30 Sep Ostrich Syndrome (Q3-19)
S&P LCD (“LCD”) recently updated in its recovery study database for leveraged loans and corporate bonds, which covers USD$1.1 Trillion in credit defaults over the past thirty-one years. Recoveries are determined by valuing loans at three different points in the recovery process: emergence, settlement, and liquidity event. Emergence is when a loan defaults and a lender proceeds to exercise its rights and remedies, including enforcement over collateral. Settlement occurs when the lender and borrower have resolved the default. The receipt of final recovery proceeds from a defaulted loan is considered a liquidity event. Since restructurings can take varying lengths of time to resolve, even several years, discounted recoveries should be used rather than nominal ones. The discounted recovery is calculated by finding the present value of the nominal recovery discounted using the pre-petition default interest rate back to the date of default. The faster the restructuring process, the higher the discounted recovery rate.
The average nominal recovery for all the corporate bonds and loans tracked in LCD database is 66%; the average discounted recovery is 59%. Looking at just bank loans, the historical average nominal rate is 86% and the historical average discounted rate is 79%. However, for newly tracked loans added by LCD in the last year (up to August 2019), the recoveries on bank loans has underperformed the historical average: average nominal recovery of 77% and the average discounted recovery of 76%. Two major factors have influenced lower recoveries for recent defaults in the LCD database: (1) these bank loans had a lower safety cushion than is the case historically – 20% versus 43%; and (2) these bank loans contained a higher concentration of covenant-lite terms.
Safety cushion, which can be measured by total loan-to-collateral coverage, or amount of junior debt or equity below the senior, is the most significant factor determining recoveries. Loans with more than a 75% cushion (an LTV of 25% or less) have a 94% average discounted recovery, with a coefficient of variation of just 0.18. The average discounted recovery is 86% for bank loans with a 51–75% cushion, 73% for those with a 26–50% cushion, and 69% for a cushion of 25% or less.
According to LCD, of all first-lien term loans issued this year in the U.S., only 66% had any kind of safety cushion, which is a record low. Not surprisingly, such loans are typical for smaller, closely-held borrowers, which prefer to preserve equity and provide loan guarantees from its owners. For all loans tracked by LCD, including revolvers and both first and second-lien loans, 26% did not have a debt cushion, slightly below the 27% historical high at end of 2018. In addition, the average debt cushion is now also at a record low of just 20%.
The prospect of lower loan recoveries should have investors more anxious about the timing of the next default cycle. Most loan managers in the U.S. remain sanguine about the default rate. According to LCD’s Q3-2019 buyside survey, loan managers say they do not expect an impending spike from the historically low trailing default rate at 1.29% in September 2019. In fact, consensus is that loan defaults will only push to 2.52% by the end of 2020, still below the 2.92% historical average. Yet, credit fundamentals do not support this optimism. Issuers listed in the S&P/LSTA Leveraged Loan Index (“LLI”) have weighted-average leverage of 5.59x, cash flow coverage of 2.95x, and annual EBITDA growth of 2%. The share of loans in the LLI that are rated single-B or below has been climbing since 2015 and is at a record 49%.
Private lending managers in Canada also maintain a benign outlook on defaults based on informal surveys at recent private debt conference panels in which the author participated. Not a single manager (other than the author) was concerned about weak loan structures or deteriorating corporate credit fundamentals, and nearly all of them believed that any credit downturn would be short-lived. A bottom-up analysis of eighty-five publicly traded companies since 2007 shows that the overall health of Canadian corporates has weakened dramatically: profitability metrics and interest coverage ratios are at their lowest levels.
Canadian non-financial corporate debt levels are very high (see Q1-2019 Investor Letter) and the export-intensive Canadian economy is vulnerable to any incremental deceleration in U.S. growth. Whether looking short-term or long-term, corporate credit fundamentals in Canada are bad. Private debt managers who choose to ignore the overwhelming negative information will bear the consequences of sticking their heads in the sand.
Banking on Losses
The big six Canadian banks are the largest players in the Canadian financial landscape and hold ~75% market share in consumer and retail banking (which includes small business loans and commercial lending) and dominant positions in wholesale banking (dealing with corporate and institutional clients) and wealth management, where market share is about 80%. Banks have adopted a secular trend toward favouring growth in non-interest revenues over net interest income. Since 1980, non-interest income has risen to 45% of total revenues from about 20% (it was close to 60% before the GFC in the second half of 2007) because of low interest rates pressuring margins and a de-emphasis on capital-intensive lending businesses (see Figure 3 below).
The greater exposure to capital markets was helpful to banks in Canada during the GFC. Loan losses tend to lag an economic recovery while asset values lead; therefore, by the time Canadian banks felt the effects of higher credit losses, wholesale banks were benefiting from attractive capital markets trading conditions. Return on equity (“ROE”) for Canadian banks was higher during the GFC than in prior downturns because of the increased diversification of revenues and lower exposure to traditional credit risk. ROE troughed at 13% in 2009 compared to negative ROE for U.S. banks.
Loans represent a smaller proportion of banks’ assets today than in anytime during the 20th century. However, loan growth has remained positive as total assets have increased. Business loan growth has traditionally coincided with the business investment cycle. Since the GFC, business loan balances for Canadian banks troughed in the first half of 2010 and total loan balance growth has improved since then to double digit rates. In addition, many larger businesses have locked-in low financing costs by issuing long-term bonds rather than borrowing short-term from banks, which has been positive for Canadian banks’ debt underwriting revenues. Banks have shown a willingness to price business loans aggressively for certain borrowers, specifically where they can generate non-interest income from sources such as account fees, cash-management support, foreign exchange services, payroll solutions, group savings plans, insurance products, and wealth management services to business owners. Their full-service capabilities have allowed the big six banks to capture more market share in business lending than their competitors including other chartered banks, trust companies, credit unions, mortgage companies, and other non-bank lenders combined.
Loan losses have historically been volatile at banks, with those having high concentrations in industries and issuers facing difficulty incurring the highest losses. Banks’ internal workout departments are small, regimented, and banal and are not equipped to restructure or turnaround distressed businesses to maximize going concern values. Bank personnel will generally give defaulted borrowers time to find a refinancing solution and, if that fails, resort to an asset liquidation under an expensive receivership process. Banks aim to mitigate risk through industry limits and single-name limits depending on the borrower’s risk rating. Credit risk and loan losses are inevitable for banks (it is the one of the primary reasons for their existence) but Canadian banks are less exposed today than in the past. In the peak yearfor loan losses in the early 1990s, losses represented 26% of revenues (and were even higher at 55% in 1987). In the early 2000s, they represented 15%, and in 2009 14%.
In 2009, some banks experienced loan losses well above their historical averages, which in large part reflected business mix (i.e., more exposure to consumer lending). This was predictable because the two credit cycles prior to the GFC (the early 1990s and early 2000s) were characterized by problems in the business sector, which shifted bank lending activity to consumers. The current credit cycle in Canada has, again predictably, seen an unprecedented surge in corporate credit. If you want to know where the next crisis will be, then follow the leverage.
The future size and direction of business loan losses can be forecast by tracking two metrics: (1) business health, and (2) the trend in business bankruptcy proposals and filings. On the first measure, we highlighted in the previous section (see Figure 2 above) a significant deterioration in the health of Canadian companies since the GFC. In a weakening economy, Canadian businesses will struggle more than ever to stay current on their debt. The second metric is showing worrisome signs for the near-term outlook of business loan losses at Canadian banks.
According to statistics published by The Office of the Superintendent of Bankruptcy Canada (“OSBC”), total business insolvencies in Canada increased 30% year-over-year in July 2019, with most provinces experiencing a material jump (particularly in Quebec and the Western provinces). During Q3-2019, the greatest number of insolvencies were concentrated in three main industries: residential developers and contractors (including sub-trades), freight trucking companies, and full-service restaurants. Incidentally, TEC has exposures in all these industries but in companies where fundamentals and outlook are strong. A total of 29 proceedings under the Companies’ Creditors Arrangement Act (“CCAA”), a federal law allowing insolvent corporations that owe their creditors in excess of $5 Million to restructure their business and financial affairs, were filed in the twelve month period ending September 30, 2019, mostly in the mining, oil and gas, retail and manufacturing industries. The primary objectives of the CCAA are to facilitate a successful restructuring, maximize value for creditors, protect the public interest, and rescue insolvent debtors.
A rise in Canadian business insolvencies has been a strong predictor of gross impaired loan (“GIL”) formations within banks. Loans are classified as impaired when the bank no longer has reasonable assurance of timely collection of the full amount of principal and interest. Bank published GIL figures are misleading, however, because they are netted with general allowances, which are meant for performing loans not impaired loans. Reported GILs are increasing at Canadian banks and are now higher than pre-GFC levels (see Figure 4 below).
Rising business insolvencies will drive higher loan loss provisions for Canadian banks in the coming quarters. This will, undoubtedly, cause a cyclical shift in the banks’ credit mix away from companies and further open the door for alternative lenders to fill the gap. Also, because banks lack the ability and willingness to restructure distressed borrowers, sophisticated alternative lenders like TEC with the specialized skills and experience to orchestrate major business and financial turnarounds will be positioned to prosper. The demand for debtor-in-possession (“DIP”) financings will increase with rising defaults. DIP financing provides liquidity to debtors seeking to reorganize and restructure in an insolvency process. As an incentive to extend credit to an insolvent debtor, DIP providers receive superpriority creditor status from a bankruptcy or CCAA court that grants them the right to be repaid from collateral proceeds before any pre-petition creditors, including existing senior secured lenders.
TEC has been providing DIP financing since its inception. Banks rarely provide DIP loans due to the high-risk weightings and capital charges imposed on them by regulators for such financing. In Canada, there are very few alternative lenders willing and experienced enough to navigate through a complex restructuring process using a DIP financing. TEC’s track record using DIP financings has been exceptional and is well known among Canadian insolvency professionals; recently, we have seen DIP financing requests increase significantly in line with the jump in business insolvencies. Research published in the Journal of Financial Economics shows that DIP financed firms are more likely to emerge from a restructuring process than non-DIP financed firms. DIP financed firms also have a shorter reorganization period; they are quicker to emerge and also quicker to liquidate. The time spent in restructuring is even shorter when the DIP lender also has a prior lending relationship with the debtor.
Canadian bank executives have been consistently providing positive guidance on the credit outlook. We believe such optimism needs to be tempered by a challenging macro environment and growing business loan losses. Despite their immense scale and market dominance, banks can very quickly change credit priorities and leave certain sectors stranded. For instance, after crude oil prices fell to decade lows in 2016, many Canadian energy companies defaulted on their loans and Canadian banks have been reluctant to support the sector ever since. Thanks in large part to the torrid pace of business lending by banks, alternative lenders in Canada, particularly those that know how to manage distress, should get set for another wave of outsized returns.
Excerpted from Third Eye Capital Management Inc.’s Q3 2019 Investor Letter.