As is always the case in investment banking, there are variations on the theme:  the bond may be pik from inception; the issuer may have the right to convert the bonds from cash to pik, if he needs to; or the issuer may be able to “toggle” back and forth between cash and pik as he desires.

In my limited junk bond experience, pik bonds only rear their heads at bond market peaks.  And they’re here again.

contingent convertibles, or “cocos.’   The original cocos, spawned by the financial crisis, are bonds issued by financial companies that can be forcibly converted into equity–thus shoring up regulatory capital–if the issuer gets into financial trouble.  In my view, the buyer is exposed to all the downside of owning an equity with few of the rewards.

According to the Financial Times, a new variation on the coco theme has recently appeared.  The new securities are called “sudden death” or “wipeout” bonds.   Their attraction is that they pay coupons of around 8%.  The catch is that if the issuer’s regulatory capital falls below a ratio specified in the bond indenture–so far its been if a bank’s Tier One equity ratio falls below 7%–then coco holders lose all their money.  

To me, this looks like an equity put dressing it up in bond clothing so fixed income managers can buy it.

the Fragile Five.  2014 opened to a bout of bondholder angst about their positions in the debt of places like Argentina.  Argentina?   Really?  Isn’t this the same place that nationalized Repsol in 2012?   …the same place that defaulted on its sovereign debt in 2001?   …where capital flight has accelerated to the point that the government has shut down online shopping to prevent money from leaving the country?  Talk about risky.

I think these areas worry the Fed, too.  They’re why I think we’d have to see considerable economic weakness in the US before tapering comes to a halt.

high yield (junk) bonds (ii)

what went wrong

1.  Junk bonds began to be used as a substitute for bank financing–but to a large degree by takeover specialists targeting either mediocre industrial companies or consumer staples firms of any stripe.  In both cases, more efficient management would boost cash flow enough to service the massive debt incurred in the acquisition.  Fear of the required debt service would act as a powerful motivator toward greater profitability.

Arguably, the substantial change of control among underperforming companies during the 1980s that junk bonds made possible laid the groundwork for the industrial renaissance the US experienced in the early 1990s.

Nothing wrong with that.

But in some cases, rapacious acquirers went further.  They targeted well-funded employee pension plans, replacing a conservative investment menu with a diet of exclusively junk bonds.  Others, particularly in the natural resources area, forced the acquired firms to operate for maximum near-term cash generation.  Timber companies, for example, harvested 3x-4x the usual number of trees every twelve months–leaving no time for replacement trees to grow.  As a result, companies went out of business; employees found their pension plans, after the junk bond collapse, unable to meet obligations.  The acquirers just walked away with the cash they’d drained from the firms.

Drexel also pleaded no contest to SEC charges that it illegally supported acquirers through stock manipulation and by helping them avoid 13-D reporting requirements.

2.  By the end of 1986–maybe a little later–Drexel and Milken had done all the junk bond/leveraged buyout deals in the US that made any economic sense.  What to do then  …close up shop or continue to do junk bond deals, even though they made no sense and might ultimately fail.  Drexel/Milken chose curtain #2.

By early 1989, the consequences were becoming evident.  Junk bond default rates were rising sharply, depressing junk bond prices.  To my mind, October 13th of that year marked a tipping point.  That’s when the media reported the failure of a proposed $6.75 billion leveraged buyout of United Airlines.  This was the first big junk bond deal not to get done.  Psychology changed decisively for the worse.

That’s when retail investors, who had been sold junk bonds on the idea that they had all the return potential of stocks plus all the safety of bonds, found out their dark side   ..if nothing else, how illiquid they are.  Junk bonds fell, on average, by about 30% in the following months.  Some investors also found out, to their sorrow, that up until that time their mutual funds had been pricing their holdings at what proved to be unrealistically high levels.

3.  We can all understand, though not condone, why Drexel/Milken would want to continue to sell dud junk bonds.  It’s what they did.  But why would any professional buy them (I know I characterized bond fund managers as not being among the best and brightest in my Friday post, but you;;d think they’d catch on eventually)?

The Federal government had an answer.  It was that Milken and Drexel bribed prominent junk bond fund managers to look the other way and take part in bad deals for their clients.  The Wall Street Journal had an in-depth investigative series on this issue in 1990.  I’ve been unable to find in the the WSJ online archives, however.

The government was unable to prove its case.  A New York Times article and one from the LA Times that describe the charges are the best documentation I can find.

Personally, it feels to me that the government was right, but that it had no way of getting any of the small number of people who would have been involved in a scheme like this to testify against themselves.

still, a revolutionary idea

By the early 1990s, the junk bond market had revived, though on a firmer footing as a result of the government action.

high yield (i.e., junk) bonds

Addled perhaps by too much turkey and a football triple header, I’ve decided to write a (very) brief outline of the development of junk bonds .  Today’s post is the first of two installments:

The first junk bonds were “fallen angels,” that is, corporate bonds that were investment grade when they were issued but whose credit ratings fell as the issuing company encountered difficulties and its finances deteriorated.

In an investment banking class in business school in the late 1970s, I heard a speaker from Drexel Burnham Lambert, the junk bond kings, deride the corporate bond establishment as a bunch of clubby coupon-clipping Ivy Leaguers without a brain among them, who simply sold such poor-performing bonds without analyzing the underlying fundamentals.  Drexel, he said, thanked God for creating these slackers, whose pockets they picked daily.

He then gave an example of a small oil exploration company that was in the midst of a sharp positive surge in profitability but whose bonds were still priced as if Chapter 11 loomed the next day.  As it tuned out, working as an equity analyst, I covered the company he mentioned.  Everything he said was accurate–and apparently unknown to the general run of bond managers.

The problem with the Drexel business at that time was that you used up the available pool of fallen angels pretty quickly.  How did you make money then?

The innovation of evil (and I do mean evil, despite the SEO puffery you see if you Google his name) genius and convicted felon Michael Milken was to realize Drexel could offer junk bonds as original issues.

Companies with less than pristine credit were already getting financing from banks, which were making a fortune on the business.  They were taking in retail deposits that they paid, say, 3% interest to customers on–and lending the funds to sub-prime corporates at, say, 12%.  To state the obvious, that’s a gigantic spread.

Suppose, Milken, thought, Drexel were to float bonds for these companies at 9% instead and market them to junk bond mutual funds + pension investors.  Retail investors would get around an 8% yield after fund expenses, the companies would get a cheaper interest rate, Drexel would collect enormous investment banking fees.  Everyone, ex the banks, would be happy.

The banks would be “disintermediated” (cut out of the action), as the term goes, in the same way as money market funds were cutting them out of the market for time deposits.

As it turns out, there was another gigantic plus for the issuing companies.  The junk bond fund managers appear to have had either terminal brain freeze, clubby Ivy League bond backgrounds, or absolutely no prior experience in corporate lending.  Cluelessly, they failed to require that the junk bond issues they bought have any of the protective covenants that Banking 101 would have taught you to demand.  No wonder sub-prime issuers were chomping at the bit to obtain Drexel’s underwriting services.

More on Monday.