Life and Death

The Credit Strategist Blog

Many important industries are facing existential challenges in the coming months.

Commercial real estate was described this week by The Wall Street Journal as potentially entering a “doom loop” in a well-researched deep dive into the industry (“Real-Estate Doom Loop Threatens America’s Banks,” Sept. 6, 2023). Banks (mostly small and medium-sized banks) roughly doubled their lending to landlords to $2.2 trillion between 2015-22. But their exposure is even larger; indirect lending brings banks’ total exposure to commercial real estate (CRE) to $3.6 trillion according to the Journal’s analysis. Potential borrowers report that banks are pretty much out of the lending game right now as they try to shrink their exposure (which in many cases is backfiring and leading borrowers to hand them back the keys to distressed properties). And non-bank lenders (private credit funds, mortgage REITs and bond investors) are unlikely to save the day as they are stuffed with bad loans and rely on banks to provide them with financing (which is no longer forthcoming). Approximately $900 billion of CRE loans come due by the end of 2024; it’s a fair bet that a decent percentage of those loans will default. This is what happens at the end of a bubble, but as usual people acted as though interest rates would stay low (low? at zero!) forever. Investors should keep this in mind in the future. Many of the so-called titans of real estate turned out to be midgets.

Corporate credit quality is slowly and steadily eroding under the pressure of higher interest rates. EBITDA/Interest expense declined from ~5.0x to ~4.0x over the last year (it hit a low of ~3.0x during the pandemic in June 2021) (Source: Torsten Slok, Apollo Chief Economist). Since EBITDA is often grossly inflated by bogus non-cash adjustments, interest coverages are likely much weaker than these numbers indicate. Leveraged borrowers refinancing today are paying significantly higher borrowing costs than during the last cycle which is one reason why leveraged buyout activity has slowed to a crawl (which is a good thing for the economy and the world in general). Private equity is in a decided down cycle (though you wouldn’t know that from the performance of the stocks but if these firms every honestly mark their portfolios to market perhaps this will change).

Regional banks continue to suffer from reckless real estate lending and poor balance sheet management. Those that managed to survive the crisis that sunk First Republic Bank earlier this year are still carrying heavy mark-to-market losses on their bond and real estate portfolios while they lose deposits to more attractive Treasury yields. Banks with under $100 bn of assets have CRE exposure equivalent to 279% of their equity cushions according to Moody’s, which downgraded ten small and mid-sized institutions in August and placed some larger ones on watch for downgrades. We should expect more bank mergers as the big banks get bigger and the number of banks in America keeps shrinking. No need to worry about antitrust enforcement here - the government will prioritize protecting depositors and the banking system from collapse now that the world of ZIRP/QE is over. The damage wrought by the Fed is truly incalculable.

Hollywood is engaged in a truly existential battle over how to cut up the revenue pie with no clear answer on who wins and who loses. What is clear is that NFLX unleashed a true revolution in the industry, creating a new delivery model in streaming that turned the traditional model totally upside down by effectively disarticulating traditional and cable television delivery systems. Add to that the threat posed by artificial intelligence (AI) to writers and actors and the industry is left trying to figure out how to reconstruct itself from the bottom-up. At the same time, some of its biggest players (DIS, WBD) are wrestling with massive programming/streaming losses and high debt levels in the wake of huge business combinations that are hurting profitability and disrupting their internal cultures, putting the entire industry on edge. The final piece of the puzzle is the entry of FAANG competitors like AAPL and AMZN who are outspending the networks and studios for sports and entertainment programming ($18-20 million per year for a football announcer? Really?) (and that’s before Mideast sovereign funds join in the fun). Hollywood as we know it is dead; the question of what replaces it, and the economics of what replaces it, remains unanswered while many talented people remain out of work.

All of these industries that are now under pressure benefitted from low interest rates that enabled them to borrow money to fund projects that never should have been done in the first place. Lower interest rates lower the intelligence of the people borrowing money; it’s just human nature to drop your guard when you are paying 5% interest instead of 15% interest for a risky project that should be financed at 15% and not 5% (or more likely not be financed at all). Think of that 10% difference as the stupidity quotient that gives people the courage to do things they shouldn’t do like overpay for a company or a building or finance a film or television series that nobody wants to watch. The result is billions of dollars of write-offs occurring in all of these industries for projects that never should have seen the light of day.

Debt can be a form of death because it can kill a company if it can’t be repaid. Nobody thinks of it that way but if they did there would be a lot less of it.