KUHN CAPITAL Thursday, October 19, 2017
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Debt Too Clever by Half


"Situational Analysis"
So it seems that the spreading contagion of lending uncertainty, originally sparked by mortgage defaults, is being compounded by two new factors:

• It’s proving quite difficult to identify the ultimate owners of mortgage loans in whole or in part. The notes have been sliced, diced and packaged so many different ways and so many times for so many investors, that tracing the connection between Fred Homeowner and Titan Hedge Fund is hard, in some cases nearly impossible.

That’s a problem both for the debtor – who has nobody to explain his case to – and the creditor, who has no idea what the individual circumstances of his debtors are or how severe Fred's problem is. Used to be that if a local bank wrote and held the mortgage, it could pull Fred into the office and try to figure out some way to avoid repossession. In our new faceless quantitative risk management era, creditors have severely reduced work-out options. Many of them are not mortgage specialists, and many of them are halfway around the world. Instead they’ve used numbers as a substitute for lending expertise and human dialog. Now they often have only a single decision: sell out at market rates (if they can find a buyer) or hang in there.

• Second, because of this elaborate chain of debt ownership, exotic financial instruments and proliferation of complex, mysterious hedging models, creditors are dealing with a raft of uncertainties: Is their position up or down? What’s their floor? Will their models work for or against them? Will their investors pull out? The result is no appetite for new business, setting up a liquidity crunch which in turn drives up rates.

This lack of information even cripples the Fed’s ability to “helicopter” in with fresh liquidity, as it has done with banks in the past. That’s because banks are a much smaller source of mortgage financing today: instead, thousands of hedge funds play the game. How would the Fed finance these private operators, assuming it were motivated to do so, or even find them all? If the hedge fund doesn’t know what its position is, what would the Fed take as collateral?

Our Take-Aways
We’ve long opined that PE firm M&A leverage would one day be recognized as unsupportable, and we thought the parade would grind to a halt when a few of these mega-deals subsequently bankrupted. See our Financier Worldwide piece. That wasn’t quite right, but nobody else we know got it right either.

Instead -- while the wake-up call did come in the form of highly visible PE firm LBO’s -- the problem was that these deals didn’t make it past the closing table. Lenders of all stripes (both banks and hedge funds) were closeted in their offices worrying about their home mortgage exposure. We and most other people missed the intricate connections between mortgage defaults and the general credit market.

Lessons drawn? While it’s early, as usual we don’t hesitate with fresh opinion. The situation is reminiscent of Long-Term Capital’s fate. You’ll recall that at LTC back in the early Nineties a bunch of leading quant jocks got together and built a giant hedging model that “couldn’t fail”. Banks even lent them billions for free. But it did fail in a spectacular “black swan” event that saw both sides of their hedging positions fall at once. The lesson then, as now, is that events with no historical precedence can occur, so confidently taking on extreme leverage is never prudent.

A lesson that may be unique to this circumstance, however, is the realization that substituting hedging models for expert and experienced lending judgment will forever be dangerous. The further you separate debtor from lender, the greater the risk. Come to think of it, that’s an old lesson.

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