Market data provided in this post was accurate as of the time of publication, (4:30 p.m. ET on March 23, 2020), but may quickly become dated given current market conditions. Data seen here should not be used for any analysis or transactions.
This past week saw no abatement to the market uncertainty and volatility that had characterized the previous two weeks. Against the background of the widening impact of coronavirus on U.S. economic activity as more businesses have temporarily shut down or curtailed activity, and consumer activity has declined with more of the population restricting travel and trips out of the home, one of the major themes impacting our client base has been severely tightening credit conditions. Key economic indicators over the past few weeks show all the signs of these conditions and a “flight to cash” (or more specifically a “flight to the U.S. Dollar”) as market participants look to build up cash reserves to weather what is looking more and more to be a protracted period of economic contraction. The strengthening of the U.S. Dollar Index (USDX), measuring the strength of the U.S. dollar against a basket of major currencies, reflects the increased dollar demand from foreign central banks and corporates with dollar denominated obligations. The cost to insure against default on corporate debt has spiked as the market perceives a much more difficult funding environment for corporates. Similarly, the price of insuring against defaults by banks on their debt and their cost of short-term capital have both increased.
These circumstances led to one of the most eventful weeks in the history of the Federal Reserve, which has taken a wide range of policy actions to try to ensure continued liquidity in credit markets. To summarize what we’ve seen over the past week:
- Sunday, March 15: The Fed cut the target range for the Fed Funds rates to 0-25 bps, and announced that it would purchase a minimum of $700 billion in Treasury bonds and MBS in the coming months. It struck agreements with five foreign central banks to provide access to inexpensive U.S. dollar liquidity, and it reduced the rate and increased the term at which banks could borrow on an emergency basis at the discount window.
- Tuesday, March 17: The Fed announced the Commercial Paper Funding Facility (CPFF), establishing a Treasury-backed SPV that can purchase up to $1 trillion in commercial paper. It also established the Primary Dealer Credit Facility (PDCF) which offers financings to large banks in exchange for collateral in the form of a wide range of corporate bonds, commercial paper, and municipal bonds. These measures are both aimed at encouraging continued lending in corporate and municipal credit markets. The Fed also announced twice daily $500 billion overnight repo operations for the remainder of the week, designed to ensure continued liquidity in repo markets.
- Wednesday, March 18: The Fed announced the Money Market Fund Liquidity Facility (MMLF) which will lend cash to banks to buy Treasuries, agencies, and commercial paper with terms of 12 months or less from Prime Money Market funds. In normal markets, these funds are significant providers of short-term liquidity to corporates, taking cash from their investors and purchasing commercial paper from these corporates. As investors have flocked to cash, however, these funds have faced redemption requests that have reduced their ability to supply liquidity to corporates. This facility is designed to allow these money market funds to continue to provide funding even in the face of these redemptions.
- Thursday, March 19: The Fed expanded its dollar liquidity facilities to nine additional foreign central banks.
- Friday, March 20: The Fed expanded MMLF to include certain types of municipal debt.
- Monday, March 23: The Fed expanded its bond buying program (announced on March 15) to include Agency MBS and clarified that its securities purchases could essentially be unlimited and well in excess of the $700 billion minimum previously announced. It also announced three new lending facilities designed to provide up to $300 billion in additional liquidity to consumer and corporate credit markets: the Term Asset-Based Securities Lending Facility (TALF), which was previously used in 2008 and provides funding to investors seeking to purchase securities backed by consumer debt; a facility to provide bridge financing to investment grade corporates; and a facility to purchase corporate bonds issued by highly rated corporates and ETFs operating in the investment grade corporate bond market.
Tightening credit conditions have had immediate impacts on our clients:
- Changes in base rates: As is evidenced by the chart below, base indices for floating rate loans have behaved in a way contrary to their typical relationship to the Fed Funds rate. Many of our clients borrow on a floating-rate basis in LIBOR or, when accessing the tax-exempt market, at a weekly remarketed tax-exempt rate (a good proxy for which is the SIFMA rate, which is based on the weekly remarketed rate for a basket of tax-exempt bonds). In normal markets, these rates tend to follow the Fed Funds rate lower—as the Fed cuts this rate, borrowers typically see the cost of their existing floating-rate debt decline. As funding markets have become stressed, though, we’ve observed the opposite happening—LIBOR and tax-exempt rates have risen relative to Fed Funds. LIBOR has increased as banks have seen rates on the commercial paper they issue go up (LIBOR is now calculated in part using bank commercial paper rates) and tax-exempt rates have increased as the Money Market Funds that purchase tax-exempt debt have backed off from this market in the face of investor redemptions. Apart from the immediate impact this has on interest expense, it also factors in to how many clients are looking at swaps on floating-rate debt. With LIBOR currently at ~95 bps, but longer term swap rates much lower (1-month LIBOR loans can currently be swapped to fixed at rates of ~42 bps, ~53 bps, or ~64 bps [before transaction costs] for periods of 5, 7, and 10 years, respectively), there’s perception of opportunity. We encourage clients to consider these opportunities but also to consider that floating rates may fall quickly if and when stresses to short-term funding markets are relieved.
- Changes in swap credit charges: Even as swap rates have declined, we have started to see some hedge providers increase the transaction-specific mark-up they add to these base rates. We see this occurring as a result of two factors. First, as rate volatility increases, providers observe larger potential exposures on the swaps they provide, which translates into higher capital charges. More broadly, just as credit is generally becoming more expensive (regardless of the specific market) the cost for swap exposure seems to be going up as well.
- Lending terms and availability: Over the past two weeks, our valuations practice has performed coordinated outreach to market participants, including many Chatham clients, for market color to better inform Q1 debt valuation conclusions. As a result, we’ve been able to observe rapidly changing conditions in lending markets across asset classes and lender types. Unsurprisingly, we hear that lenders are not pricing hotel and some retail transactions. In other asset classes, we see some clients able to get deals with pre-existing signed terms sheets across the finish line, though we’ve begun to see more situations where deals have been pulled or terms adjusted. Many lenders are still quoting new deals but there’s a strong sense that this is day-to-day guidance and could change on a moment’s notice. We observed a dramatic deterioration in the credit markets from the beginning of last week to the end of last week, and that deterioration has continued over the weekend. Some interesting anecdotes we’ve heard over the past week include:
- In the multifamily space, we’ve seen pricing sheets on Agency deals with spreads in the 240-280 range and anecdotes of spreads exceeding 300.
- LIBOR floors in floating-rate loans have increased. Non-bank bridge lenders are quoting deals now with 50 bps and 100 bps floors, and we’ve seen some bank balance sheet lenders quoting deals with non-zero floors. We’ve even seen some situations in which floors have been adjusted on active deals, including one in which the floor was increased from 0% to 1% (changes in LIBOR floor levels on loans have material implications for any such floater being swapped).
- We’re seeing significant impacts in the bridge lending space as debt funds and other bridge lenders that rely on repo lines for financing see their funding sources dry up or reprice. This is the sector of the lending market where we’re seeing the most situations of lenders going “pencils down” on or repricing previously approved deals.
We’ll continue to provide updates as we see market conditions evolve, and implications for our CRE clients change. In the meantime, please don’t hesitate to reach out to your Chatham representative with questions on any of the themes above.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0085
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