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Liquidity, Volatility, and a Credit Bust

A bank expert's take on the markets

FS Insider recently spoke with the Chris Whalen, Chairman of Whalen Global Advisors LLC and editor of The Institutional Risk Analyst. Whalen discusses the big move in high yield spreads, tightening liquidity, and preparations for a credit bust (see Large Funds Preparing for a Credit Bust, Says Chris Whalen for audio).

What Changed in October?

"Two things happened: you had the weakness in the stock market but you also had credit spreads move in a serious way for the first time in months.

Spreads have been relatively muted...[but] when they get too high above treasuries both bond market activity and also other types of risky lending tend to come to a halt.

You saw this in 2016 when China scared everybody and spreads blew out. High yield spreads went to almost 9 percent over Treasuries and everything stopped for 6 months. The ABS market for real estate stopped because people couldn't price anything and they couldn't hedge so they didn't do any deals...

Our population doesn't have any tolerance for corrections, as you know, so the Fed cushioned everything, but now as they stop their extraordinary action and this does unwind we are going to tighten liquidity and also we're going to have a lot of volatility."

Surprise Defaults

"What you’re starting to see now is that the fund community is anticipating that deals are going to get busted because the paper they own is going to get downgraded.

That should concern everyone because what that tells you is the infrastructure in an industry that’s got 12 trillion dollars in total assets is under stress...

When you see negative loss rates for both commercial and residential real estate in the U.S. that means the bank gets all their money back on default and they make more money. Think about that. The loan's completely paid off and they make money at default.

This tells you that those prices are skewed and they're going to go down. They've gone up a lot, they make credit look free for awhile but there's a certain amount of default that's going to come out in those portfolios in the next three, four, five years that I think will surprise people.

Numbers have been so good for the past five years that you almost wonder, ‘Have we suspended the laws of gravity when it comes to credit and real estate?’ No, we haven't, so that's the next chapter—it's going to be three years out and we'll be talking about defaults.”

Credit Problem Coming

"What you're starting to see now is the that the fund community is anticipating that these deals are going to get busted because the paper they own is going to get downgraded.

There's going to be an opportunity to take these old deals apart and buy them into new deals that are basically set up as vulture funds. What this tells you is that we do have a credit problem coming. The street wouldn't be spending time and money on this if there wasn't an opportunity out there."

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