Enabling Credit Trades

IlliquidX provides liquidity and best execution in tough markets

Originally published in the March 2011 issue

IlliquidX operates in illiquid and distressed markets, helping provide liquidity and market information. A large proportion of our clients are hedge funds which rely on the firm’s sourcing capability and the wide range of products this allows us to offer. The distressed market has become a household term in finance these days, more than ever, given the recession, double dips and slow recovery that generate daily news coverage. Hedge funds have been a focal point of cleansing the system of illiquid financial assets, and IlliquidX’s mandate has been to provide liquidity to other players in the system and thus source the products they seek to invest in.

There are two examples that illustrate how IlliquidX works with hedge funds. First, we source claims from creditors against bankrupt companies across the world – an area where hedge funds have been big buyers. The sheer volume of claims accumulated by a hedge fund buyer can give it substantial influence in the eventual restructuring or liquidation of a position as well as in its valuation. Secondly, a hedge fund itself may hold a distressed and certainly illiquid position which it would like to dispose of in a discrete way – and this is also where IlliquidX comes in, providing liquidity and anonymous best execution.

As a trading and advisory boutique, IlliquidX offers a trading platform for institutional, corporate and professional high net worth clients to trade illiquid debt. The current environment offers terrific opportunities in this area. Firms are going bust and investors are looking for interesting and strong business plans. The characteristics of this recession are particularly poignant for IlliquidX as it has enhanced the business opportunity that we target – the trading of bankrupt, defaulted and distressed assets. And hedge funds are major players in this space.

IlliquidX seeks to provide an independent, transparent and discreet service. The aim is to help the financial system cleanse itself of toxic assets in an efficient, conflict-free and transparent way. The IlliquidX team has global reach and is comprised of sector specialists speaking 15 different languages. It is the power of the global sourcing of assets, the efficient and regulated infrastructure existing in London and the trust clients have in the firm that makes IlliquidX’s service offering attractive to hedge funds.

Since the beginning of the current financial crisis, distressed assets have been strongly ‘a la mode’. The current developments and even greater difficulties faced by banks have made them even more pertinent. The market for pricing and trading illiquid securities is a well-established and sophisticated one, with $305.1 billion in deal activity from completed transactions in 2010 of which $135.7 billion was completed in the US alone. Naturally this market grows especially during times of market turmoil where defaults are rampant, and numbers point to a strongincrease in those since September 2008.

The market in the US is mature and relatively liquid and transparent, but in Europe it is a very different story where it is immature, poorly developed and with far from comprehensive coverage of the range and illiquid assets. While completed EMEA deal volumes totalled $166.9 billion during 2010, this number was achieved in a very complex and opaque market. There are several key topics that define the current market:

1. CMBS maturities
2. Growth of the non-performing loan (NPL) market
3. Sovereign crises
4. Financials – regulation and capitalisation

CMBS market and maturities
There has been little activity in the commercial mortgage-backed securities (CMBS) market for 18-24 months now, after its spectacular peak in 2007. That year alone saw $230 billion of loans in the US. In comparison, only a fraction of these securities, $11.6 billion, were issued in the US in 2010. This added to the already poor liquidity for the asset class over 2009-2010 and to the difficulty for buyers and sellers to reach agreement on price. There are bankers and analysts who predict that as much as $50 billion of CMBS will be issued in the US in 2011. The growth reflects stabilizing values in the national commercial real estate market as well as the low interest rate environment that has magnified the appeal to investors of the relative high yields of CMBS.

Some of the new issues would come up to refinance the maturing bonds, and some of the maturities may not be able to be refinanced. It is this issue that the market will have to deal with. The structure of the CMBS is such that to create a CMBS bond, banks make commercial property loans and then bundle those mortgages into bonds. There are two levels of debt and maturities: the underlying loans and the bonds into which the loans are bundled. Since the cash flows of the bond instrument are dependent on the cash flows of the commercial property, the latter has been weak for several years now. This year is seeing a lot of bond maturities, where the underlying loan maturities have already been extended to the bond maturities, and no more extensions of maturities are possible. With much of the commercial property empty in the London market, issues like White Tower and Plantation Place should struggle and are at low valuations.

The new issue market is a double-edged sword. Abundant issuance could lead again to the erosion of underwriting standards and poor structures. Even if standards for loans have remained relatively conservative, deal structure has not changed significantly.


NPL market growth
Globally, bank NPLs declined in 2010 relative to 2009. But Europe and Central Asia witnessed an increase in NPLs and investors remain concerned. Bank NPLs not provisioned for varied widely in Europe between 35% and 57% of bank portfolios.

The UK market is expecting to see an increased level of NPL volume and transactions in 2011, namely from:

1. Commercial real estate refinancing deadlines being estimated at £120 billion over the next few years. According to research by HSBC, 85% of the loans made in this sector in the past five years are not fulfilling covenants which creates pressure on banks’ financial statements.

2. The possibility the Bank of England will raise rates this year and undercut asset prices in a weak economy. In contrast, the US Federal Reserve is quite willing to keep current rates as they believe raising rates will increase unemployment.

3. Exit by foreign banks to focus on core markets as several US and European institutions continue to dispose of non-core asset portfolios.

US investors remain bullish about the opportunity to put out significant sums into NPL purchases in 2011. Most of them prefer distressed whole loans backed by office, industrial and multi-family properties. The second most desired class is distressed residential loans such as single family and condo loans as well as Acquisition and Development (A&D) and construction loans. This is followed by CMBS, hotel and land loans, while generally few favour residential MBS loans.

Hedge funds are some of the biggest buyers of NPLs. Frequently a fund buys loans and services them through an outsider servicer, bringing them to maturity at a higher recovery value than the purchase price. This efficient mechanism helps cleanse the system, as well as positioning IlliquidX at the centre of a sourcing platform. Our firm has far-reaching sourcing capabilities, whereby we find NPLs and introduce them to the buyer hedge funds.


Sovereign crises
The debt issues faced by Greece, Ireland, Spain and Portugal receive frequent press coverage. The debate over whether financial aid is needed continues with little sense of how resolution may bring about greater certainty. The danger is that a sovereign crisis spills into a corporate and/or political one. The current volatility in sovereign bonds is cause for activity by the holders (usually commercial banks and traditional asset managers who historically have held them for their safe features) and the buyers (hedge funds who participate in the likes of the Argentina debt restructuring). IlliquidX intermediates between these two types of investors and provides pricing and relevant local research. These bonds continue to enjoy strong demand: all their spreads tightened, while Ireland was downgraded. In sum, there was little impact on the market.

Regulation and capitalisation
European financials have been, and continue to, struggle. The new Basel III rules are putting significant pressure on financial institutions to deleverage – again leading to the sale of assets in the market. Basel III will also require strengthening of the capital base and issuance of quality capital – something that will be strenuous for financial institutions. Specifically, Basel III introduces the following reforms:

• Increased overall capital requirement – between 2013 and 2019, the total capital requirement will increase from 8% to more than 10.5%. The common equity component of capital (Tier 1) will effectively increase from 2% of a bank’s risk-weighted assets before certain regulatory deductions to more than 7% after such deductions. These changes will certainly make banking activities more expensive.

• Narrower definition of regulatory capital – common equity will continue to qualify as core Tier 1 capital but other capital like Upper Tier 2 and Lower Tier 2 will be replaced by instruments that are more loss-absorbing and do not have incentives to redeem.

• Increased capital charges for banking book exposures – from 31st December 2010, securitisation exposures will require more capital and banks will be allowed to invest in securitisations only if the originator or arranger retains 5% of the risk, unhedged, for the life of the deal.

• Increased capital charges for trading book exposures – from 31st December 2010, capital charges will increase significantly for banks across the trading book: they will be subject to new VaR models, increased counterparty risk charges, etc.

• New leverage ratio – a minimum 3% Tier 1 leverage ratio, measured against a bank’s gross and not risk-weighted balance sheet will be adopted in 2019.

• Two new liquidity ratios – a liquidity coverage ratio requiring high quality liquid assets to equal or exceed highly stressed one-month cash outflows will be adopted from 2015. A net stable funding ratio requiring available stable funding to equal or exceed required stable funding over a one-year period will be adopted from 2018.

Financial institutions have a few difficult years ahead of them. Basel III will be phased in over a 12-year period that commenced last year, being in full effect by 2013, although most changes will become effectivewithin the next six years. The impact of this on banks is significant. Reform under Basel III will increase materially the regulatory cost of most banking activities. Equally importantly, capital charges for many trading book and other activities will increase materially as well.

These developments will create, and already have created as seen in the stress testing over the summer of 2010, volatility in bank paper, specifically Tier 1, Upper Tier 2 and equity. Stories like Germany’s HSH Nordbank, Austria’s OVB and the Irish banks might become more frequent occurrences and should provide ample opportunity for hedge fund investors to consider taking positions.

Galina Alabatchka co-founded IlliquidX in 2009 with Celestino Amore.