May 12, 2020
We continue to monitor the impact of the COVID-19 pandemic on liquidity and solvency matters.
- Short Positions: During the credit crisis, several large funds established substantial short positions against the residential mortgage market. They used indices like the ABX, an index of 20 credit default swaps referencing certain residential mortgage backed securities, to establish their short positions. Now, we see similar activity with certain funds establishing multi-billion-dollar short positions betting against the CMBX, a group of indexes that track the commercial mortgage-backed securities (CMBS) market through 25 tranches of CMBS, each with a different a credit rating.
- Fund blowouts: A large multi-billion dollar fund of funds recently announced a decline in NAV of more than 20 percent and as a result is now facing significant client redemptions. The fund in turn has made redemption demands on its investments of up to $1 billion. We are likely to continue seeing substantial redemption activity, perhaps to a much greater degree than 2008, taking place across the funds sector. Funds to watch include those that are overexposed to credit default swaps (CDS), collateralized debt obligations (CDOs), commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), and collateralized loan obligations (CLOs).
- Passive Strategies: Passive strategies like ETFs and ETNs, as well as mutual funds that were designed to mimic passive strategies, are facing significant price pressures and many have been delisted because of market volatility. In the aftermath of the Volmageddon, we have started seeing investor-led litigations and fund board of director-led investigations in response to market volatility over the last one month.
- REITs: REITs are facing issues because of falling prices of securitizations (e.g., RMBS, CMBS and CLOs), pressure on cash flow from delinquent rent payments, and general investor bearishness. Given the collapse in prices for various securitized products, REITs could struggle to meet expected margin calls. While some REITs have made a partial comeback and have reduced leverage to a certain extent, things may get worse before they start getting better. Further, dividends will suffer as REITs are immediately impacted by disruptions in cash flow and will use credit facilities to make debt service payments.
- Mortgage wholesalers: Mortgage wholesalers recently faced margin calls because they shorted TBA forwards and because of government buying activity prices went up from par to 104. These funds were hedged in the medium-term but because of short-term margin calls need to outlay cash to their counterparties. Cash shortages are causing these firms to reach out to their counterparties and work out forbearance agreements.
- Leveraged Loans: Leveraged loans will face defaults and we could see this sector falter in the near term. For example, a large global investment bank recently liquidated a multi-billion-dollar portfolio of leveraged loans tied to total return swaps. CLOs invested in leveraged loans also face significant price pressure. Investment banks that structured these products (i.e., CLOs and synthetic CLOs) may be exposed to future litigation risk, like CDOs and synthetic CDOs in the credit crisis.
- Derivative workouts: As funds default, there will be derivative workout work and eventual litigation that will come about.
- Consumer loan defaults: Consumer loans like credit card loans and auto loans have started experiencing defaults and payment delays. This may have a cascading effect rolling into defaults on ABS securitizations and place stress on lenders and loan loss reserves. Financial institutions and advisors are actively evaluating loan loss reserves and bank stress test results, as well as analyzing projected cash flows of borrowers to assess potential forbearance arrangements.
- MAC cases: As a direct consequence of the pandemic, companies are cancelling previously agreed upon mergers. These disrupted transactions may precipitate litigation.
- Corporate Restructurings: We are seeing lenders starting to take a stance upfront in restructuring debt covenants and helping formulate restructuring plans with borrowers to managing their cash flow and debt as it comes due.
- Private equity: Numerous private equity portfolios are stressed due to the levered nature of portfolio companies and crunch of dwindling cash flows coupled with debt service. Private equity funds are known to sell loans between their own portfolios and cross lend to various entities owned by them. As a result of cash flow shortages, there could be loans in default that would then lead to a cascading series of defaults against all structures. Investor litigation could be directed against not only the PE funds but also the banks that loaned the funds.