Business

No One Is Going To Buy A Synthetic CDO For A Reasonable Price During The Next Crisis

ValueWalk’s interview with Solomon Berkoff on topics ranging from fintech to CDOs and everything related to credit and loans (Berkoff’s bio is at the bottom of the article)

Small Business Finance
rawpixel / Pixabay

Can you tell us about your background?

I have been in asset-backed finance for almost 20 years.  At various times I was a structurer, a banker, and a trader — which is nice as it means I have seen different sides of the business.  I am also one of the few people still in the market that saw the bull market, the crisis, and then the recovery.

Get The Full Series in PDF

Get the entire 10-part series on Charlie Munger in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Q1 hedge fund letters, conference, scoops etc

What does your current firm do?

Charleston Capital is an alternative asset manager that makes senior loans to small business finance companies.  Our edge is the proprietary technology provided to us by our affiliate, inFactor. This technology separates the origination and servicing of assets, providing clarity on performance.

Within Fintech, origination and servicing are rarely separated.  Often, this means investors cannot independently verify performance.  We think clarity is essential to making good investing decisions and that, as time passes, more Fintech investors will agree.

What do you think of all these Fintech platforms for funding small businesses?

Fintech is the future of small business finance. Americans now pay for most goods and services electronically. Electronic payments are much easier to track than payments made with paper.

Clear insight into performance is helping to expand the credit available to small businesses.  Connecting to small businesses’ point of sale technology and directly to their bank accounts is reducing friction and also helping to expand credit.

We are at the beginning stages of a revolution in the way businesses are funded.

Small banks are in decline and cannot compete with Fintechs when it comes to data analysis and speed of underwriting.  Large banks cannot profitably fund small businesses and are looking to Fintechs to build the infrastructure for them.

Several Fintech platforms are doing a great job of prudently expanding originations. Small business finance is underserved -- there is almost $100 billion of unmet demand.  We think that means several platforms will be able to reach scale.

Tell us about your financial crisis experiences?

I was at RBS during the financial crisis.  I had a front seat to huge declines in asset prices and then the subsequent recovery.  I remember a lot of speeches about how Americans would never default on their homes en masse.  I also remember a lot of speeches about how the housing market would never recover. I think in both cases, the data available ahead of time suggested both outcomes.

Can you tell us about your story with RBS CDS bet?

In 2007, delinquencies in private label mortgage deals began to pile up.  The idea that those delinquencies would reverse seemed unlikely. We identified a few mortgage originators that seemed particularly weak.  In those days, in order to figure out which originators were in a deal, one had to actually read the data tables in individual bond prospectuses.

As a desk, we got short a combination of 2006 deals with originators we did not like and 2005 paper.  At the time, 2005 paper was cheaper to short than 2006 paper. Our theory, after spending a lot of time with the data, was that eventually the 2005 paper would have trouble as well and the lower negative carry would be easier to handle.  It took some time for the 2005 paper to deteriorate, but our thesis turned out to be correct.

What did you learn about liquidity from the crisis?

The ability to sell something easily today can be very misleading.  Many investors judge their risk by how easily an investment can be sold.  Meaning -- if I own something I can sell easily, then it is less risky than an investment that cannot be sold easily.

The problem is, when fear takes over, there are often no buyers.  In a crisis, even high-quality investments will sometimes see zero buying interest.  At that point, prices begin to drop, which causes more fear. You really have to experience this cycle first-hand to know how dangerous it is.  Once it starts, you do not get to go back and reposition yourself.

That is why we at Charleston Capital like making loans backed by short duration collateral.  Paydowns mean cash. Cash gives one flexibility and optionality in a crisis. Owning long duration bonds that were liquid before a crisis is no help once fear takes over.

Can you tell us what liquidity is?

Liquidity is a measure of how easy it is to turn an investment into cash.

What do you define as risk?

Risk is the possibility that you are wrong about an investment.

Passive just overtook active according to a Morningstar report, thoughts?

Technology has made it a lot easier and cheaper to own beta.  I think the trend of using passive investments to buy beta is going to continue and should continue.

Alpha, however, is alive and well.  Investors will pay for insight and access.  An example is alternatives; they are seeing huge inflows.  Better managers have recently been able to increase fees.

This is being driven by alternatives? I thought mostly indexing, can you clarify?

Passive management of traditional assets outperforms active management of traditional assets.  Most active managers in stocks and bonds underperform the market. This is a statistical fact.

If I can own traditional assets like stocks or bonds and pay really low fees, why pay for a manager unless you think they have real insight or invest in a space that is difficult to access?

Increasing allocations to alternatives is a sign that investors are looking for alpha in markets they cannot access through traditional investments.

When you say traditional assets are not as liquid as they used to be why is that the case? Is that all asset classes like bonds, stocks etc?

Liquidity in the corporate bond market is much lower than it was before the crisis.  Bond dealers are also no longer expected to buy when liquidity dries up. Right now, the system is working fine.  But when the next crisis comes, who is going to buy when fear hits?

Mutual funds own a much larger percentage of corporate bond outstandings than before the crisis.  When they see large redemptions, where is the cash going to come from if everyone sells together?

At a moment like that, prices on supposedly safe assets could plummet.  In that situation I would much rather own short duration collateral.

What are the long-term ramifications of that?

The ramifications are more extreme selloffs.  I think the selloff in early 2016 and the sell-off in late 2018 are both examples of this phenomenon.

Thoughts on HFT and the impact on liquidity

HFT is here to stay.  It will get even more sophisticated as time passes.  At the moment, its downside is it also makes selloffs more extreme.

Same with synthetic CDOs

Synthetic CDOs are better off dead.  There was just an article in Bloomberg on how they are “cheap”.  Who is going to buy a synthetic CDO for a reasonable price during the next crisis?

Solomon Berkoff joined Charleston Capital as a Principal in January 2019. Prior to coming aboard at Charleston Capital, he spent almost twenty years as a structured finance trader and banker. Solomon began his career at Bank One in Chicago, and was part of a team that helped to make them a top ten asset backed origination franchise.