Hello, and welcome to The Credit Edge, a weekly markets podcast. My name is James Crombie. I'm a senior editor at Bloomberg. This week, we're very pleased to have on the show Carmen Arroyo, who covers structured markets for Bloomberg News in New York. How are you, Carmen, I'm good.
Thank you for having me, James.
We're also delighted to welcome back Paul Vickers, who covers utilities for Bloomberg Intelligence in London. Hello, Paul, James. We'll be coming back to Paul to talk about Thames Water, the UK utility that's blowing up and dragging the whole sector down. So do stay with us. But first, Carmen Arroyo with Bloomberg News, what's the big story now with asset backed securities?
Sure, well, thank you so much for having me. But let's talk a little bit about asset backed securities. As you said, sip back securities are basically bonds that repackage any type of consumer dead and they're typically very safe and investors love them. The problem right now is that the dead that they repackage, which is given to consumers,
is got getting a little bit more hairy. Consumers are basically running out of pandemic savings, so they're falling back on their payments, and some of the loans they took out, they're just not paying them back, which is impacting the bonds that are or this impacting the bonds that are associated with those loans. And that's specially true in the subprem autos sector.
So let's just break that down a little bit for those people who don't know this stuff. Asset backed securities. I mean, you know, David Bowie once got a big loan from repackaging revenue from future music sales. Then streaming came along, so that didn't work out so well for investors, but he did get the money. And then in two thousand and eight the global financial crisis, structured finance ced. All these structured products were responsible for the implosion of
the global financial system. What about for cars car loans? How does this all work?
Yeah? Sure, so how it works is basically, if you're like a subprime model lender, you're basically a company that gives out loans to consumers that need a loan for a car. Right, So, in order to get more capital in, what you do is you put all those loans together and you sell them as a bond to investors in Wall Street, and then that way you can access like cheap financing. That's usually how it works. It's just putting together a bunch of different loans and then repackage them
as a bond. So it's basically like financial engineering, like it's a secondary market for the debt. Does that make sense?
Yeah, that's good, But so then why are we talking about them now? What's the big deal with abs and why in particular in the car sector.
Sure, So, this shit that's happening in the auto abs world is that consumers are increasingly not paying back their auto loans. And that's usually fine, but it's not fine for bonds associated with two specific lenders. Those are American Car Center and US Auto Sales. Those two subprime lenders basically close down their dealerships and close down their businesses like a few months ago, So consumers that had loans with them are no longer paying them back and that's
becoming an issue for Wall Street. There are bondholders out there that own the riskiest trenches of those bonds that are associated with those loans, and they're starting to get worried because the borrowers are defaulting a lot on their debt. So the issue there is that if they fought, if a critical mass of borrowers stopping back their dead, they could take losses on the bonds. And that's basically never happened in auto bonds. Just a couple times in the
nineties and it was like really really different scenario. So Wall Street is starting to get worried about how like consumers are paying back their debt or not within the auto sector.
Why is it so unusual to see losses here, Well.
It's very unusual because the way this bonds work is that you put up a lot of collateral I meaning you put up a lot more loans than you expect them to default. So when that one loan defaults, you take it out of the basket. But right now so many loans are defaulting that there's just not enough protection
for investors. So these like the borrowers are like the bond holders of those risky ast trenches, stand to take losses if borers keep defaulting at the same rate, and that's we're almost there, basically, and that would be a really big deal for the audubon market because it's just never happened before in the public audubon space, like subprime. Yes, so it's it's it's supprime. It's not prime dead, so
it's prime. It's dead given out to kind of like the riskiest borrowers, like people that have like maybe lower FICO scores or that have like maybe don't have W two. So it just depends. But it's usually like bor wars that have like lower credit scores or lower capability of paying it back.
But by subprime, I mean, you know, the last time I heard subprime defaults on this scale, it was two thousand and eight and the whole housing market was falling apart and that led to a catastrophe. We talk about the same same scale here.
It's not the same scale though. First of all, like other loans are much shorter in nature, so they're also like the loan sizes are smaller. It's not like if you have a mortgage, like a mortgage is almost in the US, a mortgage can be like a thirty year product, so you're really tied to that as a borrower, but like auto loans can be like five years, can be three years, so you can kind of pay it back. So it's not the same scale at all, And in this case in subprime auto bones, it's just this is
happening subprime auto bones defaulting. It's just happening with some lenders that were particularly tailored to risky borrowers. So it's not happening across the space yet.
And some investors are going to take a loss. How much are they going to lose? They're going to get wiped out, They.
Could get they could potentially get wiped out. We just have to see how those defaults evolve. So if if a critical mass actually defaults, yes, they could stand to lose almost everything on those bonds, like they would take losses on the principle, not on the interest, which is a pretty big deal. But we we still have to see. We're not there yet.
So some investors, you know, large investors, presumably institutional guys, they took some risk. Now they take some losses. Who cares? I mean, is there a bigger impact from this? I mean, is there a ripple effect that that rips through the entire structure finance market? Is there something that's going to blow up here? Do you think so?
One of them One of the bigger takeaways of this is just like this, this subprime lenders. Auto lenders kind of like started relying a lot on the ASCID backed securities market to get liquidity, and they issued like their issuance went up by a lot in the past five years. So kind of the takeaway is that if investors start losing faith on these kind of bonds, how are these lenders going to get financing? And do we expect to see more of these slenders go bankrupt?
And then sort of underlying it though, I mean, is this just really a story about the US consumer? Is that where the pressure is coming from.
Yeah, that's correct, And it goes back to the same thing, right, like, if there's fewer subprime lenders out there available to give credit to consumers, where a consumers going to get financing for their needs, They're just going to be squeezed out of the market.
And those subprime consumers that we're talking about, they depend on a car in lots of cases for their livelihood. They need it to get to work. It's the last thing they'll give up, you know, before that. You know, maybe housing is the last bit, but the car is next to the last. Does it imply some kind of desperation on the palf of the American consumers.
It's definitely showing that there's a portion of American consumers that can not would stand this current rates, current rate environment, and they're just running out of pandemic savings and if they can't get liquidity from you know, their credit cards, so they're auto dead. Where are they going to go? So it definitely signals that the economy is turning.
Is there any regional pattern to this? Are there parts of the country that are doing better or worse?
As far as we know, so the lenders that have gone bust, we're mostly and more in the South and in the north of the US, But it's broadly speaking, it's happening and across the country.
So just going back to the financial engineering aspect, you mentioned that that term always really worries me. You know, the most complex, least transparent markets are often where trouble starts. You know, how worried should we be about structured finance right now? Are we expecting this to lead to another financial crisis?
I don't think it's going to be a broad financial crisis. I think we're going to see it more like kind of like more pockets of the market go bad. So just like for instance, in the Audobonne space, it's subprime auto and it's specific lenders, and I think that's going to basically happen across everything that's structured. It's just like specific pockets, specific companies that are that cannot withstand the current rate environment, and that kind of grew a lot when rates were really row.
And the rates on these things. A lot of it's floating rate, right, so it just as base rates rise.
Yeah, it really depends, for instance, like mortgages are mostly fixed, Like it really depends on what product we're talking about. But yes, it like you're just seeing more consumers struggle with how much they have to pay on their debt.
So before we talk to Pull Vickers at Bloomberg Intelligence, what's the next big thing we should be watching here? Common more downgrades, more losses, more distress.
Yeah, that's basically we should be watching for which subprime lender is going to struggle next basically? And were are they going to go for liquidity if they can't go to the bond market, are they going to go to private credit? Are they going to go to distressed buyers? Like, what's the next step for them?
Great stuff? Karaman from Bloomberg News Thank you so much for joining us. Read all of Carmen's scoops on the Bloomberg terminal and of course at Bloomberg dot com. So, as I mentioned earlier, there's a crisis in the UK water sector and we're very pleased to have with us Paul Vickers, who covers utilities for Bloomberg Intelligence based in London. How's it going, Paul James?
Hi, we'll go here Banks.
Great So Thames Water. It's the UK's biggest water provider. They polluted the rivers and they're being investigated by regulators and they're at risk of being nationalized because they can't pay back eighteen billion dollars equivalent in debt. Things are evolving. We're talking on July fifth. But what's the situation today, Paul. The bonds have dropped again. What's the latest.
Well, the bonds are certainly jumping around quite a lot. I mean, if we don't usually get this volatility in water barns, it should be very stable and stable regime. But waiting for Thames Water to release their annual report, which is due by the fifteenth of June. That should give a lot more information. We're also waiting for us to see if they can get another billion pounds from their shareholders who have stump to up around half a
billion only in March of this year. They probably need that other billion that they had here marching their business plan, the eight year business plan from the launch in twenty
twenty one. Of course the CEO is resigned syntense, maybe that business plan is maybe not so valid anymore, but certainly they need to get that money from shareholders and press reports at the weekend we're encouraging in that respect, but they certainly need that otherwise they are at risk of getting put into what's called special Administration Regime regime or SAAR, which as you mentioned, is a sort of it's a form of there's an alternative to insolvent if you like,
imposed by the regulator on essential services like energy and water to ensure that these companies can keep providing the services to essential services to the customers while a new buyer is found. And this is the last time we saw this was Bold Energy during the energy crisis, and you can getting transferred to Octopus Energy. So we have
one example of this happening. You know, obviously bondholders and everyone termes of work, I'm sure I hopes we can avoid the second one, but I think for that to happen, it is going to need quite a considerable cash injection from existing shareholders, and hopefully will have that. I assume the news may come with any report on the fifteenth of June, which is the regulatory deadline, at least with the anual report. So we go, we're keeping it on the news until then.
As you say, Paul, the water is a very stable business. What's the history though? How did it get into so much trouble?
Well, yeah, terms does have the highest gearing in a sect, as you say that, they've got about fourteen billion pounds worth of debt eighteen billion dollars as you say, but this amounts around eighty percent of the sort of regulatory capital value, and that's above what of what caees is sort of acceptable level of sixty percent. That's a level that it it has set its sort of regulatory formula
on and remunerates companies accordingly. So it cont a free this they're gearing above the sixty percent hide life and Thames has been an eighty percent for many years and plans to stay there for many more. But of course, yeah, this increases the risk and the return profile you know for shareholders. But obviously the risk side of that has been exposed by larger well AA and a poor operational performance. You say that they they've got a poor rep track
record on more water leakage and sewer leakage. They've been fined for that customer service, that their operation record isn't good. But the bigger problem really is sort of financial pressure there under and all of that arises from the spike inflation which we've seen over the last year or so
in the UK. Yeah, this has a number of effects on Thames Water and really it's the factor that it's putting them under financial pressure and if their regulators see deems they might be unlikely to be able to pay their debts, and that's a subjective due from the regulator, they can put them into an SAAR. And all the evidence and points to the fact that they are certainly getting very very tight against the sort of interest cover ratishops.
I mean, what's happening is, you know, earnings are decreasing, is the cost to replace pipes and pay their staff are increasing a lot faster than their revenues. It's sort of increasing interest costs on their debt fifty eight percent, which is linked to RPI, and also any on any new debt issue in the market. Has also seen that the fair value of the index link which increases with inflation, and that's rising fast, and the regulatory caple value, So
all of these things that are coming into play. Particular is RPI has moved well above CPI, which is what
their revenues are based on. The gaps now around four percent, so the costs are rising four percent faster than the revenues are increasing at the same time, so actually say reducing earning, it's reducing interest cover, it's increasing gearing is putting a lot of pressure on those and almost covenant levels, and the last time they re bought with them in September, they're getting close to what we call a trigger covenant level, in which case, you know, bondholders can sort of step
in and demand the sort of explanation and remedial action they're they're not put the heading away from default levels, so we're not at that sort of extreme point yet. But when they do release that was six months ago, when they do release the latest results with this annual report to you by the fifteenth of July, you know, I expect to see further pressure on those ratios because inflation has still been rising, that gap between RBI and CPI
has increased even further. So we're really waiting to see where they are and if they are breaching any trigger covenment levels or on a fully of bases, in which case, without the equity injection, the regulator would be fully entitled to put them into an sa R.
So it's basically a privatization. The new owners leathered up a lot of floating rate, a lot of inflation linked as you say, they pay themselves dividends. They kind of ran this thing into the ground and walk off and the government steps in. I mean, what's the big lesson Hippaul.
Also, the privatization happen a long time ago. In terms has been running with very high gearing for a long time and they did story. The shareholders haven't actually taken dividends out of the company for around six years, so for them it's not being a particularly great investment. Recently. The Thames does of a very high one of the highest sort of capital expenditures. Is the largest water company UK.
As you say, it serves as sort of you know, Thames Valley London area, So there's some pretty complicated old Victorian pipes and sewers they have to deal with. They're building a big super sewer along the Thames to try and alleviate some of those pressures. But it's certainly been a very challenging environment for Thames Water and the shell holders I say, haven't taken dividends and they've put another five hundred million in in March. They've been asked now
to put another billion in. Whether they do or not, we'll have to see. But yeah, certainly, Yeah, the SAI is it is not quite a nationalization. I mean, what it would be is that the regulator would be looking for a new buyer to transfer the business to and they would be obliged to accept the best off another market offer, or any reasonable offer. But they would do
to be obliged to accept the best offer. And of course that may well mean if the alternative is insolvent to your nationalization, that could mean as sort of the ecuyholder's getting zeroed and the bonds taking or or all the debt possibly taking quite a significant haircut. You know,
are very broad to a rule of thumb. We looked at if a new owner wanted to take this company on at sixty percent gearing and said the current eighty percent, it would have to write into total amount of debt down by twenty five percent, and that would be, you know, a worst case scenario. But it just sort of shows extent of the risk facing the bond holders and certainly equity holders. And the equity holders now face to the dilemma, do we put another billion in? Is that enough to
keep it going? Is that enough to provide enough liquidity and repay the debt that they've got due? I think one point eight billion to debt next due next year, next year, in twenty twenty four. Is that going to be enough for this to survive as a going concern and then in the long run turn it around and have to get the dividends back in the future. I mean,
it's a very long game. That the water business is is strong, it's stable, so they can take a very long term view here and then may see, this is the short term pressure and another billion isn't really a problem, but it really is going to hinge on whether it get that extra capital.
And some of the bonds were they not protected by some going clause that if there was nationalization, they'd get made whole.
I believe there were some some private placements that were made during the time when the Labor Party under Jeremy Corbyn were talking about nationalizing the water industry. I think when they issued some bonds at that particular time, investors were concerned and so they put the covenant in saying that the nationalization would be able to like a change of control, if you like, you to learn some maximization be able to investors could put them back at part
that doesn't apply to most of the bonds. They have live in existence for a lot longer than that, and the ones issue more recently, they's not seen the problem because obviously that that sort of pressure has gone away. And say an s AI isn't the nationalization. It's a different things. It's where it's put into a special regime in order to transfer the access to a new private buyer who would take it on, presumably at a sort of bargain basement price, a discount to bar or zero
prevalue and try and turn it around. The last is aught they couldn't find a buyer, then the last resort would alms have to be in nationalization. And yeah, some of those bonds could under those circumstance could trigger those clauses. But there are really any applies to few private placements, not the vast majority of their public debt.
What's your base case now, Paul? Can they avoid special administration?
Can they avoid it? Well, only if they get this capital injection from those shareholders in my opinion, As I said, press reports were favorable on that over the weekend. There's some very large long term sort of infrastructure funds, some pension funds in there, some sovereign wealth funds. So there's certainly some deep pocketed shareholders who could take a very long term view on us and say, yeah, we do
still like the sector. There is another regulatory review coming up in twenty twenty five when maybe some of these problems could be resolved and we still have faith in the sort of the UK water system as it spans. So yeah, we will have to hope for that extra rebellion. As I say, that should be the news on that certainly should be coming with the annual report. But short of that, then they really they have plenty of they
say liquidity, as are therefore liquidity. Whether they can draw all on that, all of that down is debatable because they have some other covenant that restrict the amount of debt maturities they can have over over the twenty four month period. So yeah, they certainly have they say they have it a sufficient liquidity back. Certainly that billion capital is required to shore up the balance. You probably bring gearing down from about eighty to around seventy five percent.
It would alleviate any sort of the liquidity the debt problems that they had. It wouldn't immediately solve their sort of low interest cover problems, but I mean as they redeem debt, hopefully with some of that cash, it should ensure they shouldn't breach their trigger levels at least. But that's certainly what's needed. I think the regulator, the off what rather, was in front of Parliament a day or two ago saying they may well need more than a billion.
That was their view. So we'd have to see what's going to be forthcoming. But that really is the only way I think they can avoid an.
Essayar If I'm a debt investor sitting anywhere, not just in the UK, but you know, anywhere in the world, then thinking about conservative long term you know, maybe not massive returns, but they should be stable. I'm going to think about utilities. I'm going to think, you know, possibly
about water because everyone needs it. What are the takeaways from this situation for the broader sector, you know, not just in the UK, but I mean, are there any other other bigger takeaways for utilities in general?
I think this is isolated to the UK water sector. It's really down to it's the mismatch between the CPI h link revenues which are much lower and the RPI linked costs that they have, and that gap is creating pressure on the financial position in the UK water sector, but doesn't apply to other regulated sectors in the UK which are maybe still out the eye base and don't have the same sort of levels of gearing as Thames Water for example. So in my view, it's certainly restricted
to the UK water sector. But that's quite a big sector. I mean, there's around sixty billion pounds worth of debt in the sector that's bond and bank debt, so I mean it's a big sector. I mean it's around eight or ten percent of the sort of European pan europe in Utilities index, So it's enough to make it and make it a difference and to have ripple effects across the broader sector and markets and disturb components and what's
otherwise strong sector. If you look at other European utilities now the energy crisis is over, they're doing very well. And really this is a sort of an isolated event. It might not be isolated. Just as Thames Water, we didn't analysis looking at other companies that may be susceptible as well, looking at companies with particularly high gearing or very high proportion of RPI link debt or very low interest coverage. Companies like Affinity, Welsh Water, Angli and Southern
certainly raise a few red flags in that respect. That's not to say they're going to get dragged into it, but I think if anyone else is at risk of getting dragged into this sort of CPI RPI mismatch, it could be companies like that that have sort of stressed financial positions. Should we say, But again Thames is almost a nice unique event, a unique company, and that it had the just high scheering eighty percent the average is
around sixty five. That's very low interest coverage, quite a high proportion of RPR linked and a poor operational performance. And you combine all those things and end up where we are. I don't think any other company is quite in the same position, so read across at the minute is limited to Terams, but as you've seen another company's bond at the water company sector bond, they have the spreads have widened, yields of risen because of the increased risk that people are assigning to them.
Thanks very much, Paul Vickers of Bloomberg Intelligence. You can read all of this great analysis on the Bloomberg Terminal. Do check it out and hope to see you back on the show soon.
Paul, Yeah, look forward to it.
Thanks James, and thanks again to Carmen Arroyo from Bloomberg News. Read all of her great structured finance scoops on the terminal and at Bloomberg dot Com. Thanks James, I'm James Crumbie. It's been a pleasure having you join us again next week on the Credit Edge.