Could CLOs Trigger the Next Financial Crisis? (w/ Dan Zwirn)
ED HARRISON: Ed Harrison here for Real Vision. I'm talking to Dan Zwirn, who is the CEO of Arena Investors. Dan, great to have you here for debt week. DANIEL ZWIRN: Thanks for having me. ED HARRISON: I think before we came on camera, I was telling you off camera that we're having what's called debt week, with the beginning of 2020. The reason that we're talking about debt is because a lot of people don't understand that debt is actually a bigger market than the equity market is. That's right, isn't it? DANIEL ZWIRN: Yes, the debt markets overall are far larger than the equity markets across loans and mortgages and tradable bonds, and treasuries, and all the different obligations out there. There's an enormous number of things to choose from when you're thinking about playing the markets. ED HARRISON: Give me a sense of the comparative size of the market because when I look on television, I get the sense that it's all about stocks. DANIEL ZWIRN: Yeah, well, you can imagine, there are literally trillions of different opportunities out there and in fact, we've never had more debt than we do now because of the tremendous amount of issuance that happened over the last 10 years. A lot of that debt ends up getting bought by the very same people who issue it when you think about the sovereigns globally. Basically, if you're an owner of an asset, there's never been a better time to raise debt against it. ED HARRISON: Now, we're going to do a soup to nuts conversation on debt, because my understanding is you look at a full panoply of different markets, where their potential dislocations. I think of it, there's this term that I came across called fingers of instability that accumulate over time and then at stressful points, maybe you'll have a trigger, and it will cause a mini crisis or a larger crisis, like we had in 2008. Your thesis is basically that it's not a question of if, it's a question of when we get to the next crisis. January 13th, 2020 - www.realvision.com 3 The Interview: Profiting from Mispriced Credit Risk DANIEL ZWIRN: Yeah, I think there's two parts of it. First of all, there's always some combination of industry product geography where there's a debt crisis ongoing whether that's due to a particular issuer or a particular country or other geography, like a Puerto Rico or a Greece or an Italy, or whether that's related to a particular industry like oil and gas, there's always something going on. When we look at all of the things out there, we're always comparing risk reward and thinking where are people running from, so that we can take a look at where we might want to place ourselves. At the same time overall, there can be-- at the end of the day, everything's correlated. There are times of extremes like in a way, or a 102 or 98 or 94 where a lot of the issues that arise in one or more market starts to bleed into the other ones. In an ideal world, we like to avoid macro views generally, because markets can be if you will, stupid longer than you can be solvent, so to speak. We try to focus on where the actual idiosyncratic or alpha related distortions are the greatest. ED HARRISON: One of the things I guess that I'm thinking about is the length of this credit cycle or this business cycle. You hear the term that we're near the end of the cycle and as a result, these kinds of issues are things that we want to talk about. Before I go into what those issues are, because I think you have an interesting framework, what does that term we're late cycle, what does that mean to you? DANIEL ZWIRN: Well, I would say it's hard to discern and that we simply, as [indiscernible] of a matter, don't have that many data points, depending on who you look, who you speak to, and the data that you look at. Perhaps we have 100 or 300 or 600 years of data, depending on what markets you examine. To draw any particular conclusions other than what goes up must come down is difficult. Certainly since '08, we have had a series of basically market distortions created by primarily developed market monetary authorities that preclude actual risk from being appropriately priced. It's been a long, long time since there's been legitimate price discovery in the markets. At the end of the day, when you look at even equities, equities are ultimately the derivative of the credit markets. They're just the thing at the bottom of the capital stack. Over time, people compare dividend yield on stocks with yields on debt. That entire structure has been distorted by monetary authorities effectively underpricing the front end of the term structure of risk reward. What we have is a whole series of distortions that have arisen when that bubble ultimately pops unclear, because when you keep rates flat or negative and there's very little premium put on top of those rates to price risk, ultimately, issuers that are not terribly credit worthy can frequently afford to pay very, very minimal rates to sustain a level of principle and particularly, when structures are really weak, can live to fight another day for years and years and years. When we look at the world, we don't want to focus on what the greater fool may do or what might happen. We try to focus on places where those distortions have presented themselves typically in some particular, again, geography or industry, etc., that allow us to hopefully take advantage. ED HARRISON: I want to get to that, this specific markets that we're going to be talking about, but first, let's go to your framework in terms of what you were thinking about in terms of where these fingers of instability are. That's because since 2008, there've been some institutional changes within debt markets. I think you enumerated five basically that are critical to thinking about how this could play out. Can you go through step by step, maybe we'll go through the five, one after the next? DANIEL ZWIRN: Sure. Well, I would first say I enumerated those five factors in an academic paper. There's only a subset of those things that we see that were able to be substantiated in an academic level. It's not to say that there are no other factors that we see in the marketplace every day, but it's hard to get your arms around some of the numbers. With regard to those five, I would start with collateral. At the end of the day, a number of folks look at default rates as an example. When they think about the quality or lack of quality of debt obligations, what we have seen is that at the extremes, if I have incredibly weak covenants, and I charge a really small coupon, well, then I can have no defaults. People tend to-- agencies and other evaluators of credit, look at coverage meaning how much cash there is to cover the obligations that I have from my debt instrument. Well, again, if I don't charge a whole lot, then I can have high coverage and I can be comfortable. Nevertheless, I may have an actual overall obligation that's very large. In fact, maybe larger than my asset value. We like tend to look at leverage, not coverage. When you just dispassionately look at the amount of leverage in the system across corporate property, structure, finance, consumer and other personal applications out there, what you see is an enormous amount of debt relative to the underlying asset value. Actually, you have a tremendous appreciation in asset levels. What is not necessarily understood is the degree to which people perceive there to be substantial equity value, because debt is cheap and lenders tend to-- there are situations where lenders tend to price very low because they perceive a lot of equity value. Those two things are not independently evaluated. They're effectively a zero sum. ED HARRISON: Basically, you're saying that equity is the residual value with debt at the top of the stack? DANIEL ZWIRN: Correct. We're at historical highs in terms of the enterprise value divided by cash flow that people are willing to pay for businesses or assets. Part of that is because we can access very cheap and large amounts of debt that allow us to make equity returns that we otherwise wouldn't have been able to make. At the same time, providers of debt are saying, well, this, I have real confidence that my loan to value is relatively low because of all the equity that these people with equity are willing to put in underneath me. Effectively, it's like two drunken sailors keeping themselves up. At some point, one of them might stumble over. When you look dispassionately at the credit statistics out there, you're seeing enormous amounts of debt relative to asset values, you're seeing structures that are very, very weak, where people are not getting appropriately protected as creditors at the top of a capital stack. You're seeing terms in duration, which effectively, we have not seen the intrinsic risk of duration priced as low as it has for decades. Everything is set up for such that people are not getting compensated for risk they're taking. If you look at the stats across the-- and I think we go into the second area, the ratings agencies, you're seeing a tremendous amount of BBB relative to the rest of high yield. Why is that? Because there's a very particular subset of investors that will only invest investment grade and above. There are tremendous incentives to do a whole lot of numerical gymnastics to be able to access an investment grade rating that otherwise perhaps 10 years ago, wouldn't have been given in order to access that group of investors that tends to be comfortable taking a relatively low return for any given risk that they're assuming. ED HARRISON: Let me back up on two things because yeah, and by the way, when you were saying that, I was thinking about David Rosenberg, as I spoke to him, and he was talking about this too, I want to get a point in about the credit quality of BBBs relative to what they were before. The interesting thing, I think maybe this is a rhetorical question on some level, because you mentioned the Fed and other central banks in the developed economies. Why is it that these investors are not being compensated for extending out for duration, or for taking on the risk that they're taking off? DANIEL ZWIRN: I think it comes down to the sheer supply and demand. There's only so many issuers. There's such a tremendous volume of capital that needs to be deployed, it needs to attempt to get some level of return, that people are willing to accept historically low levels of return when they think about the return they're getting relative to the other alternatives they have. When you see, unfortunately, a vicious cycle where if you lower rates, you make that hunger for yield all that greater and we'll have people who are willing to buy more of it and take less return over time until the market tells them no. ED HARRISON: One of the things that hits me when you talk about this is this whole concept of servicing debt. Debt service costs being the marker versus leverage. To me, that smacks of hubris in the sense that as soon as rates go up, those debt service costs go up and suddenly, you have what seemed like low default rates not become low. DANIEL ZWIRN: Sure. Well certainly, that's certainly the case with regard to floating rate obligations. Ultimately, even fixed rate obligations as a reprice will be priced against the available floating rate and move up themselves. What I think is not taken to account by investors frequently is the fact that there's a level of correlation between risk free rates and premium to risk free. If you see a real move up in risk free rates, ultimately, you frequently see big moves up in spreads. At same time if both happen, you have potentially a reevaluation of the underlying asset yields necessary to appropriately compensate investors for owning assets or enterprises, and therefore a material decline in not only asset values as you perceive, but also more importantly, equity values that are subordinate and effectively managed by that debt. These things can spiral out of control as they have in prior crises. That said, again, there's tremendous incentives on the part of monetary authorities to keep rates low as well as support the term structure of risk through other means, including buying obligations directly in the marketplace. I think while a crisis is not inevitable, it may be highly likely and in fact, it may ultimately be preferred, because I would argue that what is inevitable is either a crisis or a long term malaise. Where, as an example where you have Japan, already at and potentially Europe going. That's not such a great thing either. We have this tremendous number of distortions happening because risk isn't appropriately priced and because price discovery is not out there. In fact, that leads to the third issue, which is that-- in addition to the fact that collateral is relatively misjudged in terms of its underlying risk, and in addition to the fact that it's not necessarily evaluated appropriately by available agencies, you have the fact that in the wake of the crisis, the number of people who are willing to make markets in fixed income across the world is very low, and to the extent that they're willing, their abilities is in turn very low. ED HARRISON: Why is that? DANIEL ZWIRN: Well, I think part of it is that there's been a tremendous level of pressure, perhaps rightly applied post-crisis on banks, that that participate in market making. One, to effectively put capital up against certain obligations in their balance sheet at levels that really preclude them from owning that risk in the first place. Second, through the Volcker Rule and other rules that they have to follow, there is a tremendous level of pressure for them not to effectively take a proprietary position. Unfortunately, in over the counter markets, the difference between making an OTC market and taking a proprietary view is very hazy. Why take that risk when the downside of doing is so great? ED HARRISON: That means basically, liquidity has been shrunken over time. DANIEL ZWIRN: Tremendously so. As an example, we, in our business, we owned a few million bonds of a-- have a $400 million issue and decided, after doing additional work, that we didn't want to be involved and it took us almost two weeks to get out of just a couple of million bonds. The reality is, and that turns to a another factor we see out there, not one of the five, but as a general whole, there have not mentality which is that if you already have, whether it's corporate, again, property, consumer, etc., there's really no lower bound on the level at which you can borrow. If you are have not, there's really no price you can pay to get access. What happens is if you have an obligation of one of those have nots, it's effectively a permanent holding until you effectively get your hands on the assets either through a maturity or covenant violation, etc., and effectively forced the monetization. That then leads to yet another factor, which is the mismatch in assets and liabilities across many of the entities that have been raised in order to house a lot of this fixed income. You'll see in mutual funds, shorter term, shorter duration hedge funds, ETFs and others, situations where there's a presumption that you'll be able to sell the obligations in order to deal with redemptions that's not really there. In fact, even in the last couple of years, you've had situations in Europe where there are property trusts, effectively, that own giant real assets that are levered, that are daily liquidity open ended and people somehow still are surprised when in fact, the redemptions come that they can't effectively sell those buildings on demand. ED HARRISON: I call this fake liquidity basically in a sense that the underlying asset is illiquid and then you have a liquid trading ETF or other asset on top of that, and people get the sense that I can get in and out of this when actually the underlying asset, there's a mismatch there. DANIEL ZWIRN: Either you in fact, won't be able to get out and redemptions will be suspended, or there'll be relatively low correlation between the price of the ETF in which you're invested and the actual price action in the underlying assets. Either way, you're not getting what you thought you would get. ED HARRISON: You could see net asset values of these ETFs, they could trade well below the stated value, because I'm thinking about it-- DANIEL ZWIRN: Not an open-ended. In open-ended structures, the nav is the nav. In close-ended, you can have a discount to nav. That's fine, because there's a fixed number of shares effectively, and those trade where they trade independent of the nav. When you have open-ended and you have redemptions, people actually need to get their money. You have things like the breaking of the buck that happened in the-- ED HARRISON: In the money market fund. DANIEL ZWIRN: The money markets. I think there has been relatively little focus by regulators on this asset liability mismatch out there because it presumes a backward looking view at what obligations had liquidity at one time. Don't be surprised and if you go back to for instance 1998, between August and December, there was basically just no trading in anything OTC. ED HARRISON: Oh, yeah, I remember that. I was rotating through at Deutsche Bank on a synthetic product market for Russian currency obligations or actually Russian-- I forgot what they call them now, but basically, that whole market blew up and there was no trading. People were panicked as a result of that and that's when the Fed had to step in or those companies stepped in. DANIEL ZWIRN: Well, and by the way, that leads to the fifth of the five factors that I wrote about, and that is that the regulatory control has been far greater now. Many years ago, people who had hedge funds didn't necessarily have chief compliance officers or general counsel, or third party marketing. There's a lot of things that have been instituted since those earlier times that may mean, that may point to situations where effectively people are going to shut down or suspend redemptions because they can't strike in half. As an example, in '07, when you saw BNP Paribas Mortgage Fund had issues, part of the problem was they couldn't actually strike a nav they couldn't get prices and so they said, okay, well, no investors can move it around. That, in turn, creates panic. ED HARRISON: To me, this liquidity issue-- there are tons of other things I want to go back to on those five because it's great, especially with regard to the ratings agencies, but this liquidity issue, I find it very pernicious. When you think of potential triggers for what I would call contagion, to me, that's a primary vehicle. DANIEL ZWIRN: Sure. Well, I think you never know where it's going to start. When you saw what happened in Asia, those were issues that had arisen in the early mid-90s that didn't really catch fire until '98 with the Thai baht issue. I think at the same time , in '07, you could have pointed to many different subsets of fixed income where pricing was really, really off but it happened to be the fire started in residential mortgages. What we all know today is whatever it is, that will cause it will be something unexpected, whether it's something like those two situations or there's an enormous fraud like what happened in WorldCom where the market suddenly repriced in the wake of the revelations that occurred in that company. You just don't know where it's going to come from. ED HARRISON: Just to back up a second, your second thing when you're talking about the ratings agencies, I thought that was interesting, because basically, you were saying that 10 years ago, we could have had debt to EBITDA ratio or leverage ratio of x. Now, we can have 1.3 x. The ratings agencies will give us the exact same rating that we had before. Why is that happening? How is it that the ratings agencies are not cracking down on that? Why are they letting this slow bleed into basically BB statistics for all these BBBs? DANIEL ZWIRN: Well, today's BBB was yesterday's BB. I think I was actually invited by one of large agencies to come in and discuss this, and I don't think they'd agree with me. Nevertheless, I think the statistics do point to it. Furthermore, I think that even if you assume a static level of, as an example, debt to EBITDA, what counters EBITDA these days is much different than before. There's these tremendous numbers of different adjustments that are taking into account even all things being equal with regard to the credit stats that exacerbate that issue. Ultimately, what you've seen is that when individual names even in the last quarter or two quarters, correct, they correct big because there's a total reevaluation effectively moving the credit from a have to a have not very suddenly. They're the step functions downward in pricing. ED HARRISON: One other issue, before we go to individual asset markets, that I thought that just jumping back to this leverage, or rather to the liquidity issue that I found very interesting, I read the paper that you had co-written about the illiquidity and one of the things that you mentioned that caught my eye was the fact that if you have a stock, let's say the stock of GE as an example there's one stock common equity. It's liquid traded over a market. If you have a bond, first of all, as you had mentioned, it's OTC where the markets happen, there's no New York Stock Exchange, but also you have discrete issues that are much smaller and so the liquidity is almost automatically constrained in those markets. DANIEL ZWIRN: Yes. Well, I think part of where we've seen opportunity in the tradable markets is that these days, there are relatively few folks who are simultaneously looking at, as an example, bank debt, all the bond issues, CDS, stock and options. There are situations where there are distortions even within capital structures. We see situations where effectively, we can create cheap options, cheap put options, cheap call options, through different combinations of those securities that will never require us to seek a bid from someone else. A key thing that certainly I learned pre-crisis even was that in some of these OTC markets, there are a subset of opportunities available that are effectively self-liquidating. You can be effectively someone who benefits from the lack of liquidity by having a bid when people don't want it in that subset of situations that are selfliquidating so you yourself don't need that bid. You're never allowing to be the greater fool. ED HARRISON: Well, let's go through some of these markets one by one. One that doesn't get a whole lot of mention that I find interesting, because it goes to the reach for yield is private credit. Private credit, my understanding of it is that people said, look, we're long term investors so we don't really need to have liquidity. We can invest in these private credit actions, and wait it out for the long term. What's going on in that market? Why is that not a-- and as a result, we can get a higher yield, obviously. Why is that not a story that that that makes sense? DANIEL ZWIRN: Well, I think the original thesis was that there was a difference between obligations that were traded and/or had two sets and private obligations. The underlying presumption is there's a different level of liquidity and by not having a CUSIP, or not being traded on a desk, I should get paid more. The reality is that difference is not really there. The reality is that the leverage loan markets and the middle market, lending markets, effectively price against each other and so there's been a real harmonization between those two markets. That's point one. Point two is the notion that I am somehow intrinsically more patient, so I don't need market making to be there. May or may not be the case. However, what it doesn't take into account is effectively the fact that the longer I have a debt obligation, because I'm never going to get paid more than par, so the longer a debt obligation I issue to a borrower, the more put optionality I'm short. Effectively, throughout the life of that loan, I can only make my coupon but I can lose it all at any given time. If I can only lose it all for two years versus only losing it all for 10 years, all things being equal independent of market making capability, I'd rather have the two years than the 10 years. When you look at the differentiation between pricing of things that are short versus long, it does reflect that. People have been willing to effectively be super borrower friendly in that regard and that will ultimately cause problems. Third is the aforementioned drunken sailor issue, which is that in the middle market, lenders are taking comfort from the fact that, well, geez, if I lending it seven times, and an equity sponsor is putting up four times, I must have an LTV of seven divided by 11. Ultimately, the equity provider is paying that equity out to the seller. It's not somehow staying in the enterprise. Independent of what the equity sponsor viewed to be the enterprise value of the enterprise, I'm still out seven times. In fact, it may very well be the case that instead of seven divided by 11, my LTV is seven divided by eight. Then the question is, am I getting insurance premium and appropriately paid, the equity provider might be willing to pay, provide that four terms of equity, because the pricing of my debt is so cheap that he can still make an equity return. Whereas at the same time, I take comfort somehow as a lender in lending seven times, and then somehow then willing to charge really low because of the presence of that four types. The two work together to effectively overprice an asset and put the asset in a position where the equity is disproportionately paying up but also taking advantage of the amount of debt, the pricing of debt and the duration of debt as well as the structure of it. ED HARRISON: Related to that, I guess, is leveraged loans when in that when we're talking about this market for bank loans, there's a tradable market for bank loans, leveraged loans and a lot of people that talk about high yield and leveraged loans as a collective market, which is of the size of the mortgage market. Dislocations there could be a trigger point in a crisis situation, what's going on in those markets? Do you think there are opportunities there? DANIEL ZWIRN: Well, I think there are clearly ultimately going to be opportunities because the credit statistics don't make a lot of sense. If there is a reason that those opportunities may present themselves, it's because a number of middle market lenders themselves are levered typically two to three debt to equity in their own capital structures, which are then using to make loans to issuers. In fact, even more CLOs are 10 or more times levered and owning these obligations. Now, those who are saying what about those markets, say, well, versus previous times, there's a level of asset liability matching between the owners of CLOs, and the capitalization of the CLOs and the underlying obligations. True. However, that doesn't take into account the fact that there are effectively triggers in the capital stacks of CLOs that may shut off distributions of certain pieces of those. Furthermore, that, in fact, while it was the case that a lot of that really bad CLO equity did come all the way back post-crisis, that doesn't take into account that ammunition in the quality of the collateral, as well as the intrinsic notion of if I am a semiinstitutional owner of a CLO equity, and I get a statement saying my equity is down 90 cents, am I going to just calmly be able to tell my stakeholders that somehow, it's going to be okay if we all just wait a decade? The answer is probably not. There's a lot of reasons why the three can be issues. Again, in the last couple of quarters, we've seen that rise where a given leveraged loan that is relatively low quality has turned out to be owned almost exclusively by CLOs. When you take that issue, and the fact that they don't want to own collateral that could cause triggers in their own CLO structures, and they want it and you combine that with the fact that there's relatively little market making and in fact, relatively little ability even to get information on the credit, what you have is that when there are issues in those underlying credits, all of the owners of it want to sell all at the same time and have a bunch of buyers who are not located, a bunch of intermediate who are not transacting and information that's not well distributed in order to make a market happen. What you've seen then is step function down pricing until it finally clears at some really tough level. ED HARRISON: Doesn't it have a knock on effect to the other issuers that are within that same collateralized loan obligation? DANIEL ZWIRN: Yes. Well, this is a great example of one of the factors that I consider putting the paper but it was hard to get numbers around in order to substantiate an academic level. What we've seen anecdotally is you suddenly start to have credits that are owned by different structures, different organizations, different funds, different CLOs, each of whom have their own particular interest in situations, and we've seen firsthand situations where, as an example, a creditor's willing to do things that are really unnaturally generous to the equity owner in order to not acknowledge the credit problem that's there, because they don't want to trigger something in their own structures that may hurt their own credit. If that happens, and you happen to be a creditor that just wants its money back, you're going to have conflict, not only with your borrower, but with your fellow lenders. ED HARRISON: At a macro level, when we talk about CLOs, collateralized loan obligations, to me, it strikes have mortgage backed securities in the sense that you're taking credit and you're putting it into a structure slicing and dicing and so forth. Can you give viewers a sense of what's going on in that market? What's going on in the whole collateralized debt obligation market and how CLOs, collateralized loan obligations, are coming to be an outsized portion of that market? DANIEL ZWIRN: Well, I think what you fundamentally-- if you boil it down, what you have going on in that market is very similar to what you had in the mortgage market, which is that ultimately, it's very unclear who wears the risk. There's a tremendous amount of incentive throughout the chain of value for more and more paper to be issued, and very few people thinking about what the outcome is going to be. Why is that? Well, because if you look at these very leveraged structures, in many instances, the manager of that leveraged structure is not the owner of the residual risk of that structure. Therefore in time where rules around creating what they call skin in the game, where the manager needed to have exposure to the obligation, those were effectively taken away again. What happens is there's a whole lot of people who own that risk without managing at the same time. Therefore, if I'm a manager who's taking no risk, by its end, it is just to manage more under any circumstance, because I'm not going to be suffering the consequences. Similarly, in the residential mortgage markets, you had that type two, which was that not only that do you have that same dynamic, but you had originators, who weren't going to wear the risk who just needed the originated, owners, managers of the risk, who just needed to own collateral of some sort, and weren't taking the risk. On top of that, you had effectively managers who were able to get short certain of the obligations so not only were they not interested in the positive outcome of the deal, they were interested in the negative outcome of the deal. ED HARRISON: That sounds just like the mortgage market. DANIEL ZWIRN: Yeah. We haven't seen people materially-- I have yet to hear of CLO managers writing effectively getting long protection in components of their deals, but every other piece of the data incentive cycle or structure is there. ED HARRISON: Interesting. One market that I think that you expressed some interest in before we got on camera was about the commercial property market. When you talk about commercial property, it goes back to the story I was telling you about with the highline and how I used to live there 20 years ago, and how it's just unbelievable how much building's going on there. That at some point, it seems to me that that's not going to come to good. What's going on in that market? What are the pitfalls there? DANIEL ZWIRN: Well, I think throughout urban markets in the US, you're seeing very, very high prices driven again, by access to capital and the energy pricing of capital. That's not only with regard to existing assets, but also it's very much encouraged the building of new assets. I think if you surveyed people in a number of the largest city markets in the US, what you'd see is occupancies are starting to get shaky, rental levels are starting to get shaky. The ability to sell out condos is starting to get choppy, and there are a number of people with construction loans that are very nervous. We like those situations. In fact, in Manhattan, we purchased a mortgage loan, have a situation where there was-- you would have thought it would have been a relatively easy sell out whereas unfortunately, we're going to have to go to a effectively a multifamily rental business plan in order to make it work because the bid's not there on the condo side. That's already happening and showing itself. ED HARRISON: When you look at this, are you looking at it from the long side or the short side in terms of here's a distressed market and I could get in long or this is a distressed market and I think that actually bad things going to happen? DANIEL ZWIRN: Both. In direct obligations where we are and are looking to buy existing obligations at discounts, either reprice or restructure commercial real estate assets, but also looking to make new loans in situations where people are stuck in some way. At the same time, within the tradable markets, there are certain situations where you can create either short situations or cheap put options. For instance, in situations where, as an example, a lender might have-- that's publicly traded might have overlent to some of these urban markets and you can create a structure using different capital structure components. That leaves you effectively net short the outcome there in a very, very leveraged commercial real estate lender that is exposed to these markets. That actually allows us to create a very interesting, compelling cheap put option, but also one that it's inversely correlated to a lot of the other bets we have. ED HARRISON: Which markets in particular do you find interesting. You mentioned New York, any other markets that you're interested in? DANIEL ZWIRN: We've been involved recently in Miami, San Francisco, LA, I think Chicago, we're involved at all of them. I think you're seeing the very beginnings of real issues there. Again, those have been fueled by cheap access to debt financing, cheap access to securitization markets, and this hunger for yield. I think we'll see that moving along. ED HARRISON: One other question I had on that is that when you talk about commercial real estate, there is the business side that is where I'm running out to businesses, but there's also I'm renting out to families, multi-families, etc. Then there are within the family sector, there's the entry, mid-level, luxury, super luxury. Now, anecdotally, I understand that at the very high end, there's a tremendous amount of overbuilt in Miami in particular. Any thoughts on that? DANIEL ZWIRN: Well, there has been. We actually are a very significant residential mortgage lender in Miami, and in related markets. We do it in a way where we're focusing on non-US citizens. Instead of lending 80% for 10 to 30 years, 4%, were lending 55% for two years at 12%. We are creating those positions at the level that we're lending at levels equivalent to where they would have traded in 2008. We feel relatively protected from what may come and in fact, maybe a beneficiary of what may come. Yes, we've definitely seen prices move down at least 10% to 20% across the board there. We've seen the ability to sell condos go down significantly. We've seen people get stuck in in construction loans. It's again, I would call it a first or second inning opportunity but we're going to see a bunch of it. ED HARRISON: When you think opportunity again, short long, that was an opportunity on the long side, the we're talking about, but what about on the other side of that? DANIEL ZWIRN: Well, actually, the commercial lender that's publicly traded that we're net short has a big exposure. That itself is 10 times levered in that market. ED HARRISON: Interesting. DANIEL ZWIRN: In that situation, we're effectively-- we set up a trade where we are longer put and short a call spread, where that package effectively doesn't expire until after the election. ED HARRISON: The election, what's the significance of that day? DANIEL ZWIRN: Well, the thought was perhaps on one side, you'd have a guy who's no longer interested in jawboning rates down or someone who is far less interested in the positive benefits for commercial actors. Either way, that may not be good for yields. ED HARRISON: The interesting bit about that is we haven't talked about politics at all during this whole thing. 2020 is an election year pivotable in some ways, what impact do you think that's going to have on debt markets in general or could have on debt markets? Because that's one. DANIEL ZWIRN: I do. It could be. I think that on the Republican side, if there's a Republican win, I think you're going to see relative stability, relative to where we are today, although as I said, you may either have less incentive, unless he decides to have a third term, there's less incentive to effectively jawbone rates down and there's certainly a greater chance all things being equal of creating a geopolitical issue. On the other side, depending on what you have, I think if you have a Biden presidency, everything is just going to be fine. If you have a far left presidency, if you look at the UK election, and you saw some of the policies that Corbin proposing, those could cause real-- some things like that could cause real havoc. ED HARRISON: The interesting bit is that this dichotomy that you're presenting does leave the potential for a uptick, not only in rates when you took a look at the term structure, but also in terms of spreads. That could trigger some of the things that we're talking about in terms of a phase shift in terms of those in the weaker end starting to default. DANIEL ZWIRN: Well, I think there are lot of places where that could happen. Again, geopolitical is a big one. I think you can see a large scale fraud, I think we've seen things like Steinhoff and others where they're not quite the global issues of an Enron or WorldCom but there have been these very generous credit markets have allowed people to manipulate numbers. ED HARRISON: It's the bezel, if you will. Like John Kenneth Galbraith said, we don't see the bezel now. DANIEL ZWIRN: Yes. As Buffett said, when the tide goes out, you see who has a bathing suit on or not. There's, I think, a lot of things that have been covered up. If we didn't have the crisis, we've never would have never seen made off. It was only because of the crisis and the fact that a number of his investors needed to redeem in order to cover other obligations, that the fact of the matter of his operation came to light, and so who knows what such things can bring? ED HARRISON: Now, one last thing in terms of markets that's less sexy. The investment grade market, opportunities there that you might see, either long or short. DANIEL ZWIRN: I think when it comes to that world, all things being equal, we're probably most interested in municipals. Many years ago, I created one of the earlier business focus on distressed municipal finance and because of the fact that you have a relatively slow world with a lot of investment, great holdings, a lot of which are not general obligations, and product property or project specific, there's a lot of small issues out there that are going to have problems. That's an area we've begun to look at again, all of these things cycle back good and bad over time. ED HARRISON: Then GOs in terms of versus the specific obligations, which ones present the most problems in a downturn scenario? DANIEL ZWIRN: Well, there's clearly already basket cases brewing, just like Illinois and Connecticut, etc. The issue there is, what price is the right price? There's no limit to the lack of responsibility of those governments. Handicapping, how that's going to go is very difficult. I would argue that when you see situations like that, it creates situation specific opportunities, because again, the baby's getting thrown out with the bathwater. As an example, in Puerto Rico, we're very active across a number of different underlying collateral types, but have never been involved in the GOs because there's so many things that are hard to, again, hard to handicap, hard to guess how they'll go. It's, for us, it's very hard to take a view. ED HARRISON: On the long side, basically, if you do your homework, and you say, this particular asset, or this income stream is what's behind this particular asset, you can actually do well when they throw the baby out with the bathwater. DANIEL ZWIRN: When that's the case and as well, there's a trigger that will allow you to actually realize the pricing distortion. Is there a maturity or a covenant violation or some other thing that will allow me to actually get at the asset, sell it off and effectively monetize the difference between the price at which I'm paying and the level at which I'll realize it? The people get hurt in situations like for instance, when the convertible bond market exploded in '05, generally, convertible bonds are very long dated with very few covenants. You're just sitting there waiting for a greater fool to take you out. Furthermore, in that case, a lot of those players were leveraged. They needed to seek a bid however they could get it. At that point, we went from zero to half a billion dollars' worth of debt. Then people started to come back in the market, we got back out again. Again, we always want to be on the right side of that equation, where we are effectively a global chaser of illiquidity and are providing effectively a market making function for people who have no other option. ED HARRISON: Let's dive in a little deeper into this, the CLO thing because a lot of people are very interested in this. I think that the question is in terms of the specific structures that you're looking at to take positions there, how do you take advantage of what's happening in that space? DANIEL ZWIRN: Well, part of the reason why what's happening is happening is because there are very few ways by which you can effectively get short that scenario, those situations. In contrast in the mortgage business pre-crisis, when people created mortgage securities or even mortgage securities made up of mortgage securities, there was a pretty ready market by which you could effectively create credit default swaps to take a view against those. As a result of what happened in the crisis and the lack of market making that's out there to the degree to which you can be very nimble about using CDS in order to get short components of structure finance structures, is very much reduced. ED HARRISON: Why is that? DANIEL ZWIRN: Because a lot of people got murdered doing it, or trying to do it. Ultimately, a lot of that was predicated on situations where perhaps everyone had the same amount of data, but there were different levels of ability to understand and interpret the data and so people didn't feel good about it. When the-- ED HARRISON: Because this is like a bespoke market basically. DANIEL ZWIRN: Yes. We have yet to see opportunities to effectively get short structured obligations within stacked securitize valuable structures using CDS. What you can do is you CDS in credits, in corporate credit specific ways, and you can do that against different parts of a given company's capital structure. We'd love to do things like that within CLOs, it's just no one will take the other side of it. That will potentially allow it to persist but on the downside, it may allow it to persist such that the distortions are so great that when it explodes, it really explodes big. Within corporate specific situations, as an example, there are situations where we can be long a bank loan, long credit protection, create a basis differential that will effectively collapse because they're two of the very same things, where we can effectively use puts, or other long dated options in order to create situations where, as an example, we are long a mid-tier part of a very large energy company's capital structure or also long a very long dated out of the money put. Having set that up, we know that there's a very small bound of points we can lose and anything better than that is ups and so you may not actually create a cheap put option, in that case, you would create a cheap call option. The reality is that these pricing distortions within capital structures provide opportunities to create cheap optionality off the back of the market. ED HARRISON: These are, what duration are you talking about in terms of how this-- DANIEL ZWIRN: Within three years, typically. ED HARRISON: One other market that I think is interesting, and I think, in particular, because a big debt manager said that he expects defaults in emerging markets in 2020. Emerging markets are generally considered moving out the risk spectrum in the same way that high yield would be. What's going on in that market in terms of this reach for yield? DANIEL ZWIRN: Well, over time, all things being equal in a given industry or business, you'll see people demand a premium if they're going into an emerging market. Ultimately, they're taking a view on a sovereign and its effective fiscal sanity, as well as its adherence to the rule of law. I think what we've seen is that the degree to which sovereign finances are managed appropriately, is very different among different emerging markets. Similarly, even within a given emerging market, as regime changes, governments change, the degree to which those governments act responsibly can vary quite a bit. What it creates is real volatility. When everything is comfortable, well, then you get your little extra hundred bps on this oil company versus that developed market oil company and you're happy. Again, when you see the reality is there's a correlation. When risk free moves up, spread moves up, perceived issues within a given series of markets move out, you have real problems, and those are then further exacerbated by the fact that a lot of this is intermediated by people who aren't making markets and a lot of its held in structures that are relatively short duration and don't take into account the lack of intermediation that's there. When we think about emerging markets, like in many situations, we want to own the volatility for free. When you see those explosions, at times, they creates babies that are thrown out with the bathwater that you can take advantage of. As an example, we find ourselves at times looking at busted assets in Greece, or we're looking at private transactions now in Brazil, or we've done things in Argentina, at precisely the time when people are really freaking out. ED HARRISON: Are these more on the public or the private side in terms of the issuers? DANIEL ZWIRN: Typically, they're private side transactions that are able to get priced because of what's happening in the broader universe. ED HARRISON: Now, I think that's a perfect example, good lead in into what we're talking about in terms of opportunities, and you've already talked about that, owning the volatility. You talked a little bit about some of the things that you could do in CLOs, where are-- from your perspective, given the outlook that you're seeing, on a macro level, where do you see opportunities in debt markets going forward? DANIEL ZWIRN: Well, it really depends on the geography. Today, North America. I think we're very interested in non-sponsored private corporate debt transactions. We're very interested in the whole universe of funds, meaning buying and selling interest in funds, lending to funds, because the wrapping in a fund structure precludes normal corporate oriented lenders from being involved, there are frequently opportunities and there's been such an explosion of issuance of those funds. There are so many misalignments of interest among LPs and between GPs and LPs. I think that will be an opportunity for years and years to come. We're also very interested in North America in oil and gas, which has basically been completely redlined the pegs who periodically effectively take price bets. We like oil and gas where we don't have to take bets on oil and gas prices. There are times when everyone wants to do oil and gas and the Enrons are there, the Merylls are there and no price is too low. Then there are times when it all explodes, and no one wants to touch it and a lot flatter since we're involved and actually now in the last 20 plus years, this is the third time we've been heavily involved in that area. ED HARRISON: Interesting. You don't think that the oil and gas is due, especially because of maturities coming forward, for a difficult period where rollover of debt causes a problem in that space. DANIEL ZWIRN: I think it very well could be. I think there's a lot of-- in the tradable markets within energy, there's a lot of misinformation or bad information about underlying asset values that has yet to make itself known. We're getting too specific, basically, within oil and gas tradable markets. There are ways to look at the quality of different types of assets. As an example, there's a notion of pre-proved developed producing, which is basically I stick a straw on the ground and it comes right up and all the metals there in order to make that happen, and then there's proved out not producing, then there's proved undeveloped, then there's probables, then there's lower levels of probable. In the private markets, when we get involved, we only care about this stuff that it doesn't take a geology degree to understand. When you look at the way credit has been provided to those markets, there's a lot of assumptions about exploration risk that are embedded that will leave people incredibly disappointed. I think there's a real opportunity for that to happen, but it could, it might not because of the same factors we've talked about with regard to monetary authorities and the overall overprovision of credit. What I am certain of is that in the private markets where you're not getting agency ratings, where you're not getting large leveraged loans, there are very few options available. I'm quite certain that there are opportunities where, again, the non-geologists out there can make very limited low LTV, high rate debts where we are able to effectively force our borrowers to sell for the commodity so we're not taking commodity risk and we can charge 15% or 20%+. ED HARRISON: It sounds like you're talking about both the short as well as alongside. Rather than finish off talking about the short side, I want to talk about the one last point that you made about the monetary authorities, because a lot of this-- earlier in the conversation, we were talking about Europe, Japan and the United States. There are two potential ways that we could go. It sounds to me like there is the potential for given the fact that debt servicing costs are low and increasing rates creates the potential for exactly the kinds of crises situation that we're talking about, that we just keep going at this very low status level turn into the next Japan. Do you really think that monetary authorities won't be there as the buyer of last resort, essentially, to bail out the system if the situation starts to unravel? DANIEL ZWIRN: Well, it depends on how much freedom of movement they have at a given time. If you haven't been raising rates, and if you haven't been curtailing your buying, it's time to start lowering rates and buying, you don't have many more bullets in the gun. I think they're trying to gently reload so that they can be there. Ultimately when you're not, what ultimately is going happen is you're going to damage those who are the savers, those who are responsible by debasing your currency, because that's the only way it ultimately works, which is you service the debt with devalued currency and you become basically a giant emerging market. ED HARRISON: You think basically that that's one way that we could go in the United States or we can deal with the problem head on? DANIEL ZWIRN: Yeah, I think there's very little incentive for it to be dealt with head on. Ultimately, if a crisis arises, I don't think it's going to come in the way that it did as an example, in the '80s where Volcker point 1.0 took a stand, made rates appropriately priced risk, and effectively cause some short term pain for long term gain. The will of central government monetary authorities to do that thing, I think, is very low. I wouldn't hold my breath for that. Therefore, if we see something precipitating a crisis, it'll be one of these things that none of us counted on, whether it's geopolitical or fraud related or whatever it is that'll cause an issue. Where that comes from, who knows? ED HARRISON: It's been a pleasure talking to you. This has been a great soup to nuts conversation on debt. I really appreciate it, Dan, thanks for coming on. DANIEL ZWIRN: Thanks for having me.