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Speaker 1: Hello, and welcome to the Credit Edge of Weekly Markets podcast.

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Speaker 1: My name is James Crombie. I'm a senior editor at Bloomberg.

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Speaker 1: Today's guests are Reshmi Basu, who covers distressed debt for

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Speaker 1: Bloomberg News in New York. We're delighted to have you

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Speaker 1: on the show.

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Speaker 2: James, thank you so much for having me here. I

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Speaker 2: love your podcast.

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Speaker 1: Thank you. We're also very pleased to welcome Himanshu Bakshi,

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Speaker 1: who covers banks for Bloomberg Intelligence, also in New York.

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Speaker 3: Hi, James, thank you for having me today.

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Speaker 1: We'll be coming right back to Himanshu a little bit

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Speaker 1: later in the show, but before we do. Reshmi Basu

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Speaker 1: with Bloomberg News, you cover distressed debt in the US.

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Speaker 1: A lot of companies are running into trouble at the moment,

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Speaker 1: with interest rates rising and the economy slowing, potentially tipping

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Speaker 1: into a recession, maybe a hard landing. Stagflation, inflation and

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Speaker 1: volatility in the financial don't help. A lot of regional

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Speaker 1: banks are really struggling right now. What's the level of

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Speaker 1: distress in credit markets at the moment? Resh me, How

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Speaker 1: worried should we be? Well?

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Speaker 2: The days of cheap money are over as the FED

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Speaker 2: has steadily increased interest rates, and higher interest rates are

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Speaker 2: putting pressure on the cash flow for companies, especially for

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Speaker 2: tech names, and this is where we're seeing quite a

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Speaker 2: bit of distressed activity. You know, global default rates have

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Speaker 2: now reached the highest level since the twenty twenty pandemic,

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Speaker 2: and now over the last few months, we've seen several

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Speaker 2: high profile bankruptcies as you mentioned, you know, from banks

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Speaker 2: such as Silicon Valley to bed Bath and beyond. We're

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Speaker 2: seeing a number of companies entering into negotiations with their

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Speaker 2: lenders to extend the twenty twenty four maturity wall. You know,

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Speaker 2: for instance, data center operator six Terra is looking at

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Speaker 2: multiple options ranging from selling assets to our capital raised

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Speaker 2: to tackle heavy debtload. If they can't do that, then

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Speaker 2: it's going to end up filing for bankruptcy.

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Speaker 1: So the companies you mentioned they're in trouble, what are

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Speaker 1: they doing to sort of buy them? That has a

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Speaker 1: bit more time here, right.

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Speaker 2: This is a market where it's extremely challenging for people

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Speaker 2: to make money, and what we are seeing is that

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Speaker 2: some lenders, private equity owners, companies themselves are exploiting loopholes

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Speaker 2: in the credit agreements that allows for these contentious debt

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Speaker 2: maneuvers to take place. So, in industry terms, there's a termination.

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Speaker 2: There's a term called designation of an unrestricted subsidiary or

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Speaker 2: a drop down box, and that is something no one

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Speaker 2: ever wants to hear. But in layman terms, this means

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Speaker 2: that the company is moving assets from the collateral package

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Speaker 2: backing lenders loans away from their reach. So basically what

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Speaker 2: it kind of means is like, let's say I agree

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Speaker 2: to give a company a loan, and I believe there

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Speaker 2: were five businesses in this package. All of a sudden,

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Speaker 2: the company says, oops, no, not so fast, We're going

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Speaker 2: to take away two businesses from that enemy. And now

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Speaker 2: your recovery values are going to go down and those

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Speaker 2: assets have been taken away from you.

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Speaker 1: Let me just start you there, the collateral package, unrestricted subsidiary.

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Speaker 1: There's lots of quite complicated terms in there. I just

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Speaker 1: wanted to break it down even more. We're saying that

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Speaker 1: when a company borrows money, they essentially they have something

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Speaker 1: that is worth something that the lenders will attach as

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Speaker 1: collateral and they expect that that will remain in their

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Speaker 1: reach when you know, when they're in this lending agreement,

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Speaker 1: and the companies are essentially taking this collateral and putting

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Speaker 1: it somewhere else.

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Speaker 2: Yeah exactly. So when you know a company does a

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Speaker 2: leverage buyout, you as a lender, we're a lend money

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Speaker 2: to the company, and you're believing that when you do

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Speaker 2: this loan that you have the amount of assets. And

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Speaker 2: now what the companies are doing are saying not again,

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Speaker 2: We're going to take away some of these assets and

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Speaker 2: give it to other lenders.

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Speaker 1: Okay, So the word drop down, the phrase drop down

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Speaker 1: does that what does that apply to?

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Speaker 2: Job down basically means that you are the company is

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Speaker 2: moving collateral away from the reach of lenders and putting

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Speaker 2: it into a separate legal entity, and at that entity

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Speaker 2: they can raise financing.

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Speaker 1: Okay, So lenders are not only losing the collateral, but

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Speaker 1: they're also kind of being exposed to the risk of

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Speaker 1: the company taking on more debt at another level of

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Speaker 1: the company.

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Speaker 2: Is that Yeah exactly, and they're kind of going to

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Speaker 2: be primed, which basically means that those lenders who lose

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Speaker 2: those assets are being pushed down to be payment line.

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Speaker 1: Okay, so where is this happening? Can you give us

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Speaker 1: any examples of what we're seeing right now.

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Speaker 3: Yeah.

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Speaker 2: You know, for instance, we covered a company Club Corp,

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Speaker 2: which is Apollo as Apollo is the private equity owner

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Speaker 2: and Club Corp operates private clubs and golf courses. And

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Speaker 2: the company recently informed lenders that it was moving to

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Speaker 2: business entities into legal and into like legal subsidiaries, which

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Speaker 2: basically means it's basically a precursor that the company is

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Speaker 2: going to probably raise financing at that box, and those

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Speaker 2: businesses have been kind of stripped array from lenders. And

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Speaker 2: reason why this is so interesting is because the company

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Speaker 2: was actually in negotiations with lenders to extend on near

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Speaker 2: term maturity. That deal fell apart, and shortly after the

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Speaker 2: company created an unrestricted box drop down box or basically

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Speaker 2: moved to business says Interleegal a different legal entity.

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Speaker 1: And is this quite common now, this drop down transaction?

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Speaker 1: Is it widespread in the industry.

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Speaker 2: Yeah, it's becoming common enough that we are seeing situations

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Speaker 2: where the lenders were banned together in a preventive move

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Speaker 2: with law firms and signed cooperation agreements, which basically is

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Speaker 2: telling a company we are united, don't try to do

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Speaker 2: these kind of aggressive debt maneuvers.

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Speaker 1: But it's not entirely new. We've seen these in the past, right, Yeah.

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Speaker 2: We saw it in twenty twenty seventeen with Jay krue

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Speaker 2: where it moved Made Well but at the time, which

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Speaker 2: was its kind of crown jewel into a drop down box,

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Speaker 2: and there's a lot of legal action that took place.

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Speaker 2: And then shortly after we saw you know, pet Smart

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Speaker 2: do the same thing where it moved Chruey it's online

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Speaker 2: pet Stow retailer into a different box, and Nieman Marcus

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Speaker 2: moved My Teresa again an online retailer, into a different box.

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Speaker 2: But you know, with pet Smart and My Teresa, we

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Speaker 2: actually saw those entities do go public. And in these

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Speaker 2: kind of more recent situations, we're not seeing those new

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Speaker 2: businesses go into like you know, be spun off into

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Speaker 2: a publicly listed company. We're actually seeing those companies such

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Speaker 2: as like a curt of Simmons, which it did a

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Speaker 2: deal in twenty twenty going to Chapter eleven.

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Speaker 1: But so in the past, these these maneuvers have actually

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Speaker 1: worked and they've saved companies.

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Speaker 2: They and you actually saw them being able to spend

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Speaker 2: off those assets into a publiclisted company and those proceeds

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Speaker 2: would then be used to pay off the lenders.

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Speaker 1: But in this case, because the IPO market isn't as hot,

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Speaker 1: we think that these won't work this time.

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Speaker 2: Yeah, and we're seeing, you know, in Kora, which is

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Speaker 2: an aerospace supply, or we're seeing you know, we're hearing

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Speaker 2: you know, we're hearing that they're having liquidity issues. Obviously

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Speaker 2: we had sort of semons and Envision is another company.

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Speaker 1: So the main difference is then between prior use of

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Speaker 1: the dropdown and what we're seeing now is just the

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Speaker 1: exit to the IPO. Is that right?

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Speaker 3: No?

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Speaker 2: I think we saw that quite a bit in the

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Speaker 2: beginning that you know, the companies would say like, look like,

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Speaker 2: even though we're removing these assets from you, eventually we're

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Speaker 2: going to do some type of we'll make it a

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Speaker 2: publicly traded company and you're going to see value from

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Speaker 2: this IPO.

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Speaker 1: So we're talking about something that is really not very

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Speaker 1: good for the creditor. Right, So how are they reacting

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Speaker 1: to this other than organizing, what are they doing to

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Speaker 1: be able to protect themselves in these situations?

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Speaker 2: They're filing lawsuits. We saw that with Mike Tell, We've

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Speaker 2: seen it with in Kora, that there's a lot of

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Speaker 2: lawsuits coming and they're basically calling these deals as kind

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Speaker 2: of sham transactions, and they're not done in good faith negotiations,

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Speaker 2: and they are a complete manipulation of the documents that

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Speaker 2: they initially agree to.

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Speaker 1: Have we seen any of these lawsuits succeed orre they

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Speaker 1: still working their way through the courts.

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Speaker 2: They're still working their race through the court. So we

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Speaker 2: don't have a great amount of case law. But one

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Speaker 2: thing we did see in Certi Simmon's bankruptcy court is

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Speaker 2: that the bankruptcy judge did kind of give a nod

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Speaker 2: to the aggressive or egregious debt maneuvers.

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Speaker 1: Very interesting. So before we talked to Himanshubacshi at Bloomberg Intelligence,

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Speaker 1: what's the next big story to watch on your beat? Reshmi?

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Speaker 1: What are we looking for next?

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Speaker 2: I think we're going to be seeing more cooperation agreements.

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Speaker 2: That's something that we're working on for tech company, and

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Speaker 2: we're definitely going to see more drop downs for many companies.

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Speaker 2: In particular, we're seeing a lot of it in the

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Speaker 2: tech software space.

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Speaker 1: So cooperation agreements, what are they?

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Speaker 2: Cooperation agreements are just basically when the lender is kind

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Speaker 2: of bound together for a united front, and you know

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Speaker 2: you basically kind of have to inform your lenders if

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Speaker 2: you plan to sell your loan.

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Speaker 1: Great stuff, Rashmi Bessie from Bloomberg News, thanks so much

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Speaker 1: for joining us. Thanks for having me read all of

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Speaker 1: Reshmi's scoops on the Bloomberg terminal and of course at

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Speaker 1: Bloomberg dot Com. Moving on to another key part of

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Speaker 1: credit markets. As I mentioned earlier, we're delighted to have

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Speaker 1: on the show Haymanschu Bakshi, who covers banks at Bloomberg Intelligence.

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Speaker 1: What's going on with the banks, Himanshu was We've discussed

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Speaker 1: a few times already on this show. In March, there

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Speaker 1: were serious issues, a regional banking crisis in the US,

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Speaker 1: the downfall of Silicon Valley Bank, a niche lender in

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Speaker 1: the tech sector, and also to the wineries in California.

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Speaker 1: Then much more worrying Credit Swiss imploded, one of the

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Speaker 1: biggest fans institutions in the world, heavily involved in all

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Speaker 1: parts of the credit markets, brought down and forced into

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Speaker 1: a fire sale with ubs. Now First Republic is teaching.

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Speaker 1: Is the banking crisis over in your view?

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Speaker 3: Manchu, Hey, Gems, thanks again for having me today. So

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Speaker 3: is the banking crisis over. I think the answer is

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Speaker 3: the worst of the crisis is over, but the banking

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Speaker 3: system remains under pressure. And the reason I say that

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Speaker 3: is because inflation, even though it's easy, it still remains high,

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Speaker 3: which means the Federal Reserve will need to continue to

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Speaker 3: raise interest rates, which means that the issue we save

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Speaker 3: with some of the banks that failed in March was

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Speaker 3: rising losses on the investment portfolio. That will continue to increase.

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Speaker 3: But the change we are seeing now is that the

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Speaker 3: focus has shifted from all banks globally to a few

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Speaker 3: banks with those radiosyncratic risk So even though it'll take

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Speaker 3: some time for positors, investors confidence to come back, I

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Speaker 3: think most of the crisis is behind us.

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Speaker 1: So you look at the eighty one market, that's the

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Speaker 1: riskiest form of bank debt credit Swiss wrote there's down

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Speaker 1: to zero, even though equity holders got something back. That

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Speaker 1: was a major event for that market, and we saw,

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Speaker 1: you know, a lot of panic and a lot of

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Speaker 1: people saying that the market had been killed by that transaction.

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Speaker 1: But more recently we saw a deal in Asia, so

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Speaker 1: the market, you know, it's not completely dead. What about

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Speaker 1: in the countries that you cover?

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Speaker 3: So I cover Canadian and Australian banks. These are among

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Speaker 3: the highest rated banks in the world, from mid singlely

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Speaker 3: to high double A. I think the market remains open

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Speaker 3: for these highly rated institutions, and we saw that in March.

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Speaker 3: If you looked at Australian or Canadian banks eighty one securities,

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Speaker 3: they widened along with all the market, although all the

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Speaker 3: other financial institutions, but they widened less than most banks globally,

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Speaker 3: and so I think markets will remain open. But one

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Speaker 3: thing that I would like to highlight is additional Tier

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Speaker 3: one capital is not a requirement for banks. The optimal

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Speaker 3: level the regulator asked banks to hold is about one

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Speaker 3: point five percent of their risk created assets. Most of

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Speaker 3: the banks under my coverage already are at that level

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Speaker 3: or exceed that level, so they don't have an urgent

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Speaker 3: need to come to market to issue eighty one securities.

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Speaker 3: Uh And because these banks are so well capitalized, they

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Speaker 3: don't need to issue because as I said, the one

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Speaker 3: point eighty one as a percentage of risk created assets,

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Speaker 3: it's not a requirement. Is it's an optimal level. But

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Speaker 3: if you have enough core equity, core capital, you don't

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Speaker 3: even need to issue that much.

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Speaker 1: You've talked a bit about extension risk in what you've

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Speaker 1: been writing. What does that mean and why should we

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Speaker 1: care about it?

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Speaker 3: So extension risk is basically, when you buy an eighty

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Speaker 3: one security of a bank, you are assuming that the

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Speaker 3: bank will call those security on the first called it

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Speaker 3: and banks under my cover, for example Australia. Australian banks

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Speaker 3: in the past have always called eighty one securities on

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Speaker 3: the first call date and that's how those securities are priced.

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Speaker 3: We still expect Australian banks to call the eighty one

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Speaker 3: securities on the first call date. The a couple of

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Speaker 3: structural reasons why they would do that because the eighty

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Speaker 3: one high bits. For example, they have a mandatory convusion

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Speaker 3: date three month three years after the first call date,

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Speaker 3: so for them, it makes sense to call the eighty

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Speaker 3: one securities of the first called aid. For Canadian banks,

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Speaker 3: they are not known for calling the eighty one securities

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Speaker 3: on the first cal date, so we don't expect them

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Speaker 3: to call the eighty ones. But Australian banks we two thinks.

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Speaker 3: So in terms of extension risk, I see a little

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Speaker 3: bit for Canadian banks, but not for Australian banks.

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Speaker 1: Okay, So over all the financial institutions. Where do we

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Speaker 1: go from here?

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Speaker 3: I think, as I said before, the risk has shifted

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Speaker 3: to a few banks with idiosyncreative risk, and what I

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Speaker 3: mean by that is banks with more on show loans,

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Speaker 3: what we're seeing with First Republic, where you have a

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Speaker 3: interest only mortgages on your balance sheet. So the focus

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Speaker 3: has shifted to those kinds of banks. So I think

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Speaker 3: overall the risk is going down. But something to watch

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Speaker 3: out is what will be the impact of the crisis

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Speaker 3: we had in March on the economy, the economic growth

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Speaker 3: and credit growth. And that's important why because if we

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Speaker 3: see a significant technique of underwriting standards from here on,

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Speaker 3: that will have an impact on households and businesses, which

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Speaker 3: will in turn have an impact on the labor market

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Speaker 3: right and that will put pressure on borrowers low in

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Speaker 3: the credit spectrum. And if we have that, that will

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Speaker 3: have an impact on the bank's asset quality. And that's

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Speaker 3: what we're watching right now. So I cover the big

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Speaker 3: give US credit card issues, and what I'm watching is

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Speaker 3: asset quality for card issus. With more subprime loans.

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Speaker 1: Surely we're going to be running into trouble and credit cards.

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Speaker 1: Though with the consumer when we tip into recession. I mean,

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Speaker 1: are you're not worried about that?

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Speaker 3: Not really, Because all the US card is shows that

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Speaker 3: I covered, they have ample allowance for credit losses. And

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Speaker 3: what I mean by ample, so all the card is

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Speaker 3: shows have reserved assuming that unemployment will peak at five percent.

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Speaker 3: That's what our in house Bloomberg view is. Even if

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Speaker 3: unemployment goes above five percent. We know that the Federal

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Speaker 3: Reserve last year stress tested all these card issuers at

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Speaker 3: ten percent peak unemployment, So banks have time to add

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Speaker 3: more provisions to their reserves, and on top of that,

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Speaker 3: they have ample capital to absorb any unexpected losses. So

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Speaker 3: I don't think it's a big issue for it's a

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Speaker 3: big concern for credit card is shows now. Obviously the

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Speaker 3: bonds will remain sensitive to a recession, but I think

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Speaker 3: the credit profile of all the US cardish shows should

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Speaker 3: be stable.

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Speaker 1: Are there any that are particularly concerning to you? I mean,

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Speaker 1: obviously places like Amex that have sort of high net

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Speaker 1: worth customers, they're pretty be okay. But the other ones

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Speaker 1: that maybe you know, give cards out to Banana Republic

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Speaker 1: or whatever, are they not going to be struggling a bit?

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Speaker 3: So yeah, as you said, Amex. Yes, they have a

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Speaker 3: more affluent super prime client base, so Amex should be fine.

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Speaker 3: Discovers another one that I cover, again more prime focus.

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Speaker 3: But the two that I'm looking carefully, I think the

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Speaker 3: first one is Capital One because about thirty percent of

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Speaker 3: their loan book is subprime, fifty percent of their auto

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Speaker 3: loan book is subprime. And then the other one is

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Speaker 3: Synchrony Financial, about twenty seven percent of their loan book

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Speaker 3: is subprime. So those are the two we are watching.

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Speaker 3: But these two banks also have higher alarms for credit

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Speaker 3: losses than the other two piers I mentioned with more

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Speaker 3: prime focus, and they also have higher capital. And so

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Speaker 3: even though they are taking more risk, they are actually

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Speaker 3: when the underwrite, the underwrite to the risk, they understand

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Speaker 3: what the risk is, they have higher margins, they have

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Speaker 3: more capital against that risk. So as I said, even

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Speaker 3: though their bond spreads may remain sensitive in a downtown,

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Speaker 3: overall the credit profile of even these two banks should

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Speaker 3: be fine.

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Speaker 1: So you sound remarkably up beaten optimistic, and you know

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Speaker 1: this is a credit show, and I'm very pessimistic, And

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Speaker 1: does Reshmi was saying earlier, there's a ton of things

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Speaker 1: to worry about. What keeps you up worrying mindshew.

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Speaker 3: I think, as I said before, the one thing that

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Speaker 3: I'm looking at is the impact of the banking crisis

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Speaker 3: on the economy and the credit growth. Because, as I said,

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Speaker 3: the subprime blenders that we're looking at, Capital One and

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Speaker 3: Synchrony I mentioned, they still have good regulatory supervision. So

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Speaker 3: those are not the banks that I'm concerned about. I

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Speaker 3: think the risk lies more in the small non bank

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Speaker 3: financial institutions, which they don't have much regulatory supervision, and

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Speaker 3: that's why concerned about. I don't cover those companies, but

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Speaker 3: I think the risk is over there in my view.

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Speaker 1: Thanks very much, she Manchu Bakshi of Bloomberg Intelligence.

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Speaker 3: Thank you, James.

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Speaker 1: You can see all of his analysis on the Bloomberg Terminal.

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Speaker 1: There's a ton of stuff going on in that sector,

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Speaker 1: so do check it out. And thanks again to Reshmi

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Speaker 1: Basu from Bloomberg News.

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Speaker 2: Thanks so much.

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Speaker 1: Read all of her scoops on the terminal and at

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Speaker 1: Bloomberg dot com. I'm James Crumby. It's been a pleasure

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Speaker 1: having you. See you next week on the Credit Edge