This is another thought piece on tail risk. Here’s what I am thinking: I alluded to Petrobras as a problem debtor two days ago, when talking about the coming market death in the oil patch. So it wouldn’t necessarily be a black swan event because the financial turmoil at Petrobras is well known. But the question of whether markets are prepared for the default of such a large debtor is a good one to ask in thinking about tail risk as the situation at Petrobras encapsulates the intersection of emerging market US dollar corporate debt, sovereign contingent liabilities, the oil patch downturn and, monetary policy divergence quite well. The outcome is likely to be extremely negative for markets and economies.
While I question the strength of US economy, I am still relatively upbeat about the internals. Where I have the most questions about the global economy is outside the United States, particularly in emerging markets.
I spent a good deal of my career as a micro analyst, looking at corporate strategy and balance sheets by chasing up German high yield market candidates, looking at US technology takeover and merger candidates, formulating re-engineering strategies for European banks and advising large US and Canadian companies on strategy. But starting in 2008, when the financial crisis was full throttle, I started a switch back to macro. If I were still on the micro beat and had the bandwidth, Petrobras would be the first company I would analyze in depth regarding tail risk. Here’s why.
Back in December, I wrote a piece on candidates for tail risk in 2016. Both oil and emerging market corporate debt figured high on the list. On the oil side I wrote that “Yves Smith speculated on just this today, wondering whether the US derivatives legal fight had some basis in a need to protect banks from the fall in oil prices. This is clearly speculative but the black swan event here would be a failure of major size creating contagion.” Petrobras would fit that bill.
On the emerging market corporate side, here’s what my thinking in December was: “Because of the repeated crises of the past, foreign governments have had their central banks build up significant foreign reserves to protect their economies from crisis. Nevertheless, there are two vulnerabilities. First are countries with large current account and government funding needs like the so-called fragile five. We saw this crisis already as a mini-crisis early in the year. These actors may have toughened up enough to prevent a recurrence. However, the corporate borrowers without sufficient currency hedges or hard currency revenue streams could find themselves in dire straits. This could negatively impact emerging market funds, for both equity and bonds.”
The problem here is policy divergence that has led to a strong US dollar. Back in December, the BIS warned that off-shore lending in US dollars had grown to $9 billion. And while I wrote about governments being able to insulate themselves, there is still $5.7 trillion of emerging market debt in US dollars, much of it in corporate hands. Some of these borrowers are ‘short dollars’ and Petrobras is likely one of the biggest debtors now short dollars given the drop in oil prices.
The ratings agencies have downgraded Petrobras but perhaps not nearly enough. Moody’s put the company at Baa3 in January and Fitch has it at the equivalent BBB-, a rating at the high end of the high yield spectrum. But Petrobras is a cash-flow negative debtor with a number of redemptions coming due. The total cash on hand will not fund the company without it being able to roll over debt and secure new loans and issue new bonds.
This is why, for example, Petrobras is looking to divest pre-salt fields as I highlighted on Monday. The company is looking to divest as much as $14 billion of deep water assets in a market that is cutting hundreds of billions of dollars in capex. Moreover, looking just at these pre-salt fields, Petrobras’ biggest partner, Shell is in a $70 billion merger with BG. And it is selling assets to finance that merger. That’s never going to work; in a market death scenario, you could be talking about fire sale prices or no sale at all. And the $14 billion will not cover the huge hole in Petrobras’ balance sheet from cash flow and debt redemptions.
A reasonable worst case scenario is one in which Petrobras runs out of money and either has to be financed by the state government or default. This is where the issue of sovereign contingent liabilities come into play, despite the huge foreign reserves built up by these central banks. We saw the same issues build up in Russia, due to sanctions and the fall of the Ruble in 2014. I believe the risk is still with us for emerging markets as a whole, with Asian corporates and Brazil being particularly vulnerable. The $5.7 trillion of US dollar emerging market debt is split into $3.1 trillion in bank loans and $2.6 trillion in bonds. Asia is home to half of the offshore $9 trillion of US dollar funding.
So what happens then if the state cannot or will not intervene to prevent Petrobras from going down because of political constraints due to the corruption scandal? The first thing to recognize is that when you think of emerging market defaults, this would be on par with Russia in 1998 and larger than Argentina in 2001 given the enormous size of Petrobras, a firm that accounts for one-quarter of Brazil’s hard currency borrowing. There would be a massive ripple of contagion via derivatives given the CDS market. But then there are Petrobras’ own derivatives contracts, the terms of which we are not privy to.
Elsewhere in derivatives markets is the CDO market. Because Petrobras is so large, we should consider that Petrobras is a major constituent of many CDOs, where 55% of the market is now made up of collateralized leveraged loans, which are both illiquid and high yielding/higher risk. A Petrobras default could cause huge turmoil in this very large market.
And then the ripples via funds go to at least two other sources. I will mention these and finish off. The first is the life insurance market. As companies reach for yield, they are going into more illiquid asset classes to get extra yield pickup. While life insurance money is long-lived, we should be concerned that these companies have more exposure to leveraged loans to companies like Petrobras and Asian corporate debtors that would get caught up in a sudden stop of funding. The result would be default and a loss of principle for the life insurance investors. The New York Times provides an anecdote of how the illiquid investments are happening, using the bankrupt Caesars as an example.
In July 2013, the smart money was saying the company that runs the Caesars and Harrah’s casinos would go bankrupt, when a big investor, Apollo Global Management, offered a lifeline: It was willing to pump millions of dollars into the parent of the struggling casino company.
And where would Apollo get the money?
Not a problem. Apollo, which already had a big stake in Caesars, also had been building a life insurance division called Athene. That division was bursting with cash from the premiums paid by life insurance policyholders.
“Athene Life Insurance and Annuity Company has tens of billions of dollars under management,” said Steve Pesner, a lawyer who took Apollo’s proposal to the Nevada Gaming Control Board for approval. It could spare some to help Caesars, in exchange for a promissory note and some nonvoting stock.
“This is essentially an investment by Athene, indirectly, in Caesars,” another lawyer for Apollo, David Arrajj, told the board.
This is an accident waiting to happen. And it shows you how risk has spread across the financial services landscape as regulators chase down risks at too-big-to-fail banks, the locus of the last financial crisis.
Another problem is bond ETFs, which are also now dabbling in illiquid markets similar to what we see in the CDO market. Here’s the New York Times again:
The Federal Reserve, in a February report on monetary conditions, suggests that individual investors may have gotten the misleading impression that mutual funds and E.T.F.s trade more readily than the bond markets themselves, and the consequences could be quite serious.
“These funds now hold a much higher fraction of the available stock of relatively less liquid assets — such as high-yield corporate debt, bank loans and international debt — than they did before the financial crisis,” the Fed said in the report. And as the funds expand, they may pose a threat, it said: “Their growth heightens the potential for a forced sale in the underlying markets if some event were to trigger large volumes of redemptions.”
The Fed is essentially asking how smoothly bond E.T.F. shares will trade when markets are in turmoil, as they will surely be one day. It is also concerned that, if people start to panic, traditional fixed-income mutual funds will have trouble raising the cash they need to cover redemptions.
In the report, the Fed didn’t answer its own questions. But it clearly intends to keep monitoring these parts of the market carefully. For one thing, the Fed has raised these issues previously. So has a 2014 report from the International Monetary Fund as well as a 2013 report by the Treasury’s Office of Financial Research.
These concerns have been fueled, in part, by the rapid expansion of bond E.T.F.s, which were introduced only a dozen years ago. By the end of January, they held assets of just over $308 billion, up from $57 billion in 2008. In contrast, fixed-income mutual funds, a fixture of the marketplace for decades, held about $3.5 trillion in assets at the end of January, up from about $3.2 trillion at the end of 2013.
It’s no wonder that mutual funds and E.T.F.s have become so popular: In almost every year since the 2008 financial crisis, bond E.T.F.s and mutual funds have performed well. Average bond E.T.F. returns, for example, hit 9.3 percent in 2009 and stayed strong through 2012, according to Morningstar. They moved slightly into the red in 2013, but rebounded to 4.5 percent last year and gained just over 1 percent in the first quarter of this year. Average bond mutual funds, which gained 17.7 percent in 2009, have trailed E.T.F.s a bit since then; the average bond fund gained 4.4 percent last year, and just under 1 percent in the first quarter.
But although the funds have prospered, regulators are concerned about the nature of the underlying bond market, which is far less liquid and transparent than the robust market for stocks in the United States.
The long and short here is that illiquidity is a problem in yet another market.
Given Petrobras’ size and its connection to oil, US dollar funding and the emerging markets, I think we should consider what happens if a market death scenario in the oil patch causes Petrobras to lose funding sources available to roll over its debt and meet its cash flow needs. Just running through a Petrobras default in a cursory manner like this tells you that markets are ill-prepared for this kind of event and that they are over-extended on risk as well. The outcome would almost certainly be extremely negative. There are numerous points of contagion through which a default of Petrobras would transmit distress, making it a Lehman-style event which could have devastating consequences on markets and economies globally.
This is the type of Armageddon market scenario that would derail the US economy and it highlights the fact that the locus of dislocation does not have to emerge from the US for it to have a sizable impact.