Hello, and welcome to the Credit Edge of Weekly Markets podcast. My name is James Crombie. I'm a senior editor at Bloomberg. Today's guests are Reshmi Basu, who covers distressed debt for Bloomberg News in New York. We're delighted to have you on the show.
James, thank you so much for having me here. I love your podcast.
Thank you. We're also very pleased to welcome Himanshu Bakshi, who covers banks for Bloomberg Intelligence, also in New York.
Hi, James, thank you for having me today.
We'll be coming right back to Himanshu a little bit later in the show, but before we do. Reshmi Basu with Bloomberg News, you cover distressed debt in the US. A lot of companies are running into trouble at the moment, with interest rates rising and the economy slowing, potentially tipping into a recession, maybe a hard landing. Stagflation, inflation and volatility in the financial don't help. A lot of regional banks are really struggling right now. What's the level of
distress in credit markets at the moment? Resh me, How worried should we be? Well?
The days of cheap money are over as the FED has steadily increased interest rates, and higher interest rates are putting pressure on the cash flow for companies, especially for tech names, and this is where we're seeing quite a bit of distressed activity. You know, global default rates have now reached the highest level since the twenty twenty pandemic, and now over the last few months, we've seen several high profile bankruptcies as you mentioned, you know, from banks
such as Silicon Valley to bed Bath and beyond. We're seeing a number of companies entering into negotiations with their lenders to extend the twenty twenty four maturity wall. You know, for instance, data center operator six Terra is looking at multiple options ranging from selling assets to our capital raised to tackle heavy debtload. If they can't do that, then it's going to end up filing for bankruptcy.
So the companies you mentioned they're in trouble, what are they doing to sort of buy them? That has a bit more time here, right.
This is a market where it's extremely challenging for people to make money, and what we are seeing is that some lenders, private equity owners, companies themselves are exploiting loopholes in the credit agreements that allows for these contentious debt maneuvers to take place. So, in industry terms, there's a termination. There's a term called designation of an unrestricted subsidiary or a drop down box, and that is something no one
ever wants to hear. But in layman terms, this means that the company is moving assets from the collateral package backing lenders loans away from their reach. So basically what it kind of means is like, let's say I agree to give a company a loan, and I believe there were five businesses in this package. All of a sudden, the company says, oops, no, not so fast, We're going
to take away two businesses from that enemy. And now your recovery values are going to go down and those assets have been taken away from you.
Let me just start you there, the collateral package, unrestricted subsidiary. There's lots of quite complicated terms in there. I just
wanted to break it down even more. We're saying that when a company borrows money, they essentially they have something that is worth something that the lenders will attach as collateral and they expect that that will remain in their reach when you know, when they're in this lending agreement, and the companies are essentially taking this collateral and putting it somewhere else.
Yeah exactly. So when you know a company does a leverage buyout, you as a lender, we're a lend money to the company, and you're believing that when you do this loan that you have the amount of assets. And now what the companies are doing are saying not again, We're going to take away some of these assets and give it to other lenders.
Okay, So the word drop down, the phrase drop down does that what does that apply to?
Job down basically means that you are the company is moving collateral away from the reach of lenders and putting it into a separate legal entity, and at that entity they can raise financing.
Okay, So lenders are not only losing the collateral, but they're also kind of being exposed to the risk of the company taking on more debt at another level of the company.
Is that Yeah exactly, and they're kind of going to be primed, which basically means that those lenders who lose those assets are being pushed down to be payment line.
Okay, so where is this happening? Can you give us any examples of what we're seeing right now.
Yeah.
You know, for instance, we covered a company Club Corp, which is Apollo as Apollo is the private equity owner and Club Corp operates private clubs and golf courses. And the company recently informed lenders that it was moving to business entities into legal and into like legal subsidiaries, which basically means it's basically a precursor that the company is going to probably raise financing at that box, and those
businesses have been kind of stripped array from lenders. And reason why this is so interesting is because the company was actually in negotiations with lenders to extend on near term maturity. That deal fell apart, and shortly after the company created an unrestricted box drop down box or basically moved to business says Interleegal a different legal entity.
And is this quite common now, this drop down transaction? Is it widespread in the industry.
Yeah, it's becoming common enough that we are seeing situations where the lenders were banned together in a preventive move with law firms and signed cooperation agreements, which basically is telling a company we are united, don't try to do these kind of aggressive debt maneuvers.
But it's not entirely new. We've seen these in the past, right, Yeah.
We saw it in twenty twenty seventeen with Jay krue where it moved Made Well but at the time, which was its kind of crown jewel into a drop down box, and there's a lot of legal action that took place. And then shortly after we saw you know, pet Smart do the same thing where it moved Chruey it's online pet Stow retailer into a different box, and Nieman Marcus moved My Teresa again an online retailer, into a different box. But you know, with pet Smart and My Teresa, we
actually saw those entities do go public. And in these kind of more recent situations, we're not seeing those new businesses go into like you know, be spun off into a publicly listed company. We're actually seeing those companies such as like a curt of Simmons, which it did a deal in twenty twenty going to Chapter eleven.
But so in the past, these these maneuvers have actually worked and they've saved companies.
They and you actually saw them being able to spend off those assets into a publiclisted company and those proceeds would then be used to pay off the lenders.
But in this case, because the IPO market isn't as hot, we think that these won't work this time.
Yeah, and we're seeing, you know, in Kora, which is an aerospace supply, or we're seeing you know, we're hearing you know, we're hearing that they're having liquidity issues. Obviously we had sort of semons and Envision is another company.
So the main difference is then between prior use of the dropdown and what we're seeing now is just the exit to the IPO. Is that right?
No?
I think we saw that quite a bit in the beginning that you know, the companies would say like, look like, even though we're removing these assets from you, eventually we're going to do some type of we'll make it a publicly traded company and you're going to see value from this IPO.
So we're talking about something that is really not very good for the creditor. Right, So how are they reacting to this other than organizing, what are they doing to be able to protect themselves in these situations?
They're filing lawsuits. We saw that with Mike Tell, We've seen it with in Kora, that there's a lot of lawsuits coming and they're basically calling these deals as kind of sham transactions, and they're not done in good faith negotiations, and they are a complete manipulation of the documents that they initially agree to.
Have we seen any of these lawsuits succeed orre they still working their way through the courts.
They're still working their race through the court. So we don't have a great amount of case law. But one thing we did see in Certi Simmon's bankruptcy court is that the bankruptcy judge did kind of give a nod to the aggressive or egregious debt maneuvers.
Very interesting. So before we talked to Himanshubacshi at Bloomberg Intelligence, what's the next big story to watch on your beat? Reshmi? What are we looking for next?
I think we're going to be seeing more cooperation agreements. That's something that we're working on for tech company, and we're definitely going to see more drop downs for many companies. In particular, we're seeing a lot of it in the tech software space.
So cooperation agreements, what are they?
Cooperation agreements are just basically when the lender is kind of bound together for a united front, and you know you basically kind of have to inform your lenders if you plan to sell your loan.
Great stuff, Rashmi Bessie from Bloomberg News, thanks so much for joining us. Thanks for having me read all of Reshmi's scoops on the Bloomberg terminal and of course at Bloomberg dot Com. Moving on to another key part of credit markets. As I mentioned earlier, we're delighted to have on the show Haymanschu Bakshi, who covers banks at Bloomberg Intelligence. What's going on with the banks, Himanshu was We've discussed
a few times already on this show. In March, there were serious issues, a regional banking crisis in the US, the downfall of Silicon Valley Bank, a niche lender in the tech sector, and also to the wineries in California. Then much more worrying Credit Swiss imploded, one of the biggest fans institutions in the world, heavily involved in all parts of the credit markets, brought down and forced into a fire sale with ubs. Now First Republic is teaching. Is the banking crisis over in your view?
Manchu, Hey, Gems, thanks again for having me today. So is the banking crisis over. I think the answer is the worst of the crisis is over, but the banking system remains under pressure. And the reason I say that is because inflation, even though it's easy, it still remains high, which means the Federal Reserve will need to continue to raise interest rates, which means that the issue we save with some of the banks that failed in March was
rising losses on the investment portfolio. That will continue to increase. But the change we are seeing now is that the focus has shifted from all banks globally to a few banks with those radiosyncratic risk So even though it'll take some time for positors, investors confidence to come back, I think most of the crisis is behind us.
So you look at the eighty one market, that's the riskiest form of bank debt credit Swiss wrote there's down to zero, even though equity holders got something back. That was a major event for that market, and we saw, you know, a lot of panic and a lot of people saying that the market had been killed by that transaction. But more recently we saw a deal in Asia, so the market, you know, it's not completely dead. What about in the countries that you cover?
So I cover Canadian and Australian banks. These are among the highest rated banks in the world, from mid singlely to high double A. I think the market remains open for these highly rated institutions, and we saw that in March. If you looked at Australian or Canadian banks eighty one securities, they widened along with all the market, although all the other financial institutions, but they widened less than most banks globally,
and so I think markets will remain open. But one thing that I would like to highlight is additional Tier one capital is not a requirement for banks. The optimal level the regulator asked banks to hold is about one point five percent of their risk created assets. Most of the banks under my coverage already are at that level or exceed that level, so they don't have an urgent need to come to market to issue eighty one securities.
Uh And because these banks are so well capitalized, they don't need to issue because as I said, the one point eighty one as a percentage of risk created assets, it's not a requirement. Is it's an optimal level. But if you have enough core equity, core capital, you don't even need to issue that much.
You've talked a bit about extension risk in what you've been writing. What does that mean and why should we care about it?
So extension risk is basically, when you buy an eighty one security of a bank, you are assuming that the bank will call those security on the first called it and banks under my cover, for example Australia. Australian banks in the past have always called eighty one securities on the first call date and that's how those securities are priced. We still expect Australian banks to call the eighty one
securities on the first call date. The a couple of structural reasons why they would do that because the eighty one high bits. For example, they have a mandatory convusion date three month three years after the first call date, so for them, it makes sense to call the eighty one securities of the first called aid. For Canadian banks, they are not known for calling the eighty one securities on the first cal date, so we don't expect them to call the eighty ones. But Australian banks we two thinks.
So in terms of extension risk, I see a little bit for Canadian banks, but not for Australian banks.
Okay, So over all the financial institutions. Where do we go from here?
I think, as I said before, the risk has shifted to a few banks with idiosyncreative risk, and what I mean by that is banks with more on show loans, what we're seeing with First Republic, where you have a interest only mortgages on your balance sheet. So the focus has shifted to those kinds of banks. So I think overall the risk is going down. But something to watch out is what will be the impact of the crisis we had in March on the economy, the economic growth
and credit growth. And that's important why because if we see a significant technique of underwriting standards from here on, that will have an impact on households and businesses, which will in turn have an impact on the labor market right and that will put pressure on borrowers low in the credit spectrum. And if we have that, that will have an impact on the bank's asset quality. And that's what we're watching right now. So I cover the big give US credit card issues, and what I'm watching is
asset quality for card issus. With more subprime loans.
Surely we're going to be running into trouble and credit cards. Though with the consumer when we tip into recession. I mean, are you're not worried about that?
Not really, Because all the US card is shows that I covered, they have ample allowance for credit losses. And what I mean by ample, so all the card is shows have reserved assuming that unemployment will peak at five percent. That's what our in house Bloomberg view is. Even if
unemployment goes above five percent. We know that the Federal Reserve last year stress tested all these card issuers at ten percent peak unemployment, So banks have time to add more provisions to their reserves, and on top of that, they have ample capital to absorb any unexpected losses. So I don't think it's a big issue for it's a
big concern for credit card is shows now. Obviously the bonds will remain sensitive to a recession, but I think the credit profile of all the US cardish shows should be stable.
Are there any that are particularly concerning to you? I mean, obviously places like Amex that have sort of high net worth customers, they're pretty be okay. But the other ones that maybe you know, give cards out to Banana Republic or whatever, are they not going to be struggling a bit?
So yeah, as you said, Amex. Yes, they have a more affluent super prime client base, so Amex should be fine. Discovers another one that I cover, again more prime focus. But the two that I'm looking carefully, I think the first one is Capital One because about thirty percent of their loan book is subprime, fifty percent of their auto loan book is subprime. And then the other one is Synchrony Financial, about twenty seven percent of their loan book is subprime. So those are the two we are watching.
But these two banks also have higher alarms for credit losses than the other two piers I mentioned with more prime focus, and they also have higher capital. And so even though they are taking more risk, they are actually when the underwrite, the underwrite to the risk, they understand what the risk is, they have higher margins, they have
more capital against that risk. So as I said, even though their bond spreads may remain sensitive in a downtown, overall the credit profile of even these two banks should be fine.
So you sound remarkably up beaten optimistic, and you know this is a credit show, and I'm very pessimistic, And does Reshmi was saying earlier, there's a ton of things to worry about. What keeps you up worrying mindshew.
I think, as I said before, the one thing that I'm looking at is the impact of the banking crisis on the economy and the credit growth. Because, as I said, the subprime blenders that we're looking at, Capital One and Synchrony I mentioned, they still have good regulatory supervision. So those are not the banks that I'm concerned about. I think the risk lies more in the small non bank financial institutions, which they don't have much regulatory supervision, and
that's why concerned about. I don't cover those companies, but I think the risk is over there in my view.
Thanks very much, she Manchu Bakshi of Bloomberg Intelligence.
Thank you, James.
You can see all of his analysis on the Bloomberg Terminal. There's a ton of stuff going on in that sector, so do check it out. And thanks again to Reshmi Basu from Bloomberg News.
Thanks so much.
Read all of her scoops on the terminal and at Bloomberg dot com. I'm James Crumby. It's been a pleasure having you. See you next week on the Credit Edge