The Insight: Conversations – Performing Credit Quarterly 1Q2023

0:07Hello, and welcome to the first episode of the Insight by Oaktree Capital. This new podcast will feature audio versions of Insights Publications, as well as interviews with Oak Tree thought leaders. Today, I'm pleased to be joined by Armin Panosian, Oak Tree's Head of Performing Credit, and Oak Tree's co-chairman, Howard Marks. We'll be discussing topics related to Oak Tree's recently published Performing Credit Quarterly and Howard's latest memo, Lessons from Silicon Valley Bank.

0:38Thank you both for joining me today. It's a pleasure to be with you, Anna. Thank you. So we will dive right in. And Armin, I'm going to start with you. In the latest edition of the Performing Credit Quarterly, you and your co-author note that the problems we saw emerge in the first quarter are examples of the type of stress that can abrupt after a long period of easy money comes to an abrupt end. Can you speak a little bit more about this? Sure. Thanks, Anna. As the markets have been pretty wide open following the global financial crisis and up to the pandemic period, a lot of capital structures were put in place that had sizable debt balances on them, including in the real estate asset class.

1:20When lending practices are wide open, when the cost of borrowing is quite low, what you find is that structures are put in place that at higher loan-to-values, at higher multiples on leverage, higher prices being paid for assets or businesses than what is historically normal. And those structures are predicated on those low costs of borrowing to be persistent and durable for a very long period of time. So what we're finding is upside down capital structures today that were put in place several years ago when it was just easier to borrow and easier to sort of transact in businesses, both on the buy side and the sell side.

2:01I think in addition to that, the last thing I would say is as capital flowed into these lending asset classes, whether they be direct lending or broadly syndicated loans, there was an erosion in the legal protections as well for what was historically an asset class that had very strong legal protections in the form of covenants that were tested quarterly that ensured that a company was healthy and that lenders and other investors were getting appropriately compensated for the risk that they took on. I'm going to answer the same question in a couple of different ways, but leading to the same message and the same conclusions as Armin just expressed.

2:38And the key is the old saying that the worst of loans are made in the best of times. In good times, people feel optimistic about the future. They feel there's nothing to worry about. Their biggest concern is often FOMO, the concern that they'll miss the deal. So they're not afraid of losing money. They're not afraid of making an unwise deal. they're afraid that somebody else will get the deal. So they bid aggressively. And how do you bid when you want to get a deal as a lender? You offer to take less return and less safety. Of course, those are not generally wise things to do. And if you do those things in the good times and the bad times roll around, they can really bite you.

3:21Back in February 07, I wrote a memo called The Race to the Bottom. And I talked about what happens when there's too much money in people's hands and they bid too aggressively for assets. And it's a very negative impact. As described in my December memo, sea change, from the beginning of 2009 through the end of 2021, we went through an easy money period. It had a lot of attributes, but I think they're summed up by the term easy money. And it was a period in which we had the longest economic recovery in history. We had the longest bull market in the S &P 500 in history. And of course, people reached that optimistic stage where they did the things that Armin describes.

4:01They weakened the covenants, and they permitted higher debt equity ratios. They accepted low interest rates, the sum of which we think sets the stage for some very interesting developments in the near future. And by the way, I think that the, so I say, retreat from the conditions of those years is not over. It's one of the premises of sea change that it's not going to reverse any time soon. How is some of what you're talking about here potentially related to some of the issues we saw in the banking sector in the first quarter and that, Howard, that you discuss in your recent memo? In a lot of articles about Silicon Valley Bank, you'll read the phrase that the easy money environment of the last several years created conditions at SVB that led to its demise.

4:53And the best thing that people can do to understand the workings of the cycle, be it economic, regulatory, banking, market, is to understand causality and to understand that an easy money environment like SVB faced and like Silicon Valley as a whole faced, leads to practices which are dangerous or conditions that are dangerous. In SVB's case, interestingly, what happened was that the venture capital companies or the tech companies were so awash with money that it piled up in SVB. They put it on deposit. Most of them didn't need loans. So the money stayed there. It wasn't recycled deposits from some people into loans to others, it stayed there.

5:40So they turned around and they invested it in the bond market. They bought treasuries and agency mortgages, not the worst thing in the world. But you know what? What they missed was the fact that they bought long bonds at the lowest yields in history. And when interest rates were raised by the Fed to fight inflation, the long bond loses the most value the fastest. These securities ended up underwater. Withdrawals required the bank to sell them in order to pay people out. They had to realize those losses. The losses were noticed by other people who then made withdrawals, who then required more sales by the bank.

6:23They got into a downward spiral that they couldn't escape from. It all starts with the easy money environment, or let's just say the easy environment. And sometimes things in the business world are easy. Sometimes they're hard. The key to what Armin said before and what I'm trying to say is that when things are easy, bad practices are engaged in. And if you engage in bad practices in the good times, you're unlikely to get through the bad times unscathed. Yeah, and Anna, on a case of Silicon Valley Bank, it's a variation of a theme we actually saw during the global financial crisis, which was mismatched assets and liabilities.

7:02You sort of forget that you're supposed to match your assets and your liabilities when times are good, when everything is benign, everything is pointing to the right and up. But in the case of Silicon Valley Bank, one would argue that they didn't have excessive risk in their loan book, but they did have a mismatch in assets and liabilities in that the deposits were very, very short-term liabilities, and their assets were fixed rate, very, very long-term assets that took a huge mark-to-market loss that ordinarily would be okay, but because they're just mark-to-market and not realized, but because the liabilities created a liquidity crunch, the liquidity crunch created a solvency issue for the bank at exactly the wrong time.

7:43We saw that in the global financial crisis, obviously worse in the global financial crisis because that asset liability mismatch, it also came with very risky lending practices on top of it. But it's a reminder, the Silicon Valley Bank situation is a reminder that there are shocks still possible. Nobody could predict what happened to Silicon Valley Bank, but it did. And a$220 billion bank went down in three days. And the other thing I would point out about Silicon Valley Bank, which is noteworthy and important, the speed at which markets move is much faster today than 10, 15 years ago. Today, if you had an account with Silicon Valley Bank and you heard, you know, there's going to be a write down and the equity book value is going to be written down.

8:23Oh my gosh, I'm going to take out all of my deposits. If I do have an undrawn revolver, I'm going to draw it at Silicon Valley Bank. Well, you could now do that on your phone in a minute. You don't need to go into a branch. You don't need to go through the complicated paperwork of transferring your capital into another bank or another institution. You could just click the button. So the combination of social media plus the velocity at which you could make things happen with money today caused a really acute problem in this mismatched asset liability mix at Silicon Valley Bank. I apologize for belaboring the point, but Armin and I love to knock this subject around.

8:59Mark Twain said a lot of brilliant things, one of which was that history does not repeat, but it does rhyme. In other words, the details are always different, but there are certain underlying themes that we see over and over again. When you see meltdowns in periods of difficulty. The two outstanding reasons are, number one, the mismatch that Armin just talked about, having long-term illiquid assets that it's hard to get out of, and short-term liabilities that can demand payment in short order. The other one is a high degree of leverage and having a very high ratio of assets to equity capital and not much equity.

9:42And SDB had both. It shouldn't be surprising that they couldn't survive a period of difficulty, especially in the hyperactive climate that Armin described, thanks to social media. As we look forward, what do you think will be some of the implications of the banking stress that we saw in the first quarter? Well, I'm happy to start, and I'm sure Howard is going to have a more eloquent way of describing things. But I think there's a few things. First of all, with the Silicon Valley Bank meltdown, as well as the losses incurred on banks' balance sheets from the syndication process in 2022, essentially the hung loan problem.

10:20It's a reminder that banks could actually lose money in processes where they were just trying to earn a moving fee. They were originating assets and moving them to a set of investors and thinking that it was free money, and they lost$3 to$4 billion last year. I think that issue, that reminder, will cause further regulatory oversight, which really started during the global financial crisis with Dodd-Frank and has really not let up. In Europe, the Basel III regulations. So I think we should expect to see more, not less, oversight of the way banks use their balance sheets to earn fees. As a result, I think a lot of what banks used to do is now moving into more of a shadow banking market, into a direct lending market, where institutional investors and managers are picking up the slack and taking on the opportunity to invest with companies as long as they are appropriately structured.

11:11A large market is emerging where the banks are shrinking. That's the opportunities that I see right now in terms of changes. The only change isn't increased regulation. It's a different mood. It's a different mindset. Let's go back to what I said before. The worst of loans are made in the best of times. When people feel expansive, they do things that they probably shouldn't have done. When times are less good, you can't do the same things because their psyche and other things don't permit it. The way I have been synthesizing this in the current episode is that when we were in the easy money environment and everybody was happy and optimism was riding high, you go into a bank, you have a project, you explain it, they said, okay, we'll lend you$800 million at 5%.

11:56Things get a little tougher. Some negatives come up. Now people are not uniformly optimistic. Some worry creeps in. You go in to refinance that loan. They say, okay, great. We'll lend you$500 million at 8%. Where are you going to get the$800 million that you have to pay off? Oh, for that, you have to pay a lot more or you can't get it and you default. So easy money sets the stage for bad outcomes. And a need for incremental equity. A new deal under the current market dynamics, current market rates requires a 60 % equity check, whether it's a real estate asset or a corporate asset. And if you have a deal that's four years old where there's only a 40 % equity check with meaningfully lower base rates, and you have a maturity, if you have a problem in the portfolio, if you have a cash flow issue, in the case of real estate, a tenant vacating, or in the case of corporate inflation, which we've now seen following COVID, well, where's that equity going to come from?

12:58Not everybody has reserved that kind of equity because it would have impacted their returns. So therein lies, I think, a distressed opportunity, which appears to be unfolding before us. I think the ingredients are there for a very large, multi-asset, multinational, global distressed episode here. So, Anna, what are the questions? People say, will it happen? We believe it has started. How long will it go on? We have no way of knowing. The only question is, what's taking place today? And what we think is taking place is the opposite of easy money. Money harder to get, operating conditions more difficult, cost of money higher.

13:43All of these things should be transferring the cards from the hand of the borrower to the hand of the lender, in which we can do the opposite of the race to the bottom. We can demand higher returns with more safety. So that ties into one of the key takeaways from the Performing Credit Quarterly, which is related to opportunities we're seeing in private credit. So, Armin, I wanted you to speak a bit about, you touched on it earlier, how banks have been curtailing their lending, especially related to large-scale leveraged buyouts. Could you explain why this has been happening and the implications for private credit?

14:24Sure. when banks syndicate a loan or when they make a commitment to a borrower to fund a loan to them, they take on some market risk. They open their commitment for six to 12 months while the borrower goes through its regulatory and other hurdles that it needs to jump through. And during that period of time, it takes market risk on the rates rising or something else happening with the prevailing market conditions. And that's what happened in 2022. In early 2022, banks were on the hook for$60 billion of syndicated lending. As the rate picture changed materially in such a short timeframe in 2022, they found that the uptake of those loans that were already committed to was weaker.

15:10The uptake being from funds like ETFs or mutual funds or from CLOs, collateralized loan obligations, because 2022 was a very down year in terms of CLO formation. and it also coincided in a period of time where retail funds were outflowing. Now, CLO formation continues to be sporadic this year. ETFs have only been outflowing in a pretty material way this year. So if you're a bank and you have a limited balance sheet, and if you've taken on or if you experienced such material losses in 2022, what do you do with your remaining balance sheet given the unstable backdrop of fund flows for the buyer universe of the loans that you syndicate.

15:54What you do is you just commit less. You either don't commit at all, or you very, very sporadically commit in smaller size of capital that you feel very confident that you could place successfully into the market and not blow an additional hole in your income statement. Again, fund flows on the broadly syndicated side are not strong enough to give the confidence to the banks to continue to support that market. Now, I think that that overhang remains true for a considerable period of time. Why? Because broadly syndicated loans that were originated over the last three, four, five years were put in place during easy money times, which means that the capital structures are imbalanced under the current rate environment, which means that we should expect to see elevated defaults and losses in the broadly syndicated loan opportunity set or the existing loans that are out there trading in the secondary market in 2023 and 2024, which then further means that there's going to be weaker fund formation to buy loans, just given the backdrop on the fundamental side, causing hesitation in that investor base.

17:03So it's a pretty durable opportunity set, I think, on the direct lending side to step in where the banks will have challenges to use their balance sheet to commit to new deals, given the instability in the end buyer set of broadly syndicated loans. This question is for both of you. Why do you think that competition to fill this funding gap among direct lenders may be somewhat limited? I'm happy to give my view. I think that in the current uncertain economic backdrop, only the largest, only the most well-balanced credit platforms will be able to separate out the good opportunities from the negative ones.

17:43I think they will be able to grow and they will be able to attract capital because of their framework, because of the balance in their credit platforms, the history to have invested through multiple cycles. And that isn't everybody. That isn't everybody in direct lending, and that certainly isn't everybody in credit. So I think a small number of well-heeled, well-balanced, long-term credit investors will grow and invest responsibly. And I think that investors, in terms of institutional investors, will go with those managers rather than pro-cyclical-minded investment managers that have only invested during benign market time.

18:21So that's why I think the competitive set will remain attractive and balanced for the likes of those investors that are large and have the ability or have the history of having invested through multiple cycles? Herman obviously doesn't want to say like Oak Tree, but the truth of the matter is, Anna, the private lending industry has only looked like it does today over the last, let's say, 12 years. My feeling is that it was around 2011 that the current version of private lending was invented because the banks left a void after the global financial crisis. And the market sector grew rapidly. The existing funds got a lot bigger and a lot of new funds joined the fray.

19:05Some of them, as Armin says, big, professionalized, disciplined, thorough. Some of them eager, aggressive, looking for assets under management and higher fees. The point is, if you invested so fast over this period, so voraciously, that you couldn't do thorough due diligence, you may be looking at problems in your portfolio today. So number one, you may have to spend your time on your problems, not the new opportunities. Number two, you may have to reserve capital for solving your problems. The main way you solve credit problems is by injecting more equity capital. Number three, your record may not look so good, so maybe you can't attract new capital.

19:49And so your activities kind of stagnate. Warren Buffett said, I think it was in early 2009 for the first time, that it's only when the tide goes out that you find out who's been swimming naked. it. The tide didn't go out between 2011 and 2022. It only began to go out in 2022. We think it's in the process of going out. So some managers will be exposed. Their activities may be curtailed, leading to reduced competition among lenders, which, all things being equal, back to the beginning leads to higher demanded yields and higher demanded safety. What do you think might be some of the longer-term implications for direct lending as a whole as a result of some of the changes we're seeing now?

20:38I think that if there are managers who weren't disciplined and who didn't do a great job of limiting their risk in the halcyon days, they'll get weeded out. and our Darwinian process will lead to the professionalization of the sector. And hopefully, if Armin and I are right about what lies ahead in the next couple of years, hopefully in the next cycle, when there's behaved better with more discipline, the bad loans they make in the good periods aren't as bad and the sector is improved. What do you think, Armin? Yeah, I completely agree. And I would say that the direct lending market will likely grow at even a faster clip because of the gap, the void in the market.

21:21I do think that the largest and best well-diversified firms will be the beneficiary of that growth. And the smaller ones or the more risk-tolerant ones will be the ones that no longer have a business. Just to put some numbers around it, before the global financial crisis, the direct lending market was about$250 billion in total. And today it's approaching$1.5 trillion. That's pretty significant growth, but I do think that that growth is not done. and the direct lending market is on pace to overshadow the size of the high yield bond market and the broadly syndicated loan market, each of which are right now about$1.5 trillion.

21:59So it's the continued growth of a very large asset class. I think the beneficiaries are, again, the biggest and best and most conservative, balanced investment managers. As a result of that growth, I think the other outcome will be that there will be some step out strategies that relate back to direct lending as a core asset class, including credit secondaries, including specialty funds or other sector-specific funds, asset-based lending, et cetera, or regional-focused funds. So there's going to be an evolution just within private credit with a little bit more detailed opportunities or specific targeted opportunities within the broad umbrella of direct lending or private credit.

22:39So now let's broaden out a bit to talk about opportunities and risks across asset classes. Earlier, Howard and Armin, you both mentioned this potential for a distressed opportunity. So I'd like you to both speak more about that. I think one of the implications of the easy money environment is that it was harder to go bankrupt or to default in that climate. When the economy is doing well, the markets are doing well, people are optimistic, capital providers are generous, interest rates are low, it's hard to default. It's hard to go bankrupt. If you lose a bunch of money, you can borrow more. One of the hallmarks of the last 15 or so years is that it became easy for companies that lose money continually to borrow more.

23:2930 years ago, 50 years ago when I started, you couldn't do that. Money losing companies couldn't keep borrowing money, but they did over this period. And as a consequence, the default rate, for example, on the high yield bond universe was unusually low. I started Citi's fund in 1978, which I think was the first high yield bond fund from a mainstream financial institution. And over the next 30 years, from 78 to 08, I think the average default rate on high yield bonds in the universe, not for us, but in the universe, was just over 4%. We considered that normal. Now, that meant one or two most years, and then 10 or 12 in the crises, averaged out to four.

24:10In the period 2010 through 2019, I think that the average was closer to two. As I recall, there was only one year at four. So the previous average was not the average for this more recent period. Why? Easy money. And if that's not the case going forward, our thesis, Armin and I and the rest of Oak Tree, Our thesis is that doesn't describe the near term future. So we think we'll see more defaults and bankruptcies. Yeah, and I would add that it's going to be more acute with borrowers that again have a mismatch in their assets and liabilities. So borrowers that have floating rate liabilities are experiencing the real-time impact of base rates rising so rapidly, as opposed to fixed rate borrowers that have the benefit of time in the case of investment grade bonds, several years in the case of high yield bonds, a fair number of years as well, where they have a fixed cost of borrowing and the benefit of time to get through a volatile economic patch.

25:09It's hard to say how long that volatile economic patch would last. Maybe it's not enough time, but it's certainly more time than a borrower of a floating rate liability. And so I think that the defaults will be more acute on the floating rate side and the losses will probably be deeper than what we have seen historically in those asset classes. In the broadly syndicated loan product, typically we saw about a 25 % to 30 % loss given default. I think this time around, it's easily far in excess of that because the leverage levels are meaningfully higher today than they were historically. The starting leverage points were five, five and a half times, six times total debt to EBITDA.

25:45And that's only escalated and the cost of that debt has gotten more onerous. So it's going to be a challenging time, especially in that asset class. But the rate picture, volatility around rates may create a buying opportunity in fixed rate instruments because to the extent that their value drops more because of technicals and fund flows rather than fundamentals, it creates an opportunity to buy or to rotate a portfolio from a, let's say, broadly syndicated heavy loan portfolio over to a fixed rate portfolio as long as you are up-tiering in quality, up-tiering in the size of borrowers, reducing the leverage of those borrowers, which happens to be the case that both investment-grade fixed-rate bonds and fixed-rate high-yield bonds are less levered on average than broadly syndicated loan borrowers through the first lien there.

26:38And you know what's interesting, Anna, just illustrating the complexity of making investment decisions and the fact that what's obvious is often wrong. If you went back, let's say, two and a half years to late 2020 or let's say, early 21, and you started to see in 2020, there was worry about inflation because the environment was being flooded with cash. And then, of course, in early 21, inflation started to rise. The knee-jerk reaction was, well, the thing you should do is you should buy floating rate debt because the people who own fixed rate debt, it'll be marked down in price, floating rate will hold.

27:16But as Armin points out, that's fine for the debt. But what about the issuer? The issuers of floating rate debt who are obligated to pay more and more and more interest as rates rise, they got into some trouble. Their income statement took a hit from the cost of interest, and some of them will turn out not to have been a great idea. So simplistic answers are rarely availing in the investment world. Would you say that there are any underappreciated risks in the market right now? So things that you don't think people are talking or thinking enough about? Well, I'll just volunteer one. We published the memo, Sea Change, I think it was December 8th.

28:00It's my sense that most people have not explicitly agreed that in the coming years, as Oaktree believes, we're not going to see interest rates close to zero. That is the Fed funds rate. We're not going to see steadily declining interest rates. We're not going to see such easy money. We're not going to see such unbridled growth in the economy and in markets. We're not going to see the same low level of defaults. We're not going to see the same ease in obtaining financing. That's the sea change that the memo talked about. We believe that these impacts still lie ahead. And I don't think that the investment world has embraced that view.

28:46Everybody says, oh, yeah, sure, I know that's possible. But I just don't think that there has been a coalescing of opinion around that idea, which is fine. We'd rather be the only people to hold that opinion, assuming we turn out to be right. Yes, I was going to say something similar, which is I think for the rate of inflation to decline to 2 % or 3 % from current levels, you would need to see a real continued degradation of the economy to the point where certain very important institutions in the economy break down. in a shocking way, breakdown. I don't think the Fed necessarily wants that. They do want to see 2 % to 3 % inflation, but I don't think they want to see massive foreclosures and losses and big, huge bubbles bursting.