Thinking about the Third Avenue fund freeze as BNP Paribas from 2007

Last week, the high yield market seized up, in part due to jitters surrounding a high profile freeze of funds at the Third Avenue Focus Credit fund. Some see more pain ahead for bonds. The big problem for Third Avenue is energy high yield credit and the contagion from that sector into other credits. This latest event bears some similarities to the fund freeze at three BNP Paribas funds in August 2007. I believe one should think of energy high yield as the equivalent in this credit cycle of residential MBS in the last cycle. So I want to put what’s happening in a broader context and make some conclusions about what it says about the credit cycle.

First, I am clearly concerned about these kind of events because – merely by coincidence – I wrote a post on Thursday morning telling you that when market contagion occurs, this is how it will happen. My thesis in that post was that the worsening picture for energy high yield would prove fatal for many in the sector and that this would ‘infect’ other lower quality credits via lower risk tolerance and fund redemptions – with funds “selling what they can, not what they must”. Eventually, the lower prices and risk-off sentiment would snowball to where a general aversion to credit risk would cause the end of this credit cycle.

Now, the Third Avenue fund freeze is very much in line with that thesis. And yes, I think we should be worried enough to take this as a signal to lower risk. Eventual market losses could be significant – and not just in high yield. However, from a macro economy perspective, we aren’t quite at the end of the cycle. There has been no sudden stop of credit to Ponzi energy credits yet. When the sudden stop does occur, I believe it will mark the top of the cycle and that is when the real economy impact will begin in earnest.

I want to remind you how we got here though. My mental model for monetary policy and resource misallocation says that we are seeing a BIG divergence between the monetary stance consistent with small portfolio preference shifts and low resource misallocation versus one consistent with a real economy at full employment with moderate inflation. In other words, the Fed is pushing on a string in terms of the real economy, while it has greatly skewed private portfolio preferences and asset allocation toward risk – to the point where we have a massive malinvestment unwind in front of us. This is all the result of depending on the Fed as the only game in town. And remember, the household debt overhang, while diminished, is still pretty large, making downside scenarios from a shortfall in demand and recession-induced deleveraging much worse. Think 1998 Japan.

Going back to BNP Paribas eight years ago, here is how Bloomberg described the events on 9 Aug 2007:

BNP Paribas SA, France’s biggest bank, halted withdrawals from three investment funds because it couldn’t “fairly” value their holdings after U.S. subprime mortgage losses roiled credit markets.

The funds had about 1.6 billion euros ($2.2 billion) of assets on Aug. 7, after declining 20 percent in less than two weeks, spokesman Jonathan Mullen said today. The bank will stop calculating a net asset value for the funds, which have about a third of their money in subprime securities rated AA or higher.

BNP’s announcement sent its shares down as much as 5.5 percent, pulled the benchmark European stock index lower by more than 2 percent, and helped U.S. Treasuries rally for the first time in four days. Investors are shunning bonds backed by home loans after late mortgage payments by borrowers with poor credit histories rose to the highest since 2002.

“The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating,” BNP Paribas said in a statement.

The French bank joins Bear Stearns Cos. and Union Investment Management GmbH in stopping fund redemptions. Dutch investment bank NIBC Holding NV said today that it lost at least 137 million euros on U.S. subprime investments this year.

On my credit crisis timeline, I mark the beginning of the panic phase of the crisis as the BNP Paribas fund freeze. So the obvious question now is whether Third Avenue parallels BNP Paribas, and if so, what happens next. In 2007, the month after BNP Paribas, we had the Northern Rock failure and bailout (see the timeline again here). And then as Q3 began, the mark-to-market losses at banks started to pile up. Afterward, the credit crisis was unrelenting, with major negative feedback into the real economy. The Fed made a huge interest rate cut in September, a signal that the real economy was already in decline. Recession took hold already by December.

In 2015, I expect things to follow a somewhat different path because the real economy is in a different place and because bank exposure to marginal credits is lower due to the lack of energy sector scale and the lack of securitization. On the question of scale, I don’t have the numbers on the energy high yield sector or energy capex, but needless to say it is an order of magnitude smaller than residential MBS and the residential homebuilding and property market. Therefore, from a scale perspective, I don’t believe this trigger is equivalent to the residential MBS trigger from 2007.

Moreover, to the degree that 2015 would mirror 2007, I believe we would need to see higher-rated tranches of debt come under pressure, perhaps via auto and subprime auto ABS or via student loan securitization. But those are events that would be associated with a decline in the real economy, not in the financial economy.

One other unknown here is how exposed international lenders are to the lower credit quality segment of the energy sector. In 2007, the exposure via MBS was significant, where mark-to-market accounting added fuel to the fire. Today the equivalent exposure would be through the leveraged loan market, where there is no real mark-to-market pressure – one reason we have seen loans get evergreened thus far.

So, my read here is that the energy high yield sector is too small and the biggest market contagion effects are too remote in time to make the Third Avenue fund freeze exactly analogous to the BNP Paribas freeze. The international component remains an outstanding caveat where I don’t have enough information.

A softening of the real economy is what would make crisis more likely – as it would trigger problems in several additional sectors like auto ABS, student loan securitization and US municipal debt. That said, the real economy in 2015 is better than it was in 2007. The Fed was already cutting in 2007, whereas now it is poised to raise rates. Now, clearly the Fed could be out of step with the market by getting ready to raise rates. I think it is. But, nevertheless, it’s clear that the economy is on more solid footing now than it was in August 2007 and so the real economy is less of a near-term ask than it was in 2007.

In terms of other risks going forward, the question now is contagion. We clearly have had some contagion already as the high yield ETF (HYG) is at its lowest level since 2011, with a loss of about 5.9% year-to-date. This is not just energy credits that are suffering but the whole high yield market.

A year ago, in December 2014, I outlined other candidates for tail risk in 2015. Here’s my list from then including sectors that have been hit already – with a quote from that December post on why I thought these sectors were vulnerable:

1. Oil: “The thesis here was that a combination of high oil prices and low nominal rates has made investment in unconventional oil much more attractive in the last 5 years. The result was an increase in supply to match the increase in demand coming for emerging markets without oil prices rising further still. However, when emerging market growth slowed, many analysts believe that eventually the supply became more than was needed. And the result was a decline in the price of oil.”
2. High yield and leveraged loans: “The thesis I made in October on oil was that the decline was not only negative for the oil market but would have a negative impact on oil funding markets like high yield and leveraged loans. Let me spell this out in detail. I wrote specifically that, ‘the Japanese experience with zero rates and risk spreads told us that while safe assets were firmly anchored by the central bank’s actions, risk assets decoupled from safe assets in economic downturns. What we saw in 1997-98 and subsequent Japanese downturns was that the full force of market dislocation fell onto risk assets in the form of higher risk spreads without any yield relief because of the central bank’s inability to cut rates. For shale oil producers, this should mean a gapping up of rollover payment terms, presenting those companies with a brutally different funding environment.”
3. US capital investment: “Andy Lees of the Macro Strategy Partnership wrote earlier today that S&P has calculated that energy now accounts for 41% of North American capital expenditure. This includes shale, oil sands, energy infrastructure, and everything in between I am assuming. Companies in the shale and oil sands and deepwater segments are cutting back because these are high cost endeavours. But so too are large operators like Conoco Phillips and BP. While the loss of income for producers is a net gain for oil consumers and more than that because the US is a net importer of oil, the concern here is on capital expenditure as a line item in the national income and product accounts. This measure is going to fall and I believe so quickly that GDP estimates will not capture the full reduction until we see revised data months later. In my view this will impact Q4 2014 numbers but more so 2015 numbers.”
4. Municipal debt: “North Dakota is going to get caught out here. These are not the worst states from a municipal finance perspective. So the impact could be muted. But we should add municipal finance to the areas for potential tail risk in 2015 nonetheless.’”
5. Emerging market corporates: “Here’s the thesis. The United States is doing so well relative to the rest of the world that the monetary policy of the US central bank is going to diverge from other major central banks’ policy, strengthening the US dollar. Because the USD is the major global reserve currency and because the US economy is so large, the US dollar market for credit is so deep and complex, that foreign companies and countries often borrow in US dollars. When the USD rises, this creates a asset-liability mismatch that can lead to liquidity crises and bankruptcies, particularly in emerging markets. We have seen this time and again in the fiat currency age.”
6. Canada and Australia: “Another place to look for problems is Canada because of the nexus of high household debt, high house prices and leverage to the energy sector. In Canada where mortgages are recourse loans, there is no walkaway opportunity which can bolster consumer spending if the economy gets hit by a downturn due to oil and gas profits and capex. Instead, given high household debt and high house prices, we should expect a weak housing market to develop that would bring on significant consumer deleveraging and in a worst case scenario would lower house prices, making the deleveraging more severe. Australia has similar dynamics, though it revolves more around the industrial commodities space. The household debt and house price elevation are problematic in Australia as well.”

A number of these markets are already in decline. It isn’t clear then how much further they will decline outside of a crisis. Emerging market corporates are a perfect example here. As bearish as I have been on this sector, it has already been hit by the brunt of policy divergence. We would have to see a crisis for it to go much lower. The key takeaway from these sectors is that in a crisis, they will add fuel to the fire and compound the panic. But outside of crisis, they have seen most of their losses.

The sectors to concentrate on here are the ones where we have yet to see any big problems. We should be thinking about natural gas as another sector here because today the natural gas futures market hit the lowest levels since 2002, due to unseasonably warm US weather. I would say sectors to watch also include US municipals, Canada and Australia. In the event we do have a sudden stop of credit, expect the knock-on effect for energy and commodity markets to bring Canada and Australia into the picture. And a recession in the US would bring US municipals in as well. In a recession scenario, we would also have to think about auto and student loan ABS as areas that would add distress to the financial system.

I see the Third Avenue fund freeze as a general analogue to the BNP Paribas freezes of 2007. However, there are enough differences that I am more optimistic about near-term outcomes. The caveat on this is the falling energy and commodities market. As I write this, WTI have just fallen below $35 a barrel for the first time since 2009. And the 2009 lows around $32 are not that far now. Moreover, natural gas is also getting crushed. It is now well below $2 per mBTU, which is 2002 levels. There is a whiff of panic here – and that creates downside risk both for markets and in terms of a sudden stop of credit flow.

Over the medium term, as the capital expenditure impact of a softening oil market takes hold, it will interact with the eventual stop of credit to lower quality credits, putting economists on recession watch as a credit crunch takes hold. At that point, the most negative scenarios will come into view as deleveraging takes hold.