All kinds of markets took a drubbing in mid-March as the depth of the economic disruption caused by the pandemic sank in. But what happened in U.S. securitized debt stood out, as the asset class was pummeled by margin calls that forced selling in residential- and commercial-mortgage bonds, collateralized loan obligations and even securities backed by some types of auto loans. New issuance in these markets seized up and stayed frozen for weeks even as other areas of the bond markets, like corporate bonds, roared back to life in response to U.S. Federal Reserve intervention. As the dust has settled, it’s become clear that hedge funds and banks had combined to create far more leverage in structured-credit markets than anyone knew was there.
- How did this leverage build up?
After years of record low rates, some investors — particularly hedge funds, structured credit funds and mortgage REITs — sought to increase their returns by buying securitized debt via so-called repurchase, or repo, agreements with banks, who were their counterparties. This is a type of short-term financing that allowed the funds to amplify their returns on these complex and often illiquid securities. But while leverage brings bigger gains in good times, it can also magnify losses if there’s a downturn.
- How does repo work?
You can think of the trillion dollar repo market as the world’s largest pawn shop, making short-term collateralized loans. Repo deals can be as short as overnight, though in the securitized debt market one to three months is more common. In this sector, deals generally involve an asset manager putting up cash or high-quality collateral, like Treasuries, to buy an underlying bond or portfolio of securities from a bank dealer’s inventory. Importantly, the bank will hold on to the securities, but the hedge fund will enjoy coupons from the bonds for the period of the repo. The fund agrees to fully purchase the securities at the end of the period, or renew the repo lines.
- Who gets what out of this kind of a repo deal?
The bank charges the asset manager a so-called repo spread that represents its profit on the transaction. The fund gets to keep coupon payments on a bond it wants to buy from the bank, but the bank itself usually holds onto the security. The coupon payment offsets the repo spread, making repo a cheap way for funds to finance investments.
- Where does the leverage come in?
Banks often, in effect, financed part of asset managers’ purchases of securitized debt by entering into repo agreements. Here’s how it worked:
A hedge fund wants to purchase $100 million of BBB-rated collateralized loan obligations, or CLOs, held on a bank’s inventory. CLOs are bundles of bonds built from leveraged corporate loans that offer higher rates of return than higher-rated bonds.
If the fund doesn’t have $100 million in cash on hand, it may enter into a three-month repo agreement with the bank. The bank may offer to put up $60 million of the total. That would be known as a 40% “haircut.” The bank decides on the haircut — as well as the interest rate charged — by assessing the risk of the securities it’s holding on its balance sheet, as well as the counterparty risk of the hedge fund it’s doing business with.
During the three months, the hedge fund receives the coupons, or periodic payments, from the CLOs, but the bank typically holds onto the bonds. In this example, let’s say the CLOs pay out a coupon equal to the Libor benchmark rates plus 700 basis points, or 7%.
The bank charges the fund a so-called repo spread for the $60 million in cash that it put up. For this example, let’s say the bank decided to charge Libor plus 300 basis points, or 3%. The cost to the fund is 1.8% of the $100 million (that is, 3% of $60 million). Since it’s getting a 7% coupon from the $100 million worth of bonds, and only paying 1.8% as a repo spread, the fund gets to keep 5.2% in total.
But since it only put up $40 million of its own money, and is earning 5.2% of $100 million, it just levered up its return to 13%.
- What could go wrong?
Banks can demand more cash or collateral and increase the repo spread they’re charging if the market sours. Moreover, banks have much higher capital charges compared to 2008, and amid a market rout such as the one in March, these securitized products can prove too onerous for many dealers to hold. That’s part of the reason why banks issued margin calls so quickly this time around. When the market value of securities fall — as CLOs or RMBS did during the March turmoil — banks become vulnerable to that drop in price, and ask the hedge fund to make up the difference. Funds can either put up more collateral, or the bank may have to liquidate the position altogether. Forced sales for margin calls can drive prices down, and those fire-sale prices become publicly available and establish lower price points in the market. This sets off a new round of margin calls and fire sales at the lower prices — a cycle familiar from the 2008 financial crisis.
- Who’s been getting hurt?
Mortgage REITs, who often bought securitized debt at 7x leverage via repo lines, and some hedge funds, may be the biggest victims of repo unwinds. But some in the market reason that continued margin calls on securitized debt caused by repo unwinds may harm an array of non-bank lenders and their investors. Colony Capital Inc.’s Tom Barrack, for instance, made the case that REIT investors such as mutual funds, ETFs, life insurance companies and others may ultimately suffer along with the REITs they invest in, and that an important source of liquidity to the system would be compromised. Moreover, the wild volatility in spreads caused by repo unwinds has severely disrupted the securitized sector, as proven by the wide spreads of recent weeks and pause in new issuance. That cuts off a critical source of funding for everything from mall owners to small subprime auto lenders.
- What about the Fed’s intervention in the credit markets?
The Fed announced that it will begin buying corporate debt, but generally only the most highly rated issues. While some areas of structured credit have been included in programs — namely AAA rated CLOs, residential mortgage-backed securities (RMBS), and commercial mortgage-backed securities (CMBS) — market participants still insist that large swaths of the market have been left out in the cold, including all other investment-grade classes besides AAA and all junk-rated bonds. A return to normal for the broader securitized debt markets seems distant. In fact, Wells Fargo & Co. is predicting that CMBS issuance may be frozen for months, and CMBS margin calls have already led to lawsuits. Some prominent market participants say that CMBS is one area that is likely to experience more pain if margin calls continue. Colony’s Barrack called for more direct Fed support for the CMBS market before concluding that in the current political climate, anything that looked like a bailout of aggressive investors burned by excessive debt was unlikely to happen.
- Is what happened in repo now like 2008?
Not exactly. While the amount of leverage used in recent years to buy these highly complex and risky securities via repo agreements may have come as a surprise, this time is slightly different: The current dislocation is mostly a problem with liquidity, not necessarily credit risk, as it was in 2008 (with widespread defaults on subprime mortgages).