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ED HARRISON: Ed Harrison here for Real Vision.
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I'm talking to Dan Zwirn, who is the CEO of Arena Investors.
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Dan, great to have you here for debt week.
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DANIEL ZWIRN: Thanks for having me.
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ED HARRISON: I think before we came on camera, I was telling you off camera that we're having
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what's called debt week, with the beginning of 2020.
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The reason that we're talking about debt is because a lot of people don't understand that
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debt is actually a bigger market than the equity market is.
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That's right, isn't it?
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DANIEL ZWIRN: Yes, the debt markets overall are far larger than the equity markets across
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loans and mortgages and tradable bonds, and treasuries, and all the different obligations
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out there.
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There's an enormous number of things to choose from when you're thinking about playing the
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markets.
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ED HARRISON: Give me a sense of the comparative size of the market because when I look on
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television, I get the sense that it's all about stocks.
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DANIEL ZWIRN: Yeah, well, you can imagine, there are literally trillions of different
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opportunities out there and in fact, we've never had more debt than we do now because
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of the tremendous amount of issuance that happened over the last 10 years.
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A lot of that debt ends up getting bought by the very same people who issue it when
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you think about the sovereigns globally.
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Basically, if you're an owner of an asset, there's never been a better time to raise
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debt against it.
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ED HARRISON: Now, we're going to do a soup to nuts conversation on debt, because my understanding
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is you look at a full panoply of different markets, where their potential dislocations.
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I think of it, there's this term that I came across called fingers of instability that
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accumulate over time and then at stressful points, maybe you'll have a trigger, and it
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will cause a mini crisis or a larger crisis, like we had in 2008.
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Your thesis is basically that it's not a question of if, it's a question of when we get to the
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next crisis.
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January 13th, 2020 - www.realvision.com 3 The Interview: Profiting from Mispriced Credit
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Risk DANIEL ZWIRN: Yeah, I think there's two parts of it.
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First of all, there's always some combination of industry product geography where there's
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a debt crisis ongoing whether that's due to a particular issuer or a particular country
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or other geography, like a Puerto Rico or a Greece or an Italy, or whether that's related
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to a particular industry like oil and gas, there's always something going on.
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When we look at all of the things out there, we're always comparing risk reward and thinking
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where are people running from, so that we can take a look at where we might want to
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place ourselves.
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At the same time overall, there can be-- at the end of the day, everything's correlated.
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There are times of extremes like in a way, or a 102 or 98 or 94 where a lot of the issues
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that arise in one or more market starts to bleed into the other ones.
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In an ideal world, we like to avoid macro views generally, because markets can be if
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you will, stupid longer than you can be solvent, so to speak.
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We try to focus on where the actual idiosyncratic or alpha related distortions are the greatest.
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ED HARRISON: One of the things I guess that I'm thinking about is the length of this credit
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cycle or this business cycle.
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You hear the term that we're near the end of the cycle and as a result, these kinds
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of issues are things that we want to talk about.
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Before I go into what those issues are, because I think you have an interesting framework,
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what does that term we're late cycle, what does that mean to you?
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DANIEL ZWIRN: Well, I would say it's hard to discern and that we simply, as [indiscernible]
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of a matter, don't have that many data points, depending on who you look, who you speak to,
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and the data that you look at.
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Perhaps we have 100 or 300 or 600 years of data, depending on what markets you examine.
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To draw any particular conclusions other than what goes up must come down is difficult.
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Certainly since '08, we have had a series of basically market distortions created by
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primarily developed market monetary authorities that preclude actual risk from being appropriately
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priced.
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It's been a long, long time since there's been legitimate price discovery in the markets.
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At the end of the day, when you look at even equities, equities are ultimately the derivative
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of the credit markets.
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They're just the thing at the bottom of the capital stack.
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Over time, people compare dividend yield on stocks with yields on debt.
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That entire structure has been distorted by monetary authorities effectively underpricing
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the front end of the term structure of risk reward.
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What we have is a whole series of distortions that have arisen when that bubble ultimately
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pops unclear, because when you keep rates flat or negative and there's very little premium
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put on top of those rates to price risk, ultimately, issuers that are not terribly credit worthy
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can frequently afford to pay very, very minimal rates to sustain a level of principle and
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particularly, when structures are really weak, can live to fight another day for years and
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years and years.
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When we look at the world, we don't want to focus on what the greater fool may do or what
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might happen.
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We try to focus on places where those distortions have presented themselves typically in some
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particular, again, geography or industry, etc., that allow us to hopefully take advantage.
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ED HARRISON: I want to get to that, this specific markets that we're going to be talking about,
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but first, let's go to your framework in terms of what you were thinking about in terms of
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where these fingers of instability are.
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That's because since 2008, there've been some institutional changes within debt markets.
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I think you enumerated five basically that are critical to thinking about how this could
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play out.
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Can you go through step by step, maybe we'll go through the five, one after the next?
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DANIEL ZWIRN: Sure.
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Well, I would first say I enumerated those five factors in an academic paper.
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There's only a subset of those things that we see that were able to be substantiated
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in an academic level.
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It's not to say that there are no other factors that we see in the marketplace every day,
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but it's hard to get your arms around some of the numbers.
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With regard to those five, I would start with collateral.
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At the end of the day, a number of folks look at default rates as an example.
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When they think about the quality or lack of quality of debt obligations, what we have
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seen is that at the extremes, if I have incredibly weak covenants, and I charge a really small
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coupon, well, then I can have no defaults.
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People tend to-- agencies and other evaluators of credit, look at coverage meaning how much
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cash there is to cover the obligations that I have from my debt instrument.
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Well, again, if I don't charge a whole lot, then I can have high coverage and I can be
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comfortable.
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Nevertheless, I may have an actual overall obligation that's very large.
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In fact, maybe larger than my asset value.
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We like tend to look at leverage, not coverage.
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When you just dispassionately look at the amount of leverage in the system across corporate
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property, structure, finance, consumer and other personal applications out there, what
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you see is an enormous amount of debt relative to the underlying asset value.
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Actually, you have a tremendous appreciation in asset levels.
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What is not necessarily understood is the degree to which people perceive there to be
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substantial equity value, because debt is cheap and lenders tend to-- there are situations
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where lenders tend to price very low because they perceive a lot of equity value.
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Those two things are not independently evaluated.
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They're effectively a zero sum.
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ED HARRISON: Basically, you're saying that equity is the residual value with debt at
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the top of the stack?
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DANIEL ZWIRN: Correct.
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We're at historical highs in terms of the enterprise value divided by cash flow that
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people are willing to pay for businesses or assets.
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Part of that is because we can access very cheap and large amounts of debt that allow
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us to make equity returns that we otherwise wouldn't have been able to make.
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At the same time, providers of debt are saying, well, this, I have real confidence that my
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loan to value is relatively low because of all the equity that these people with equity
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are willing to put in underneath me.
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Effectively, it's like two drunken sailors keeping themselves up.
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At some point, one of them might stumble over.
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When you look dispassionately at the credit statistics out there, you're seeing enormous
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amounts of debt relative to asset values, you're seeing structures that are very, very
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weak, where people are not getting appropriately protected as creditors at the top of a capital
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stack.
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You're seeing terms in duration, which effectively, we have not seen the intrinsic risk of duration
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priced as low as it has for decades.
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Everything is set up for such that people are not getting compensated for risk they're
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taking.
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If you look at the stats across the-- and I think we go into the second area, the ratings
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agencies, you're seeing a tremendous amount of BBB relative to the rest of high yield.
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Why is that?
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Because there's a very particular subset of investors that will only invest investment
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grade and above.
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There are tremendous incentives to do a whole lot of numerical gymnastics to be able to
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access an investment grade rating that otherwise perhaps 10 years ago, wouldn't have been given
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in order to access that group of investors that tends to be comfortable taking a relatively
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low return for any given risk that they're assuming.
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ED HARRISON: Let me back up on two things because yeah, and by the way, when you were
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saying that, I was thinking about David Rosenberg, as I spoke to him, and he was talking about
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this too, I want to get a point in about the credit quality of BBBs relative to what they
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were before.
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The interesting thing, I think maybe this is a rhetorical question on some level, because
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you mentioned the Fed and other central banks in the developed economies.
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Why is it that these investors are not being compensated for extending out for duration,
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or for taking on the risk that they're taking off?
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DANIEL ZWIRN: I think it comes down to the sheer supply and demand.
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There's only so many issuers.
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There's such a tremendous volume of capital that needs to be deployed, it needs to attempt
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to get some level of return, that people are willing to accept historically low levels
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of return when they think about the return they're getting relative to the other alternatives
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they have.
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When you see, unfortunately, a vicious cycle where if you lower rates, you make that hunger
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for yield all that greater and we'll have people who are willing to buy more of it and
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take less return over time until the market tells them no.
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ED HARRISON: One of the things that hits me when you talk about this is this whole concept
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of servicing debt.
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Debt service costs being the marker versus leverage.
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To me, that smacks of hubris in the sense that as soon as rates go up, those debt service
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costs go up and suddenly, you have what seemed like low default rates not become low.
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DANIEL ZWIRN: Sure.
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Well certainly, that's certainly the case with regard to floating rate obligations.
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Ultimately, even fixed rate obligations as a reprice will be priced against the available
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floating rate and move up themselves.
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What I think is not taken to account by investors frequently is the fact that there's a level
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of correlation between risk free rates and premium to risk free.
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If you see a real move up in risk free rates, ultimately, you frequently see big moves up
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in spreads.
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At same time if both happen, you have potentially a reevaluation of the underlying asset yields
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necessary to appropriately compensate investors for owning assets or enterprises, and therefore
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a material decline in not only asset values as you perceive, but also more importantly,
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equity values that are subordinate and effectively managed by that debt.
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These things can spiral out of control as they have in prior crises.
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That said, again, there's tremendous incentives on the part of monetary authorities to keep
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rates low as well as support the term structure of risk through other means, including buying
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obligations directly in the marketplace.
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I think while a crisis is not inevitable, it may be highly likely and in fact, it may
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ultimately be preferred, because I would argue that what is inevitable is either a crisis
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or a long term malaise.
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Where, as an example where you have Japan, already at and potentially Europe going.
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That's not such a great thing either.
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We have this tremendous number of distortions happening because risk isn't appropriately
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priced and because price discovery is not out there.
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In fact, that leads to the third issue, which is that-- in addition to the fact that collateral
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is relatively misjudged in terms of its underlying risk, and in addition to the fact that it's
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not necessarily evaluated appropriately by available agencies, you have the fact that
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in the wake of the crisis, the number of people who are willing to make markets in fixed income
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across the world is very low, and to the extent that they're willing, their abilities is in
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turn very low.
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ED HARRISON: Why is that?
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DANIEL ZWIRN: Well, I think part of it is that there's been a tremendous level of pressure,
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perhaps rightly applied post-crisis on banks, that that participate in market making.
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One, to effectively put capital up against certain obligations in their balance sheet
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at levels that really preclude them from owning that risk in the first place.
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Second, through the Volcker Rule and other rules that they have to follow, there is a
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tremendous level of pressure for them not to effectively take a proprietary position.
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Unfortunately, in over the counter markets, the difference between making an OTC market
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and taking a proprietary view is very hazy.
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Why take that risk when the downside of doing is so great?
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ED HARRISON: That means basically, liquidity has been shrunken over time.
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DANIEL ZWIRN: Tremendously so.
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As an example, we, in our business, we owned a few million bonds of a-- have a $400 million
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issue and decided, after doing additional work, that we didn't want to be involved and
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it took us almost two weeks to get out of just a couple of million bonds.
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The reality is, and that turns to a another factor we see out there, not one of the five,
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but as a general whole, there have not mentality which is that if you already have, whether
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it's corporate, again, property, consumer, etc., there's really no lower bound on the
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level at which you can borrow.
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If you are have not, there's really no price you can pay to get access.
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What happens is if you have an obligation of one of those have nots, it's effectively
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a permanent holding until you effectively get your hands on the assets either through
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a maturity or covenant violation, etc., and effectively forced the monetization.
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That then leads to yet another factor, which is the mismatch in assets and liabilities
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across many of the entities that have been raised in order to house a lot of this fixed
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income.
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You'll see in mutual funds, shorter term, shorter duration hedge funds, ETFs and others,
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situations where there's a presumption that you'll be able to sell the obligations in
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order to deal with redemptions that's not really there.
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In fact, even in the last couple of years, you've had situations in Europe where there
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are property trusts, effectively, that own giant real assets that are levered, that are
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daily liquidity open ended and people somehow still are surprised when in fact, the redemptions
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come that they can't effectively sell those buildings on demand.
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ED HARRISON: I call this fake liquidity basically in a sense that the underlying asset is illiquid
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and then you have a liquid trading ETF or other asset on top of that, and people get
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the sense that I can get in and out of this when actually the underlying asset, there's
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a mismatch there.
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DANIEL ZWIRN: Either you in fact, won't be able to get out and redemptions will be suspended,
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or there'll be relatively low correlation between the price of the ETF in which you're