Recently, Trusted Insight profiled how Mark Canavan, senior real estate and real assets portfolio manager at the New Mexico Educational Retirement Board, discovered a burgeoning niche strategy, called mitigation banking, that generated double-digit returns while revitalizing the United States’ neglected and endangered natural habitats (read it here).
Before Canavan pioneered institutional investments’ charge into a new definition of investing in real assets at New Mexico ERB, he helped his previous employer, the New Mexico Treasurer’s Office, avoid the mistakes that crippled institutions across the world – the prevalence of low-quality asset-backed securities.
Canavan was recently named on Trusted Insight’s Top 30 LPs Investing In Real Estate & Real Assets, and he graciously spoke with us on November 4. This is part two of our conversation with Canavan. Stay tuned for the final piece in the series, which draws on experiences throughout his career to formulate an outlook on the current market climate and its implications on real estate and real assets.
Trusted Insight: Prior to joining the New Mexico Educational Retirement Board, you were chief investment officer at the New Mexico State Treasurer’s Office. Before the world’s economy imploded in 2008, you removed virtually all exposure to asset-backed securities from the portfolio. In retrospect, you look like a soothsayer. What led you to do that, and did you have any idea what was coming?
Mark Canavan: I couldn’t have told you exactly what was happening. I just knew that whatever was happening was really bad. But, to give you an idea of how I came to that conclusion, I have to give you a little background. And, I have to tell you what it means to “borrow short, lend long.”
Flashback
In ’94, I was at Merrill Lynch on the sell side as a retail stockbroker. A large percentage of the brokerage industry catered to retirees living on a fixed income. Over the prior 15 years, this cohort saw rates on their fixed income investments plummet, leaving them with a fraction of the fixed income they previously received. From 1979 to 1994, rates on six-month CDs dropped to under 3 percent from over 17 percent.
People started looking for alternatives to increase interest income. And, brokerage firms were all to happy to create a host of alternatives. Closed-end funds already existed, but now they were being modified with extra leverage to generate higher yields. To achieve these higher yields, fund managers borrowed at short term interest rates and then bought long-term bonds paying higher yields. Furthermore, these portfolios posted their holdings as collateral to leverage up to buy even more bonds. As long as rates at which they borrowed were higher than the rate at which they lent, they made money. The industry jargon for this is “borrow short, lend long.”
Then in 1994, the Federal Reserve began hiking interest rates. In short order, these closed-end funds were paying more in interest on their borrowings than they were earning off the securities. In addition, the securities used as collateral were falling in value. You can't survive long in that environment. The closed-end fund market got hammered.
And, it wasn’t just closed end funds that were levered up. Insurance companies, finance companies, municipalities, government agencies, all types of entities were levered – borrowing short and lending long. When rates rose, companies and municipalities with investment grade ratings collapsed, in some cases, virtually overnight. Literally, Orange County was AA rated on Friday, December 2, 1994, and bankrupt on Monday, December 5.
The point being – having previously watched the massive failures that borrow short, lend long can generate, I knew what it looked like and felt like to have liquidity exit a system. So, heading into the financial crisis, I was more prone to see it coming.
History Repeats
Fast forward to the last quarter of 2006, and I started getting paranoid about the market. The tenor of conversations with our brokerage relationships changed. Previously, I would call firms and tell them what I wanted and they would make offers. But, then the conversations changed. They were actively trying to sell me.
Firms have their own proprietary positions in securities, called a box position. They either hold to make a profit, or sell because they know they're on the wrong side of the trade. I could sense that these guys were selling out of their box position. They went from meeting my orders to frantically trying to sell me something.
Then we looked at the balance sheets of brokerages and banks, and I realized how much garbage was on their balance sheets. I thought, "Oh my God, 150 percent of Citigroup's book value is in Tier 3 illiquid assets." There were institutions whose book value would be wiped out if their assets simply fluctuated down by 2 to 3 percent. It blew me away. I thought I must have been wrong. I thought to myself, "Wow, I must be an idiot, these financials make no sense to me.” I started having self doubt. Then, the yield curve inverted.
The cost of borrowing short went above the rate of lending long. And, at the time the whole economy was built on borrow short, lend long. The pricing of everything was inflated due to the availability of easy money.
Now, the investments we were buying for the most part were asset-backed commercial paper (ABCP), a money market instrument. Many of these pieces of paper were financing the holding of asset-backed securities for banks, brokerages and others that used the money to hold their inventory, while they were repackaged into even more esoteric securitizations like CDOs. Basically, we were providing off-balance-sheet financing for the financial sector.
We started a credit research initiative so that we weren’t simply trusting the credit agencies. First, we called the brokers, but they had no idea of what the collateral was backing the loans for the borrow short, lend long strategies of these instruments. So, we called the custodians who were not at all happy to hear from us, let alone respond to our request for the ABCP’s underlying documents and collateral pools. We discovered just how non-transparent the securities were.
What we found was that these ABCP programs were operating, at times, with a 10 basis point spread between what they were paying to borrow money and what they were earning on their re-investments (the collateral pool).
I could reference what I’d seen in 1994, when the cost of borrowing for Orange County exceeded the rate on their investments. And, I could look at the inverted yield curve starting in ‘06 where money market rates were five percent, but long rates were at least 40 basis points below. All I had to do was look at those two data points to realize ABCP programs couldn’t survive long in that environment.
The World Defaults
The tipping point for me was the end of '06 and going into ‘07, there were all kinds of articles with data about the mortgage markets. Articles were written citing delinquency rates, default rates, bankruptcies, real estate owned due to repossession, et cetera, but none of the articles matched any of the other articles. None of the numbers tied. So, I called up the guy who used to run the asset-backed desk at Merrill Lynch.
I said, “I read all kinds of different numbers in the press. I read eight percent default rates, twelve percent default rates. So what is it really? What are you seeing?"
He replied, "Well, if you include 30-, 60-, and 90-day late pays, defaults and REOs (real estate owned by the bank), the default rate is 28 percent.”
I freaked. Up to that point, I'd created a huge matrix of potential default rates with corresponding rates of loss on default for the United States residential mortgage market. In all the scenarios I'd run on the matrix, I never even remotely considered that defaults could be as brutal as 28% of subprime and Alt-A loans. It was in none of my projections. I was horrified. I thought, "Oh, my God. This is bad. Mortgages are defaulting at a rate nobody knows about.” I didn’t sleep much that month. I just kept gathering data points, and running scenarios into the early hours of the morning.
Roll Off The Books
Over the course of time, all the evidence stacked up: Bad financials at the banks and brokerages; tight or inverted spreads between what it cost to borrow and what you earned from lending; the change in behavior of some of our brokers; the lack of transparency in markets; hearing the default rates being experienced by one of the main securitization desks; and talking to heads of credit default desks trying to determine a default’s multiplier effect.
These weren’t all the signs; there were others. Regardless, one thing was clear. We needed to get out of the market. At one point, I turned to a younger portfolio manager and repeated a phrase I’d learned at Merrill long ago, “When the lightening strikes, you don’t want to be the last one out of the pool.” That’s just another way of saying, you want to get your money out of the bank before the run on the bank, not during or after.
So, that’s what we did. We got out of the water. I had a pretty good feel for the timeline that we had to get out. And, any of our investments at risk were short term. So, we simply stopped buying anything new, and let the rest roll off the books. We had two pieces of securitized paper left when LIBOR gapped out in August 2007 signaling that the financial system’s liquidity was drying up.
Shortly after we stopped buying ABCP, the market started to unravel. There were securities in the ABCP markets called extendable notes (ECNs) and structured investment vehicles (SIVs). With ECNs, the borrowing entity had the right to not return your money at maturity. They could unilaterally extend. The ECNs had never extended before. But then, without warning, in the latter part of the first half of ‘07, a handful of extendable note programs exercised that option. We had no exposure.
Also, virtually all ABCP programs had A+ ratings due to the fact that the banks and brokerages selling these securities were providing “liquidity support” to the companies issuing the CP. In other words, the banks and brokerages were promising to pay off the investor at maturity, if the issuing company could not redeem its own CP. In the summer of ’07, a handful of “liquidity support” providers began reneging on those promises. It snowballed from there.
A lot of people don’t realize, the lack of liquidity that caused the financial crisis started in the commercial paper markets. If you were in my seat at the Treasurer’s office, watching the cracks develop… if you didn’t see the financial crisis coming, you weren’t paying attention.
Trusted Insight: Given your previous experiences, you seem overqualified for your current position at the Educational Retirement Board, and I mean that with the utmost respect. How did you end up at the New Mexico ERB?
Mark Canavan: This is kind of funny. We had already exited asset-backeds. So, by fall of ’07, when other state and local government pools were blowing up around us, the State Treasurer came into my office asking, "How much exposure do we have to this?"
I smiled and said, “None. We're out." I continued with, “I put a memo under your door two or three months ago detailing the situation with talking points should the press ask.” One of the talking points was, “We don't invest for the return on our money, we invest for the return of our money.” To serve my Treasurer, and to be able to respond as I did, it was one of the proudest moments of my life.
But, I knew that call was likely the best call I'd ever make. So, I figured I’d better move on while I was still on top. ERB was looking for a real estate manager. I put in for that job and got it.
Fortunately, ERB’s board and management is very supportive and allows us the autonomy to do what we believe is right. I saw infrastructure as defensive in nature, so I stopped the ongoing real estate investment when I got here, and I rolled out our infrastructure portfolio.
I think my real estate consultant thought I was nuts. I was doom and gloom about real estate, and the economy in general. But, as a real estate consultant, his role is to recommend real estate. I told him, “I don’t want to see anything where the valuation has been driven by easy money,” which was pretty much everything back then. And then, real estate finally collapsed. I think that was when my consultant realized I wasn’t a crackpot.
I have to credit Steve (the consultant) with adapting to my beliefs and style. He proposed distressed debt, and it was a great time for that. So, we loaded up our portfolio and went significantly overweight distress. The first fund we invested in is running at a 50% net IRR, and we’ve already received all our capital back. That was another great play. Going overweight distressed debt when we did has been a tremendous driver of outperformance for our real estate program.
But, how I got to that place in life is literally a series of life experiences that led up to making one exceptionally good decision. It’s kind of luck in a way, that all those things happened to me that would give me the insight to do as I did. And, I have to give credit where credit is due. I am fortunate to have a very supportive and talented board and management team that gave me the autonomy to follow my convictions, and a talented consultant that adapted to my beliefs and is of tremendous value-add in helping build an outperforming portfolio.
Before Canavan pioneered institutional investments’ charge into a new definition of investing in real assets at New Mexico ERB, he helped his previous employer, the New Mexico Treasurer’s Office, avoid the mistakes that crippled institutions across the world – the prevalence of low-quality asset-backed securities.
Canavan was recently named on Trusted Insight’s Top 30 LPs Investing In Real Estate & Real Assets, and he graciously spoke with us on November 4. This is part two of our conversation with Canavan. Stay tuned for the final piece in the series, which draws on experiences throughout his career to formulate an outlook on the current market climate and its implications on real estate and real assets.
Trusted Insight: Prior to joining the New Mexico Educational Retirement Board, you were chief investment officer at the New Mexico State Treasurer’s Office. Before the world’s economy imploded in 2008, you removed virtually all exposure to asset-backed securities from the portfolio. In retrospect, you look like a soothsayer. What led you to do that, and did you have any idea what was coming?
Mark Canavan: I couldn’t have told you exactly what was happening. I just knew that whatever was happening was really bad. But, to give you an idea of how I came to that conclusion, I have to give you a little background. And, I have to tell you what it means to “borrow short, lend long.”
In ’94, I was at Merrill Lynch on the sell side as a retail stockbroker. A large percentage of the brokerage industry catered to retirees living on a fixed income. Over the prior 15 years, this cohort saw rates on their fixed income investments plummet, leaving them with a fraction of the fixed income they previously received. From 1979 to 1994, rates on six-month CDs dropped to under 3 percent from over 17 percent.
People started looking for alternatives to increase interest income. And, brokerage firms were all to happy to create a host of alternatives. Closed-end funds already existed, but now they were being modified with extra leverage to generate higher yields. To achieve these higher yields, fund managers borrowed at short term interest rates and then bought long-term bonds paying higher yields. Furthermore, these portfolios posted their holdings as collateral to leverage up to buy even more bonds. As long as rates at which they borrowed were higher than the rate at which they lent, they made money. The industry jargon for this is “borrow short, lend long.”
Then in 1994, the Federal Reserve began hiking interest rates. In short order, these closed-end funds were paying more in interest on their borrowings than they were earning off the securities. In addition, the securities used as collateral were falling in value. You can't survive long in that environment. The closed-end fund market got hammered.
And, it wasn’t just closed end funds that were levered up. Insurance companies, finance companies, municipalities, government agencies, all types of entities were levered – borrowing short and lending long. When rates rose, companies and municipalities with investment grade ratings collapsed, in some cases, virtually overnight. Literally, Orange County was AA rated on Friday, December 2, 1994, and bankrupt on Monday, December 5.
The point being – having previously watched the massive failures that borrow short, lend long can generate, I knew what it looked like and felt like to have liquidity exit a system. So, heading into the financial crisis, I was more prone to see it coming.
Fast forward to the last quarter of 2006, and I started getting paranoid about the market. The tenor of conversations with our brokerage relationships changed. Previously, I would call firms and tell them what I wanted and they would make offers. But, then the conversations changed. They were actively trying to sell me.
Firms have their own proprietary positions in securities, called a box position. They either hold to make a profit, or sell because they know they're on the wrong side of the trade. I could sense that these guys were selling out of their box position. They went from meeting my orders to frantically trying to sell me something.
Then we looked at the balance sheets of brokerages and banks, and I realized how much garbage was on their balance sheets. I thought, "Oh my God, 150 percent of Citigroup's book value is in Tier 3 illiquid assets." There were institutions whose book value would be wiped out if their assets simply fluctuated down by 2 to 3 percent. It blew me away. I thought I must have been wrong. I thought to myself, "Wow, I must be an idiot, these financials make no sense to me.” I started having self doubt. Then, the yield curve inverted.
The cost of borrowing short went above the rate of lending long. And, at the time the whole economy was built on borrow short, lend long. The pricing of everything was inflated due to the availability of easy money.
There were institutions whose book value would be wiped out if their assets simply fluctuated down by 2 to 3 percent. It blew me away.
Now, the investments we were buying for the most part were asset-backed commercial paper (ABCP), a money market instrument. Many of these pieces of paper were financing the holding of asset-backed securities for banks, brokerages and others that used the money to hold their inventory, while they were repackaged into even more esoteric securitizations like CDOs. Basically, we were providing off-balance-sheet financing for the financial sector.
We started a credit research initiative so that we weren’t simply trusting the credit agencies. First, we called the brokers, but they had no idea of what the collateral was backing the loans for the borrow short, lend long strategies of these instruments. So, we called the custodians who were not at all happy to hear from us, let alone respond to our request for the ABCP’s underlying documents and collateral pools. We discovered just how non-transparent the securities were.
What we found was that these ABCP programs were operating, at times, with a 10 basis point spread between what they were paying to borrow money and what they were earning on their re-investments (the collateral pool).
I could reference what I’d seen in 1994, when the cost of borrowing for Orange County exceeded the rate on their investments. And, I could look at the inverted yield curve starting in ‘06 where money market rates were five percent, but long rates were at least 40 basis points below. All I had to do was look at those two data points to realize ABCP programs couldn’t survive long in that environment.
The tipping point for me was the end of '06 and going into ‘07, there were all kinds of articles with data about the mortgage markets. Articles were written citing delinquency rates, default rates, bankruptcies, real estate owned due to repossession, et cetera, but none of the articles matched any of the other articles. None of the numbers tied. So, I called up the guy who used to run the asset-backed desk at Merrill Lynch.
I said, “I read all kinds of different numbers in the press. I read eight percent default rates, twelve percent default rates. So what is it really? What are you seeing?"
I was horrified. I thought, "Oh, my God. This is bad. Mortgages are defaulting at a rate nobody knows about.” I didn’t sleep much that month.
He replied, "Well, if you include 30-, 60-, and 90-day late pays, defaults and REOs (real estate owned by the bank), the default rate is 28 percent.”
I freaked. Up to that point, I'd created a huge matrix of potential default rates with corresponding rates of loss on default for the United States residential mortgage market. In all the scenarios I'd run on the matrix, I never even remotely considered that defaults could be as brutal as 28% of subprime and Alt-A loans. It was in none of my projections. I was horrified. I thought, "Oh, my God. This is bad. Mortgages are defaulting at a rate nobody knows about.” I didn’t sleep much that month. I just kept gathering data points, and running scenarios into the early hours of the morning.
Over the course of time, all the evidence stacked up: Bad financials at the banks and brokerages; tight or inverted spreads between what it cost to borrow and what you earned from lending; the change in behavior of some of our brokers; the lack of transparency in markets; hearing the default rates being experienced by one of the main securitization desks; and talking to heads of credit default desks trying to determine a default’s multiplier effect.
These weren’t all the signs; there were others. Regardless, one thing was clear. We needed to get out of the market. At one point, I turned to a younger portfolio manager and repeated a phrase I’d learned at Merrill long ago, “When the lightening strikes, you don’t want to be the last one out of the pool.” That’s just another way of saying, you want to get your money out of the bank before the run on the bank, not during or after.
So, that’s what we did. We got out of the water. I had a pretty good feel for the timeline that we had to get out. And, any of our investments at risk were short term. So, we simply stopped buying anything new, and let the rest roll off the books. We had two pieces of securitized paper left when LIBOR gapped out in August 2007 signaling that the financial system’s liquidity was drying up.
Shortly after we stopped buying ABCP, the market started to unravel. There were securities in the ABCP markets called extendable notes (ECNs) and structured investment vehicles (SIVs). With ECNs, the borrowing entity had the right to not return your money at maturity. They could unilaterally extend. The ECNs had never extended before. But then, without warning, in the latter part of the first half of ‘07, a handful of extendable note programs exercised that option. We had no exposure.
Also, virtually all ABCP programs had A+ ratings due to the fact that the banks and brokerages selling these securities were providing “liquidity support” to the companies issuing the CP. In other words, the banks and brokerages were promising to pay off the investor at maturity, if the issuing company could not redeem its own CP. In the summer of ’07, a handful of “liquidity support” providers began reneging on those promises. It snowballed from there.
A lot of people don’t realize, the lack of liquidity that caused the financial crisis started in the commercial paper markets. If you were in my seat at the Treasurer’s office, watching the cracks develop… if you didn’t see the financial crisis coming, you weren’t paying attention.
Trusted Insight: Given your previous experiences, you seem overqualified for your current position at the Educational Retirement Board, and I mean that with the utmost respect. How did you end up at the New Mexico ERB?
Mark Canavan: This is kind of funny. We had already exited asset-backeds. So, by fall of ’07, when other state and local government pools were blowing up around us, the State Treasurer came into my office asking, "How much exposure do we have to this?"
I smiled and said, “None. We're out." I continued with, “I put a memo under your door two or three months ago detailing the situation with talking points should the press ask.” One of the talking points was, “We don't invest for the return on our money, we invest for the return of our money.” To serve my Treasurer, and to be able to respond as I did, it was one of the proudest moments of my life.
But, I knew that call was likely the best call I'd ever make. So, I figured I’d better move on while I was still on top. ERB was looking for a real estate manager. I put in for that job and got it.
“I put a memo under your door two or three months ago detailing the situation with talking points should the press ask.” One of the talking points was, “We don't invest for the return on our money, we invest for the return of our money.”It was great timing. In retrospect, it’s funny. I had just come from the Treasurer's office where I saw the writing on the wall that real estate was doomed, yet I was hired to buy real estate. I spent the first month or so here at ERB asking if I could do infrastructure investing instead.
Fortunately, ERB’s board and management is very supportive and allows us the autonomy to do what we believe is right. I saw infrastructure as defensive in nature, so I stopped the ongoing real estate investment when I got here, and I rolled out our infrastructure portfolio.
I think my real estate consultant thought I was nuts. I was doom and gloom about real estate, and the economy in general. But, as a real estate consultant, his role is to recommend real estate. I told him, “I don’t want to see anything where the valuation has been driven by easy money,” which was pretty much everything back then. And then, real estate finally collapsed. I think that was when my consultant realized I wasn’t a crackpot.
I have to credit Steve (the consultant) with adapting to my beliefs and style. He proposed distressed debt, and it was a great time for that. So, we loaded up our portfolio and went significantly overweight distress. The first fund we invested in is running at a 50% net IRR, and we’ve already received all our capital back. That was another great play. Going overweight distressed debt when we did has been a tremendous driver of outperformance for our real estate program.
But, how I got to that place in life is literally a series of life experiences that led up to making one exceptionally good decision. It’s kind of luck in a way, that all those things happened to me that would give me the insight to do as I did. And, I have to give credit where credit is due. I am fortunate to have a very supportive and talented board and management team that gave me the autonomy to follow my convictions, and a talented consultant that adapted to my beliefs and is of tremendous value-add in helping build an outperforming portfolio.
Please check back for part III of Mark Canavan's exclusive interview with Trusted Insight.
To learn more about real estate & real assets investing, click here to view the complete list of Top 30 LPs Investing In Real Estate & Real Assets.