Profiting from Mispriced Credit Risk When you look dispassionately at the credit statistics out there, you're seeing enormous amounts of debt relative to asset values. You're seeing structures that are very, very weak where people are not getting appropriately protected as creditors at the top of a capital stack. At the extremes, if I have incredibly weak covenants and I charge a really small coupon, well then, I can have no defaults. There are a subset of opportunities available that are effectively self-liquidating. So you can be effectively someone who benefits from the lack of liquidity, by having a bid when people don't want it in that subset of situations that are self-liquidating so you yourself don't need that bid. What is inevitable is either a crisis or a long-term malaise. Ed Harrison here for Real Vision. I'm talking to Dan Zwirn who is the CEO of a Arena Investors. Dan, great to have you here for Debt Week. Thanks for having me. I think before we came on camera was telling you off camera that we're having what's called Debt Week. We're at the beginning of 2020 and the reason that we're talking about debt is just because a lot of people don't understand that debt is actually a bigger market than the equity market. That's right, isn't it? Yes. Debt markets overall are far larger than the equity markets across loans, and mortgages, and tradable bonds, and treasuries, and all the different obligations that are out there. There's an enormous number of things to choose from when you're thinking about playing the markets. Give me a sense of the comparative size of the market because when I look on television, I get the sense that it's all about stocks. Right. Yes. Well, you can imagine there are literally trillions of different opportunities out there. In fact, we've never had more debt than we do now because of the tremendous amount of issuance that happened over the last 10 years. So a lot of that debt ends up getting bought by the very same people who issue it, when you think about the sovereigns globally. But basically, if you're an owner of an asset, there's never been a better time to raise debt against it. Now, we're going to do a soup to nuts conversation on debt. Because my understanding is you look at a full monopoly of different markets where there are potential dislocations. I think of it, there's this term that I came across called fingers of instability that accumulate over time. Then at stressful points, maybe you'll have a trigger and it will cause a mini crisis or a larger crisis like we had in 2008. But your theses is basically that it's not a question of if, it's a question of when, when we get to the next crisis. Yeah, I think there's two parts of it. First of all, there's always some combination of industry, product, and geography where there's a debt crisis ongoing. Whether that's due to a particular issuer, or a particular country, or other geography like a Puerto Rico or a Greece or an Italy; or whether that's related to a particular industry like oil and gas, there's always something going on. So when we look at all of the things out there, we're always comparing risk reward and thinking, "Where are people running from so that we can take a look at where we might want to place ourselves?" At the same time overall, at the end of the day, everything is correlated. So there are times of extremes like in a way or an '02 or '98 or '94, where a lot of the issues that arise in one or more market starts to lead into the other ones. In an ideal world, we'd like to avoid macro views generally because markets can be, if you will, stupid longer than you can solvent, so to speak. So we try to focus on where the actual idiosyncratic or Alpha-related distortions are the greatest. One of the things, I guess, that I'm thinking about is the length of this credit cycle or this business cycle. You hear the term that we're near the end of the cycle and as a result, these kinds of issues are things that we want to talk about. Before I go into what those issues are, because I think you have an interesting framework, I mean, what does that term, we're late cycle, what does that mean to you? Well, I would say it's hard to discern in that we simply, as a statistical matter, don't have that many data points. Depending on who you speak to and the data that you look at, perhaps we have 100, or 300, or 600 years of data depending on what markets you examine. So to draw any particular conclusions, other than what goes up must come down, is difficult. Right. Certainly, since '08, we have had a series of basically market distortions created by primarily developed market monetary authorities that preclude actual risk from being appropriately priced. So it's been a long, long time since there's been legitimate price discovery in the markets. At the end of the day, when you look at even equities, equities are ultimately a derivative of the credit markets. They're just the thing at the bottom of the capital stack. Overtime, people compare dividend yield on stocks with yields on debt. So that entire structure has been distorted by monetary authorities effectively under-pricing the front end of the term structure of risk-reward. So what we have is a whole series of distortions that have arisen. When that bubble ultimately pops unclear because when you keep rates flat or negative and there's very little premium put on top of those rates to price risk, ultimately, issuers that are not terribly credit worthy can frequently afford to pay very, very minimal rates to sustain a level of principle. Yes. Particularly when structures are really weak, can live to fight another day for years and years and years. So when we look at the world, we don't want to focus on what the greater fool may do or what might happen. So we try to focus on places where those distortions have presented themselves typically, in some particular again, geography or industry etc., that'll allow us to hopefully take advantage. I want to get to that, the specific markets that we're going to be talking about, but first let's go to your framework in terms of what you were thinking about in terms of where these fingers of instability are. That's because since 2008, there've been some institutional changes within debt markets. I think you enumerated five recently that are critical to thinking about how this could play out. Can you go through, step-by-step maybe we'll go through the five one after the next. Sure. Well, I would first say I enumerated those five factors in an academic paper. Right. There's only a subset of those things that we see that were able to be substantiated in an academic level. It's not to say that there are not other factors that we see in the marketplace every day, but it's hard to get your arms around in some of the numbers. With regard to those five, I would start with collateral. Right. So at the end of the day, a number of folks look at default rates as an example. When they think about the quality or lack of quality of debt obligations, what we have seen is that at the extremes, if I have incredibly weak covenants and I charge a really small coupon, well, then I can have no defaults. Right. So people tend to, at agencies and other evaluators credit, look at coverage. Meaning, how much cash there is to cover the obligations that I have from my debt instrument. Well again, if I don't charge a whole lot, then I can have high coverage and I can be comfortable. Nevertheless, I may have an actual overall obligation that's very large and in fact maybe larger than my asset value. So we tend to look at leverage, not coverage. Right. When you dispassionately look at the amount of leverage in the system across corporate property, structure, finance, consumer, and other personal obligations out there, what you see is an enormous amount of debt relative to the underlying asset value. Actually, you have a tremendous appreciation in asset levels. What is not necessarily understood is the degree to which people perceive there to be substantial equity value because debt is cheap and there are are situations where lenders tend to price very low because they perceive a lot of equity value. So those two things are not independently evaluated. They're effectively a zero sum. Basically, you're saying that equity is the residual value with debt at the top of the stack. Correct. So we're at historical highs in terms of the enterprise value, divided by cash-flow that people are willing to pay for businesses or assets. Part of that is because we can access very cheap and large amounts of debt that allow us to make equity returns that we otherwise wouldn't have been able to make. At the same time, providers of debt are saying, "Well, this I have real confidence that my loan to value is relatively low because of all the equity that these people with equity are willing to put in underneath me." So effectively, it's like two drunken sailors keeping themselves up. At some point, one of them might stumble over. So when you look dispassionately at the credit statistics out there, you're seeing enormous amounts of debt relative to asset values. You're seeing structures that are very, very weak where people are not getting appropriately protected as creditors at the top of a capital stack. You're seeing terms and duration which effectively, we have not seen the intrinsic risk of duration priced as low as it has for decades. Everything is set up such that people are not getting compensated for risk they're taking. So if you look at the stats across, we go into the secondary area, the ratings agencies, you're seeing a tremendous amount of triple-B, relative to the rest of high yield. Why is that? Because there's a very particular subset of investors that will only invest investment grade and above. So there are tremendous incentives to do a whole lot of numerical gymnastics, to be able to access an investment grade rating, that otherwise perhaps 10 years ago wouldn't have been given, in order to access that group of investors that tends to be comfortable taking a relatively low return for any given risk that they're assuming. Let me backup on two things. By the way, when you were say that, I was thinking about David Rosenberg, because I spoke to him and he was talking about this too. I want to get a point in about the credit quality of triple-Bs relative to what they were before. Sure. But the interesting thing, and I think maybe this is a rhetorical question on some level because you've mentioned the Fed and other central banks in the developed economies, but why is it that these investors are not being compensated for extending out for duration or for taking on the risk that they're taking on? I think it comes down to your supply and demand. There's only so many assures, and there's such a tremendous volume of capital that needs to be deployed and needs to attempt to get some level of return, that people are willing to accept historically low levels of return when they think about the return they're getting relative to the other alternatives they have. So you see, unfortunately, a kind of a vicious cycle, where if you lower rates, you make that hunger for yield all that greater, and you have people who are willing to buy more of it and take less return over time until the market tells them no. One of the things that hits me when you talk about this is, this whole concept of servicing debt. Debt service cost being the marker versus leverage. Yes. To me, that smacks of hubris in the sense that, as soon as rates go up, those debt service costs go up and suddenly you have what seemed like low default rates not become low. Sure. Well, that's certainly the case with regard to floating-rate obligations. But ultimately even fixed rate obligations as they reprise will be priced against the available floating rate and move up themselves. What I think is not taken into account by investors frequently is the fact that there's a level of correlation between risk-free rates and premium to risk-free. So if you see a real move up in risk-free rates, ultimately, you'll frequently see big moves up and spreads. At same time, if both happen, you have potentially a re-evaluation of the underlying asset yields necessary to appropriately compensate investors for owning assets or enterprises, and therefore a material decline in not only asset values as we proceed, but also more importantly equity values that are subordinate effectively leveraged by that debt. So these things can spiral out of control as they have in prior crises. That said, again, there's tremendous incentives on the part of monetary authority is to keep rates low, and as well as support the term structure of risk through other means including buying obligations directly in the marketplace. So I think while a crisis is not inevitable, it may be highly likely, and in fact it may ultimately be preferred, because I would argue that what is inevitable is either a crisis or a long-term malaise. As an example where you have Japan already add in potentially Europe going. So that's not such a great thing either. So we have these tremendous number of distortions happening because risk isn't appropriately priced, and because price discovery is not out there. In fact that leads to the third issue, which is that in addition to the fact that collateral is relatively misjudged in terms of its underlying risk, and in addition to the fact that it's not necessarily evaluated appropriately by available agencies, you have the fact that in the wake of the crisis, the number of people who are willing to make markets in fixed income across the world is very low, and to the extent that they're willing, their abilities is in turn parallel. Why is that? Well, I think part of it is that there has been a tremendous level of pressure, perhaps rightly applied post-crisis on banks that participate market-making. One, to effectively put capital up against certain obligations in their balance sheet, at levels that really preclude them from owning that risk in the first place. Second, through the Volcker Rule and other rules that they have to follow, there is tremendous level of pressure for them not to effectively take a proprietary position. Right. So unfortunately, in over-the-counter markets, the difference between making an OTC market and taking a proprietary view is very hazy. So why take that risk when the downside of doing so is so great? So that means basically liquidity has been shrunken overtime. Tremendously so. As an example in our business, we owned a few million bonds of a $400 million issue, and decided after doing additional work that we didn't want to be involved, and it took us almost two weeks to get out of just a couple of million bonds. So the reality is that turns into another factor we see out there, not one of the five as a general whole, there's have and have not mentality. Which is that if you are a have, whether it's corporate, again property, consumer etc, there's really no lower bound on the level at which you can borrow. But if you are a have not, there's really no price you can pay to get access. So what happens is if you have that obligation of one of those have-nots, it's effectively a permanent holding, until if you effectively get your hands on the assets either through a maturity or covenant violation, etc, and effectively force the monetization. So that then leads to yet another factor, which is the mismatch in assets and liabilities across many of the entities that have been raised in order to house a lot of this fixed income. So you'll see in mutual funds, shorter duration hedge funds, ETFs, and others, situations where there's a presumption that you'll be able to sell the obligations in order to deal with redemptions that's not really there. In fact even in the last couple of years, you've heard situations in Europe where there are property trusts effectively that own giant real assets that are levered, that are daily liquidity open-ended, and people somehow still are surprised when in fact the redemptions come that they can't effectively sell those buildings on demand. So I call this fake liquidity basically in a sense that the underlying asset is illiquid and then you have a liquid trading ETF, or other asset on top of that, and people get the sense that, I can get in and out of this when actually the underlying asset, there's a mismatch there. Right. So either you in fact won't be able to get out and redemptions will be suspended, or there'll be relatively low correlation between the price of the ETF in which you're invested and the actual price action in the underlying assets. Either way, you're not getting what you thought you'd get at. Interesting. You could see net asset values of these ETFs. They could trade well below the stated value. Because I'm thinking about it- Not in open-ended, right? Yeah. In open-ended structures, the nerve is the nerve. In close-ended, you can have a discount in nerve, right? Right. That's fine, because there's a fixed number of shares effectively, and those trade where they trade independent of the nerve. But when you have open-ended and you have redemptions, people actually need to get their money. So you have things like the breaking of a buck that happened in- The money market. Yes. In money markets. Right. So I think there has been relatively little focus by regulators on this asset liability mismatch out there, because it presumes a backward-looking view at what obligations had liquidity at one time. So they'll be surprised. If you go back to, for instance, 1998 between August and December, there was basically just no trading in anything OTC. Oh yeah, I remember that. I was rotating through at Deutsche Bank on a synthetic products market for Russian currency obligations or actually Russian, I forgot what they call them now, but basically that whole market blew up and there was no trading. People were panicked as result of that, and that's when the Fed had to step in, or those companies stepped in. By the way that leads to the fifth of the five factors that I wrote about, and that is that the regulatory control has been far greater now. Many years ago, people who had edge funds, didn't necessarily have chief compliance officers, or general counsel, or third-party marketing. There's a lot of things that have been instituted since those earlier times that may point to situations where effectively people are going to shut down or suspend redemptions because they can't strike a nerve. So as an example in '07, when you saw BNP Paribas mortgage fund had issues, part of the problem was they couldn't actually strike a nerve because they couldn't get prices. So they said, "Okay. Well no investors can move it around," and that in turn kind of creates panic. To me this liquidity is issue, there are tons of other things I want to go back to on those facts, that's great, especially with regard to the ratings agencies. But this liquidity issue, I find it very pernicious. When you think of potential triggers for what I would call contagion, to me that's a primary vehicle. Sure. Well I think you never know where it's going to start. When you saw what happened in Asia, those were issues that had arisen in the early mid '90s, that didn't really catch fire until '98 with the Thai Baht issue. I think at the same time in '07, you could have pointed to many different subsets of fixed income where pricing was really off, but it happened to be that the fire started in residential mortgages. What we all know today is that whatever it is that will cause it will be something unexpected. Whether it's something like those two situations, or there's enormous fraud, like what happened in WorldCom, where the market suddenly repressed in the wake of the revelations that occurred in that company, you just don't know where it's going to come from. Just to back-up your second, your second thing, when you're talking about the ratings agencies, I thought that was interesting because basically you were saying that 10 years ago we could have had debts EBITDA ratio, or leverage ratio of x. Now we can have 1.3x, and the ratings agencies will give us the exact same rating that we had before. Why is that happening and how is it that the ratings agencies are not cracking down on that? Why are they letting this sort of slow bleed into basically double B statistics, for all these triple B's? Well, today's triple B was yesterday's double B. I was actually invited by one of the large agencies to come in and discuss this. I don't think they'd agree with me. But nevertheless, I think the statistics do point to it. Furthermore, I think that even if you assume a static level of as, an example debt EBITDA, what counts as EBITDA these days is much different than before. So there are these tremendous numbers of different adjustments that are taken into account, even all things being equal with regard to the credit stats that exacerbate that issue. So ultimately, what you've seen is that when individual names even in the last quarter or two quarters crack, they crack big. Because there's a total reevaluation effectively moving a credit from I have to I have not very suddenly, and there are these step functions downward in the pricing. One other issue before we go to individual asset markets that I've thought, just jumping back to this leverage or rather to the liquidity issue that I found very interesting. I read the paper that you had co-written about the illiquidity. One of the things that you mentioned that caught my eye was the fact that, if you have a stock, let's say the stock of GE as an example. There's one stock common equity, its liquid traded over a market. But if you have a bond, first of all, as you mentioned it's OTC, where the markets happen, there's no New York Stock Exchange, but also you have discrete issues that are much smaller in- So the liquidity is almost automatically constrained in those markets. Yes, well, I think part of where we've seen opportunity in the tradable markets is that these days there are relatively few folks who are simultaneously looking at as an example bank that all the bond issues, CDS, stock in options. So there are situations where there are distortions even within capital structures and so we see situations where effectively we can create cheap put options, cheap call options through different combinations of those securities that will never require us to seek a bid from someone else. So a key thing that certainly I learned pre-crisis even was that in some of these OTC markets, there are a subset of opportunities available that are effectively self-liquidating. So you can be effectively someone who benefits from the lack of liquidity by having a bid when people don't want it in that subset of situations that are self-liquidating, so you yourself don't need that bid. So you're never relying on the greater four. Well, let's go through some of these markets one by one. One that doesn't get a whole I mentioned that I find interesting because it goes to the reach for yield is private credit. Private credit, my understanding of it is that people said, ''Look, we're long-term investors, so we don't really need to have liquidity. So we can invest in these private credit actions and wait it out for the long term.'' What's going on in that market? As a result, we can get a higher yield obviously. Why is that not a story that makes sense? Well, I think the original thesis was that there was a difference between obligations that were traded and/or had QCIPs and private obligations. The underlying presumption is there's a different level of liquidity and by not having a QCIP or not being traded on a desk, I should get paid more. The reality is that difference is not really there and the reality is that the leveraged loan markets and the middle lending markets affectively price against each other and so there's been a real harmonization between those two markets. So that's Point 1. Point 2 is the notion that I'm somehow intrinsically more patient, so I don't need market-making to be there, may or may not be the case. However, what it doesn't take into account is effectively the fact that the longer I have a debt obligation because I'm never going to get paid more than par, so the longer a debt obligation I issue to a borrower, the more put optionality I'm short and so effectively throughout the life of that loan, I can only make my coupon, but I can lose it all at any given time. So if I can only lose it all for two years versus only losing out for 10 years, all things being equal independent of market-making capability, I'd rather have the two years than the 10 years. When you look at the differentiation between pricing on things that are short versus long, it doesn't reflect that and so people have been willing to effectively be super borrower friendly in that regard and that will ultimately cause problems. Third, is the aforementioned drunken sailor issue, which is that in the middle market, lenders are taking comfort from the fact that, well, if I'm lending it seven times and an equity sponsor is putting up four times, I must have an LTV of 7 divided by 11. But ultimately, the equity provider is paying that equity out to the seller, it's not somehow staying in the enterprise and so independent of what the equity sponsor viewed to be the enterprise value of the enterprise, I'm still out seven times and so in fact, it may very well be the case that instead of 7 divided by 11, my LTV is 7 divided by 8 and then the question is, am I getting intrinsically and appropriately paid? The equity provider might be willing to provide that four turns of equity because the pricing of my debt is so cheap that he can still make an equity return whereas at the same time, I take comfort somehow as a lender in lending seven times and then somehow then willing to charge really low because of the presence of that four times and so the two work together to effectively overprice an asset and put the asset in a position where the equity is disproportionately paying up but also taking advantage of the amount of debt, the pricing of it and duration of that as well as the structure of it. Related to that, I guess is leveraged loans in that when we're talking about this market for bank loans, there's a tradable market for bank loans, leveraged loans and a lot of people talk about high yield on leveraged loans as a collective market which is of the size of the mortgage market. So dislocations there could be a trigger point in a crisis situation, what's going on in those markets and do you think there are opportunities there? Well, I think there are clearly ultimately going to be opportunities because the credit statistics don't make a lot of sense. If there is a reason that those opportunities may present themselves, it's because a number of middle market lenders themselves are levered. Typically, two to three debt to equity in their own capital structures which are then using to make loans to issuers and in fact even more CLOs are 10 or more times levered and owning these obligations. Now, those who are sanguine about those markets say well, versus previous times, there's a level of asset liability matching between the owners of CLOs and the capital structure of CLOs and the underlying obligations. True. However, that doesn't take into account the fact that there are effectively triggers in the capital stocks of CLOs that may shut off distributions at certain pieces of those and furthermore, that in fact, while it was the case that a lot of that really bad CLO equity did come all the way back post-crisis, that doesn't take into account the dimension in the quality of the collateral as well as the intrinsic notion of, "If I am a semi-institutional owner of CLO equity and I get a statement saying my equity is down $0.90, am I going to just calmly be able to tell my stakeholders that somehow it's going to be okay if we all just wait a decade?'' The answer is probably not. So there's a lot of reasons why though there can be issues and again in the last couple of quarters, we've seen that arise where a given leveraged loan that is relatively low quality has turned out to be owned almost exclusively by CLOs and when you take that issue and the fact that they don't want to own collateral that could cause triggers in their own CLO structures and you combine that with the fact that there's relatively little market-making, and in fact relatively little ability even get information on the credit, what you have is that when there are issues in those underlying credits, all of the owners of it want to sell all at the same time and have a bunch of buyers who were not located, a bunch of intermediates who are not transacting, and information that's not well distributed in order to make a market happen. So what you've seen then is step function down pricing until it finally clears at some really tough level. Does it not have a knock-on effect to the other issuers that are within that same collateralized loan obligations? Yes. Well, this is a great example of one of the factors that I consider putting the paper, but the hard to get numbers around in order to substantiate an academic level. What we've seen anecdotally is you suddenly start to have credits that are owned by different structures, different organizations, different funds, different CLOs each of whom have their own particular interests in situations and we've seen firsthand situations where as an example, a creditor is willing to do things that are really unnaturally generous to the equity owner in order to not acknowledge the credit problem that's there because they don't want to trigger something in their own structures that may hurt their own credit. So if that happens and you happen to be a creditor that just want its money back, you're going to have conflict not only with your borrower, but with your fellow lenders. At a macro level, when we talk about CLOs, collateralized loan obligations, to me it strikes of mortgage backed securities in the sense that you're taking credit and you're putting it into a structure, slicing and dicing and so forth, can you give viewers a sense of what's going on in that market, what's going on in the whole collateralized debt obligation market, and how CLOs, collateralized loan obligations, are coming to be an outsize portion of that market? Well, I think fundamentally if you kind of boil it down, what you have going on in that market is very similar to what you had in the mortgage market, which is that ultimately it's very unclear who bears the risk and so there's a tremendous amount of incentive throughout the chain of value for more and more paper to be issued and very few people thinking about what the outcome is going to be. Why is that? Well, because if you look at these very leveraged structures, in many instances, the manager of that leveraged structure is not the owner of the residual risk in that structure. Therefore, a time where rules around creating what they call skin in the game where the manager needed to have exposure to the obligations, those were effectively taken away again and so what happened is there's a whole lot of people who own that risk without managing at the same time and so therefore, if I'm a manager who's taking no risk, by its end if it's just a manage more under any circumstance because I'm not going to be suffering the consequences. Similarly in the residential mortgage markets, you had that times two, which was that not only do you have that same dynamic, but you had originators who were going to wear the risk, who just needed their originated manners of the risk, who just needed to own collateral of some sort and weren't taking the risk. On top of that, you had effectively managers who were able to get short certain of the obligations. So not only were they not interested in the positive outcome of the deal, they were interested in the negative outcome of the deal. That sounds just like the mortgage market that was. Yes, and so we haven't seen people materially, I have yet to hear of CLO managers effectively getting long protection in components of their deals. But every other piece of the bad incentives cycle or structure is there. Well, interesting. One market I think that you expressed some interest in before we are on camera was about the commercial property market. When you talk about commercial property, it goes back to the story I was telling you about what the High Line and how I used to live there 20 years ago and how it's just unbelievable how much buildings going on there that at some point, it seems to me that that's not going to come to good. What's going on in that market and what are the pitfalls there? Well, I think throughout urban markets in the US, you're seeing very, very high prices driven again by access to capital and the cheap pricing of capital. That's not only with regard to existing assets, but also it's very much encouraged the building of new assets. So I think if you surveyed people in a number of the largest city markets in the US, what you'd see is occupancies are starting to get shaky, rental levels are starting to get shaky. The ability to sell out condos is starting to get choppy, and there are a number of people with construction loans that are very nervous. So we like those situations. In fact, in Manhattan, we purchased a mortgage loan of a situation where you would have thought it would have been a relatively easy sell out. Well, whereas unfortunately, we're going to have to go to effectively a multifamily rental business plan in order to make it work because the bid is not there on the condo side, and that's already happening and showing itself. When you look at this, are you looking at it from the long side or the short side in terms of, here's a distressed market, and I could get in long or this is a distressed market and I think that actually bad things will happen? Both. So in direct obligations, we are and are looking to buy existing obligations at discounts, either to reprice or restructure commercial real estate assets, but also looking to make new loans in situations where people are stuck in some way. At the same time within the tradable markets, there are certain situations where you create either short situations or cheap put options. For instance, in situations where as an example, a lender might have publicly traded, might have over-rent to some of these urban markets, and you can create a structure using different capital structure components that leaves you effectively neck short the outcome there in a very very leveraged commercial real estate lender that is exposed to these markets. So that actually allows us to create a very interesting compelling cheap put option, but also one that it's inversely correlated to a lot of the other bets we have. Right. Which markets in particular do you find interesting? You mentioned New York, any other markets that you're interested in? We've been involved recently in Miami, San Francisco, LA, I think Chicago, we're involved in all of them. I think you're seeing the very beginnings of real issues there. Again, those have been fueled by cheap access to debt financing, cheap access to securitization markets, and this kind of hunger for yield. So I think we'll see that moving along. One other question I had on that is that, when you talk about commercial real estate, there is the business side, that is, where I'm renting out to businesses, but there's also I'm renting out to families, multifamily, etc. Then within the family sector, there are levels. There's the entry, mid-level, luxury, super luxury. Now, anecdotally, I understand that at the very high end is a tremendous amount of over ability in Miami in particular. Any thoughts on that? Well, there has been. We actually are very significant residential mortgage lender in Miami and in related markets. We do it in a way where we're focusing on non-US citizens. So instead of lending 80 percent for 10 to 30 years at four percent, we're lending 55 percent for two years at 12 percent. So we are creating those positions at the level that we're lending, at levels equivalent to where they would have traded in 2008. So we feel relatively protected from what may come and in fact, may be a beneficiary of what may come. But yes, we've seen not only, we've definitely seen prices move down at least 10 to 20 percent across the board there. We've seen the ability to sell condos go down significantly. We've seen people get stuck in construction loans. So again, I would call it a first or second ending opportunity, but we're going to see a bunch of it. When you think opportunity, again, short, long, that was the opportunity on the long side that you were talking about, but what about on the other side of that? Well, actually, the commercial lender that's publicly traded that were net short is a big exposure. That itself is 10 times levered in that market. Right. Interesting. Yeah. In that situation where effectively we've set up a trade where we are long a put and short a call spread, where that package effectively doesn't expire until after the election. Right. The election, what's the significance of that day? Well, the thought was perhaps on one side, you have a guy who's no longer interested in job owning rates down, or someone who is far less interested in the positive benefits for commercial actors. Either way, that may not be good for yields. The interesting bit about that is we haven't talked about politics at all during this whole thing. I mean, 2020 is an election year, pivotable in some ways. What impact do you think that's going to have on debt markets in general or could have on debt markets because that's one? I do. It could be. I think that on the Republican side, if there's a Republican win, I think you're going to see relative stability, relative to where we are today. Although as I said, you may either have less incentive unless he decides to have a third term, there's less incentive to effectively jawbone rates down, and there's certainly a greater chance all things being equal of creating a geopolitical issue. On the other side, depending on who you have, I think if you have a Biden presidency, everything is just going to be fine. But if you have a far-left presidency, if you look at the UK election and you saw some of the policies that the Corbyn followers were proposing, some things like that could cause real havoc. The interesting bit is that, this dichotomy that you are presenting does leave the potential for a uptake not only in rates when you look at the term structure, but also in terms of spread. So that could trigger some of the things that we're talking about in terms of a phase shift, in terms of, those on the weaker end starting to default. Yeah. Well, I think there's a lot of places where that could be, that could happen. Again, geopolitical is a big one. But I think you can see a large-scale fraud. I think we've seen things like Steinhoff and others where there are not quite the global issues of an Enron or a WorldCom, but there have been these very generous credit markets have allowed people to manipulate numbers. It's the bezel, if you will. Yeah. Like John Kenneth Galbraith said, we don't see the bezel now. Yes. So as Buffett said, when the tiger that you see who hasn't made is a underdog. So I think there's a lot of things that have been covered up. If we didn't have the crisis, we would have never seen Madoff, right? It was only because of the crisis and the fact that a number of his investors needed to redeem in order to cover other obligations, that the fact of the matter of his operation came to light. So who knows what such things can bring? Now one last thing in terms of markets, it's less sexy. The investment grade market, opportunities there that you might see either long or short. I think when it comes to that world, all things being equal, we're probably most interested in municipals. Many years ago I created one of the earlier business focus on distress municipal finance. Because of the fact that you have a relatively slow world, with a lot of investment grade holdings, a lot of which are not general obligations and are property or project-specific. There's a lot of small issues out there that are going have problems and so that's an area we begun to look at again, all of these things cycle back, good and bad over time. These GOs versus the specific obligations, which ones present the most problems in a downturn scenario? Well, there's clearly already basket cases brewing, things like Illinois and Connecticut, etc. The issue there is what price is the right price? There's no limit to the lack of responsibility of those governments. So handicapping how that's going to go is very difficult. I would argue that when you see situations like that, it creates situation-specific opportunities, because again the baby's getting thrown out with the bathwater. So as an example, in Puerto Rico, worked very active across a number of different underlying collateral types, but have never been involved in the GOs. Because there's so many things that are hard to handicap, hard to guess how they'll go, for us it's very hard to take a view. So, on the long side basically, if you do your homework and you say this particular asset or this income stream is what's behind this particular asset. You can actually do well when they throw the baby out with the bathwater? When that's the case and as well, there's a trigger that will allow you to actually realize the pricing distortion. Is there a maturity or a covenant violation or some other things that will allow me to actually get at the asset, sell it off and effectively monetize the difference between the price at which I'm paying and the level at which I'll realize. People get hurt in situations like, for instance, when the convertible bond market exploded in '05. Generally convertible bonds are very long data with very few covenants and so you're just sitting there waiting for a greater fall to take you out. Furthermore in that case, a lot of those players were leveraged and so they needed to seek a bid however they could get it. So at that point we went from zero to half a billion dollars worth of that. Then people started to come back in the market, we got back out again. Again, we always want to be on the right side of that equation where we are a effectively a global chaser of their liquidity and are providing effectively a market-making function to people who have no other option. Let's dive in a little deeper into the CLO thing, because a lot of people are very interested in this. Yeah. I think that the question is; in terms of the specific structures that you're looking at to take positions there, how do you take advantage of what's happening in that space? Well, part of the reason why what's happening is happening is because there are very few ways by which you can effectively get short that scenario, those situations. In contrast in the mortgage business, pre-crisis, when people created mortgage securities or even mortgage securities made up of mortgage securities, there was a pretty ready market by which you could effectively create credit default swaps to take a view against those. As a result of what happened in the crisis and the lack of market-making that's out there, the degree to which you can be very nimble about using CDS in order to get short components of structured finance structures is very much reduced. Why is that? Because a lot of people got murdered doing it, when trying to do it. Ultimately, a lot of that was predicated on situations where perhaps everyone had the same amount of data, but there were different levels of ability to understand and interpret the data and so people didn't feel good about it. Because this is like a bespoke market basically? Yes, and so we have yet to see opportunities to effectively get short structured obligations within stacked securitized capital structures using CDS. What you can do is use CDS in corporate-credit-specific ways and you can do that against different parts of a given company's capital structure. We'd love to do things like that within CLOs, it's just no one will take the other side of it. So that will potentially allow it to persist. But on the downside, it may allow it to persist such that the distortions are so great that when it explodes, it really explodes big. Within corporate-specific situations as an example, there are situations where we can be long a bank loan, long credit protection, to create a basis differential that'll effectively collapse, because they're two of the very same things. Or we can effectively use puts or other long-dated options in order to create situations where as an example, we are long a mid-tier part of very large energy company's capital structure. But we're also long, a very long dated out-of-the-money put and so having set that up, we know that there's a very small bound of points we can lose, and anything better than that is "ups" and so you may not actually create a cheap put option. In that case, you would create a cheap call option. But the reality is that these pricing distortion within capital structures provide opportunities to create cheap optionality off the back of the market. What sort of duration are you talking about? Within three years typically. One other market that I think is interesting and I think in particular because a big debt manager said that he expects defaults in emerging markets in 2020. Emerging markets are generally considered moving out the risk spectrum in the same way that high yield would be. What's going on in that market in terms of this richful yield? Yes. Well, over time, all things being equal in a given industry or business, you'll see people demand a premium, if they're going into an emerging market. So ultimately they're taking a view on a sovereign and its effective fiscal sanity, as well as its adherence to the rule of law. So I think what we've seen is that the degree to which sovereign finances are managed appropriately is very different among different emerging markets. Similarly, even within a given emerging market as regime change, as governments change, the degree to which those governments act responsibly can vary quite a bit, and so what it creates is real volatility. So when everything is comfortable, well then, you get your little extra 100 pips on this oil company versus that developed market oil company and you're happy, but again when you see the reality is there's a correlation, right? So when risk-free moves up, spread moves up, perceived issues within a given series of markets move out, you have real problems, and those are then further exacerbated by the fact that a lot of this is intermediated, by people who aren't making markets, a lot of it's held in structures that are relatively short duration and don't take into account the lack of the inter-mediation that's there. So when we think about emerging markets, like in many situations we want to own the volatility for free, right? So when you see those explosions at times, they creates babies that are thrown out with the bathwater that you can take advantage of. So as an example, we find ourselves at times looking at busted assets in Greece or we're looking at private transactions now in Brazil, or we've done things in Argentina at precisely the time when people are really freaking out, right? Are these more on the public or the private side in terms of the issuer's? Typically, they are private side transactions that are able to get priced because of what's happening in the broader universe. Okay, so now I think that's probably example a good lead in to what we're talking about in terms of opportunities and you've already talked about that owning the volatility, you talked a little bit about some of the things that you could do in CLOs. Where are from your perspective given the outlook that you're seeing on a macro level, what do you see opportunities in debt markets going forward? Well, it really depends on the geography. Today in North America, I think we're very interested in non sponsored private corporate debt transactions, we're very interested in the whole universe of funds meaning buying and selling interests and fund's, lending the funds because the wrapping in the funds in a fund structure precludes normal corporate oriented lenders from being involved. There are frequently opportunities and there's been such an explosion of issuance of those funds, and there are so many mis-alignments of interests among LPs and between GPs and LPs, I think that will be an opportunity for years and years to come. We're also very interested in North America in oil and gas, which has basically been completely red line by the banks who periodically effectively take price bets. We like oil and gas where we don't have to take bets on oil and gas prices, and so there are times when everyone wants to do oil and gas and the Enron's are there and the Mirrors are there and now price is too low and then there are times when they did all explodes and no one wants to touch it, and in the latter instance we're involved. Actually, now in the last 20 plus years, this is the third time we've been heavily involved in that area. Interesting. So you don't think that the oil and gas is due especially because of maturity is coming forward for a difficult period where rollover of debt causes a problem in that and that's been- I think it very well could be. I think in the tradable markets within energy, there's a lot of misinformation or bad information about underlying asset values that has yet to make itself known without getting too specific, basically within oil and gas tradable markets, there are ways to look at the quality of different types of assets. So as an example, there's a notion of pre-approved develop producing which is basically I stick a strom and ground and it comes right up and all the metals there in order to make that happen, and then there's proved developed now producing, and there's proved undeveloped, and then there's probables, and then there's lower levels of probables. So in the private markets or when we get involved, we only care about the stuff that it doesn't take a geology degree to understand. Right. When you look at the way credit has been provided to those markets, there's a lot of assumptions about exploration risks that are embedded that will leave people incredibly disappointed. So I think there's a real opportunity for that to happen, but it might not because of the same factors we've talked about with regard to monetary authorities and the overall over-provision of credit. What I am certain of is that in the private markets where you're not getting agency ratings, where you're not getting large leveraged loans, there are very few options available, and so I'm quite certain that there are opportunities where again the non geologists out there can make very limited low LTV, high rate that's that where we are able to effectively self force our borrowers to sell forward the commodity so we're not taking commodity risk and we can charge 15 or 20 plus percent. It sounds like you're talking about both the short as well as the long side, so rather than, finish off talking about the short side, I wanted to talk about the one last point that you made about the monetary authorities, because a lot of this, earlier in the conversation when we're talking about Europe, Japan, and the United States, there are two potential ways that we could go, and it sounds to me like there is the potential for given the fact that debt servicing costs are low and increasing rates creates the potential for exactly the crises situation that we're talking about. That we just keep going at this very low stasis level, turn into the next Japan. Do you really think that monetary authorities won't be there as the buyer of last resort, essentially to bail out the system if the situation starts to unravel? Well, it depends on how much freedom of movement they have at a given time. So if you haven't been raising rates and if you haven't been curtailing you're buying and it's time to start lowering rates and buying, you don't have many more bullets in the gun. So I think they're trying to gently reload so that they can be there, but ultimately, when you're not what ultimately is going to happen is you're going to damage those who are the savers, those who are responsible by debasing your currency because that's the only way it ultimately works. Which is you service the debt with the value currency and you become basically a giant emerging market. You think basically that that's one way that we could go in the United States or we can deal with the problem head on. I think there's very little incentive for it to be dealt with that on, and so ultimately if a crisis arises, I don't think it's going to come in the way that it did as an example in the '80's where Paul Volcker took, Volcker 1.0 took a stand, made rates appropriately price risk and effectively cause some short-term pain for long-term gain. The will of central government monetary authorities to do that thing I think is very low, and so I wouldn't hold my breath for that. So therefore, if we see something precipitated crisis, it'll be one of these things that none of us counted on, whether its geopolitical or fraud unrelated or whatever it is that will cause an issue. Where that comes from who knows. It's been a pleasure talking to you. I mean, this has been a great soup to nuts conversation on debt, I really appreciate it Dan, thanks for coming on. Thanks for having me. Welcome to the end of the video. We know that on average 85 percent of you who starts a video on Real Vision finish it. That's extraordinary. On Facebook, it would just be four percent, and that's because Real Vision creates the most engaging content in the entire media world. Let us help you grow your business by making video content that really engages your customer's. Email us at customvideo@realvision.com