Over the past two years, I have become a staunch follower of Martin J. Whitman, a legend in deep value investing and founder of Third Avenue. I have read his book, Distress Investing twice now, and wanted to share some excerpts with you. Hopefully you will pick up a copy too!

According to Whitman, there have been three major trends that have shaped the credit markets since the innovation of the high yield (junk bond) in the late seventies through 2008:

1) Financial Innovation

2) New Laws & Regulations

3) 2007-2008 Financial Meltdown

1) New credit instruments, capital structures, and financial institutions grossly inflated the size of the credit and derivatives markets from the 1980s to 2008. The shadow banking system (SIVs, SPEs) and securities this system issued like CLOs were part of this trend. Credit default swaps eventually allowed banks and hedge funds to make highly levered bets against issuers, directly influencing market perceptions about credit worthiness.

New primary and secondary markets improved liquidity for below investment grade issues in the late 80s and early 90s. Leveraged loans that one would have paid 40 cents for in the 1980s, investors were paying 85-90 cents for in the early 90s through the 2007/2008 meltdown. Almost 70% of leveraged loans were held by nonbank institutions like hedge funds, CDOs, CLOs, etc.

2) After Gramm-Leach Bliley passed in 1999, commercial banks also began to act more like underwrites, completely eschewing credit risks, and collecting fees on originating loans, bonds, and ABS. Securitization allowed for the transfer of risk off of bank balance sheets.

BACPA, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 imposed new time limits for filing a plan of reorganization (POR) and shortened the amount of time required for business bankruptcy filings. It additionally shortened the time over which investors could decide to curtail payments on property and reject non-residential real estate losses. Finally, it curtailed executive pay for firms under Ch. 11 and enhanced vendor rights, so trade vendors were pari passu with the unsecured creditors.

Many of these innovations drove litigation costs so high, that today most of the reorganizations done today are prepackaged or prenegotiated filings.

History

According to Whitman, since 1950, credit market debt has grown at 4.1% in real terms, while GDP grew at 2.7%. In the 1970s, more of the below investment grade debt was classified as “fallen angel,” and was originally investment grade credit. Originally issued high yield bonds, which were unsecured and had much less restrictive covenants than loans, were quite rare. They took the form of Rule 144A securities (unregistered with the SEC).

Junk bonds were unsecured claims usually subordinate to senior loans and senior unsecured debt. But by the 1980s, they were the preferred security for driving LBO and M&A transactions. By 1989, high yield debt consisted of 20%+ of the non-financial bond universe. (to be ctnd…)

Cheers, Tom Rendon

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