The Banking Collapse and the Impact on Private Lending
The recent banking collapse of Silicon Valley Bank, Signature Bank, and Credit Suisse has impacted individuals, institutions, and industries and its effects will continue to be felt in the years to come.
Chris Carsley, our Chief Investment Officer, and I joined Left Field Investors during their Scouting Report call. We talked about the recent banking collapse and the impact it has had on the private lending space. We also discussed what investors can do to mitigate risks in taking advantage of the opportunities that have been created recently.
Video Highlights
Historical perspective on bank failures.
What can we expect moving forward.
The impact on lending both for banks and private lenders.
What opportunities were created in the private lending space.
Key characteristics investors need to look for in debt funds.
Key questions to ask during your due diligence before investing in a debt fund.
“Usually, when you’re running these big banks, running your internal debt portfolios, you’ve got time to react and adjust your portfolio or make negotiations between banks, and it just wasn’t possible for Silicon Valley Bank to move fast enough which caused their collapse.”
“You want to look at debt funds that are lending to more stable asset classes or in markets where things are more stable.”
Watch the excerpt of the full video below.
Transcript
Chad: With that, we will turn over the scouting report to the Kirkland Capital Group and we've got Brock, Ralph, and, Chris.
Guys, we'll turn it over to you and, appreciate you coming on as well to share information about Kirkland Capital Group with us.
Brock: Thanks, Chad. Thank you. I just wanna confirm that you can see, the screen. Okay, great.
Thanks. I appreciate you guys hosting us, Chris and I, and then, we have our marketing expert online as well. Ralph and we wanna talk today about banks and private lending. I'm sure there are a lot of people out there that want perhaps a little bit more insight into not just what's happening, in general with, the bank crisis, et cetera, that's been happening in the last few weeks, but perhaps how that should affect, or what effect that's having on debt funds, particularly in the real estate arena.
Chris and I wanted to talk about that a bit. A little bit about us. Won't spend too much time here going through it. My background is more on the real estate side, technology, debt, et cetera. Chris comes, from a deep background in investment as well. So we both came together to create the Kirkland Capital Group, and the Kirkland Income Fund. So the Kirkland Income Fund is a real estate debt fund that's focused on short-term debt for commercial. That might be a little scary, but of course, feel free to ask a question in the Q&A. We can talk about that more. It's not my purpose today necessarily in our presentation to dive too deep into that, but, we focus on putting up nice steady returns.
But what I wanna do here at this point though, is really pass it to Chris and let him talk a little bit about the banking crisis, particularly because really, he's got an interesting background in having lived through '08, in a very different way, working on Wall Street, working for some bigger funds.
And maybe we have a little more time for one of his stories, that you've got Chris.
Chris: There's always plenty of stories when you go through left-tail events. Hi everyone. I was scouring the internet and found this picture and I just loved it cause It just screams at you of what occurred, if you were unaware of what was happening in 2008, 2009, 2010.
Obviously, very local to us out here in the northwest. We had the failure of Washington Mutual Bank, which obviously led to further problems in derivative products called CDS. And then we had, multi-bank, issues that led to Lehman's failure. And then if we didn't jump in and save everything, it would've been catastrophic. But even with the TARP funding, even with the aid that the government came in and made, you can see the contagion and the damage that was caused by these large bank failures.
So many small names, so many little community banks, regional banks. , not all of these are failures, these little dots, they're sometimes. mergers of where someone had to be taken out by a bank with a stronger balance sheet. And you can see there was this trickle effect that went on for years, even into 2013 and 14 and I did live through that.
I was working for a group that was financing billions of dollars in having to work with a number of different money center banks. And, it was scary how early we had a look through the window before even these bank failures were occurring. Most of the heartache started occurring in August of '08, but we were getting people in the beginning of '08, even in December of 2007,
calling lines, people calling up and saying, "Hey, I need my billion dollars back." And that's an odd question. When they want a billion dollars in about a month, you're not getting it. But moving on from that and looking at what has occurred just recently is, and I think everyone knows this chart's a little dated cuz it came out before the Credit Swiss' announcement.
So we all know that Credit Swiss, we just plugged it in there because, it is a major failure that, UBS had to come in and help out with. But you've got the failure of Silicon Valley Bank. You've got a lot of things that were happening for Signature. It was a one-two punch. You had many failures across a lot of different points in crypto that was hurting Signature. And then as that run occurred, you often had this, what you guys all get to say through your investment career, you live through the fastest rise in interest rates in history. The fed really moved faster than they ever have, and that caught a lot of people off guard.
Usually, when you're running these big banks, running your internal debt portfolios, you've got time to react and adjust your portfolio or make negotiations between banks, and it just wasn't possible for Silicon Valley Bank to move fast enough. And then we quickly saw the same kind of contagion that we saw in '08 start to affect First Republic Bank, and then it's affecting even more and more banks.
I really want to pull this out if I can find it, hopefully in about six months to a year when this kind of chart is updated. I want to see what the similarities of today's events look like what happened in '08. Do I think we're in an '08 situation? No, we're not looking at a global financial meltdown, but we are looking at a number of different problems, once again in banks and what people are clamoring about and the sabers are rattling is future regulation of how you're gonna be able to withdraw your money from banks, how corporations are gonna interact with banks that have large cash amounts.
There are tons and tons of different potential regulations and new ideas on the table to help mitigate this in the future. And I guarantee you not all of them will be good. But being an ex-hedge fund trader, anytime the government comes in and tries to fix something, yeah, it might hurt something but have an open mind as an investor because government regulations usually create some form of opportunity as well. They tend to try to fix one thing and break something else. And so there might be a new trade for you as an investor, out of these changing regulations that we're gonna probably have over the next year or so. But,
Brock: Chris,
Chris: Yeah.
Brock: Just give people an idea here. What's the size or estimated size there for credit Swiss versus Silicon and Signature?
Chris: Yeah, it's much larger than probably both of them combined, but with UBS coming in and buying them up, it's really backed by the Swiss government on top of it. Credit Swiss won't be as much of an impact. but it's more of a broader signal, that these problems, I always say when money disappears and money is difficult, what happened in '08 and what's happened, throughout history when money is no longer cheap and, liquidity dries up.
I don't get quote for this. Warren Buffet had this, as when that occurs, generally the tide goes out and you get to see everybody who one, was fraudulent or two was living on the edge all of a sudden. , Warren Buffet's, actual quote is when the tide goes out, you get to see everyone who's not wearing any clothes, is the actual quote. But what he is really talking about there are the people who are pretenders, or in this case, I don't think Silicon Valley Bank was a pretender by any means, but what they were was living on the edge and pushing the limits of risk. And when things moved faster than they could react, they got caught.
And that's unfortunate, but yes, Credit Suisse is a much, much larger institution. It is a global money center bank. So the dollar impact is much larger, but we probably won't experience that much in the real estate area due to Credit Suisse's, purchase by UBS. Yeah. But what happens out of this? The impact to lending when this happens?
What we're seeing is you got a decrease in lending lines. So a lot of people's warehouse lines, are being cut. A lot of people in the real estate lending business actually across multiple aspects of Alternative lending, use credit lines from banks. If you're the supplier of your line is a bank and they're under their own stress, you can guarantee they're gonna shore up their lines and you're gonna, suffer for that from your business standpoint.
So we're seeing a lot of that. We're also seeing a lot of banks, even internally, look at, not only shoring up the private lenders but shoring up their own book. And, on that second one, they're increasing, their DSCR rates, their debt service, their interest coverage ratios they're making what used to be able to meet a conventional loan is no longer, meeting that goal. But, so we've had a lot of loans come to our desk where you've got fully occupied multi-family that is looking for a bridge loan because, the banks have pulled a rug pull on some of these, borrowers and, purchasers of property.
And they're caught, they're gonna need to buy some more time till the banks can figure out what they're gonna be doing going forward. Or these borrowers, they're gonna have to go out and find other banks, the banks that they were working with traditionally, obviously, they're gonna have to widen their scope of available, service providers for their business.
Brock: Or you're seeing, Bridge to bridge where someone was expecting to come out of a bridge loan that they got to acquire a property or fix some things, expecting to get that long-term financing and getting a "No". So seeing a lot of that, talking to a lot of people on the ground, commercial loan brokers who are expressing that planned exit is simply not working anymore for them and they're having to go to find another bridge loan because the bank or other long term lenders simply can't take them at this point.
Chris: Exactly. Which I mean is further opportunity for us. We don't have a leverage line, nor do we use leverage from a bank. So we're not suffering from anything that's immediately happening from the bank standpoint.
But this increase in interest rates, If you're on the equity side, which was most of my career, increase the cost of capital was never a good thing. cuz we all k that's an inverse relationship. But as a lender, and this applies to us and a lot of other private debt , is this increase in interest rates is allowing you to charge a larger rate.
The supply and demand right are in imbalance. Then anytime that happens and the rates are going up, you're really acting as that person who's stepping in as the bank. You're the bank, and so you're able to charge much higher rates. And in many cases, given the other factors here that we're talking about, do that at a lower risk level.
Private debt has always had a very good risk-adjusted return. When you're comparing the volatility of returns to the available returns that you can get from private debt, but you're seeing just an unbelievable spread. I don't k how many people are here, or familiar with specific portfolio risk measures, like Sharpe and Treynor, but when you run these for your private debt funds, whether it be venture or real estate, they're just off the chart.
They're almost ridiculous. They're double-digit, risk-adjusted returns. So this is a perfect time to be thinking of wait a second, if I've got that cash and I don't need it immediately, and maybe I can tie that up for the next year or so to take advantage of this, it's something to think about.
Or if you're waiting for that opportunity to deploy money and you don't have exposure to private debt, it's not a bad time to be considering because this is something that has just occurred and we have some legs left in, that trade.
The Fed's not gonna turn around and lower interest rates as much as many of my Venture Capital friends want that to happen, it's just not gonna happen. You're just not gonna see rates collapse quickly. I k a lot of people say it has to, but I think this last quarter basis point was really a solid sign from the Fed of "We are very homed in on fighting inflation, and we understand that what we've done will cause collateral damage, as it already has".
A lot of people are like the Fed can't possibly raise. Look at the damage they're causing to Silicon Valley Bank and all these other regional banks. And they raised 25 basis points anyways this last March. So don't be surprised if we see a Fed that sticks to their P's and Q's on fighting inflation.
They're gonna keep hitting the hammer and let that sort of play out until they get what they want. And, so you're gonna be looking at an environment of where we're gonna be at higher cost of capital for a longer period of time. And that's gonna be great for the private lenders.
Out of a lot of chaos, there's always opportunities somewhere. And this has been a great place for it.
Brock: Alright, let me jump in here or talk about if you wanna look at a debt fund, which, you're gonna join a lot of institutional investors out there. Chris talks with a lot of institutional investors and involved in a lot of that side of things. There's been a tremendous look towards debt. Not that hasn't already been something that's been on there in their portfolio for a long time, but we've seen the turn of a lot of individual or high net worth investors to discover debt, particularly in this higher interest rate or rising interest rate period.
So what are some things that you should look for when we are facing, additional risks, additional risk in the area. What are some things that you should look for or ask as questions to someone that you're looking at or to a sponsor that you're looking at who does debt? Let's walk through a few of these things here.
One is property valuation process. I'm gonna really, I wanna lead off with this because this is a huge, issue here. One of the reasons that a lot of institutions classically have looked at debt, particularly in volatile times, was because someone else, an equity holder, was holding the cushion on any kind of difference between where you get a haircut on valuation.
We're probably hearing, or you've seen the headlines that continue to pop up about the crash or the chaos in commercial property or commercial real estate. Although, truth be told, when you actually look more deeply into those articles and really read what's going on, it's mostly, and I say mostly here, office. Office. And I'll talk about that in a minute. Although multifamily and some other ones are feeling the pinch a bit. But really when you talk about the value of something going down, it's your equity holders that are gonna take the brunt of that hit. Your debt holders are gonna be at a better position. if, and that's a big if that the, debt fund used "As-is" current values to write that debt and did it fairly conservatively. So when we talk about "As-is" current values, we're talking about, okay, today you bring a property to the debt fund and say, “Hey, Mr. Debt Fund, I want a loan for this property'. And they go, okay, 'No, we're not gonna base a loan some future value that you may get to, that you may bet on”.
Sometimes we call that ARV or after repair value, or even sometimes loan to cost on a construction loan. Those are all things we're looking at, basically, almost like future value. Like we, we hope that it gets to that value. What you want is you want conservative approach, which is based on current value today.
When you've got high vacancy. Today, when you've got issues with the property. What is the value today? And we're gonna base that loan today on what that is. Second, in a debt fund, you wanna ask, what's your exposure to different, asset classes? and really key on, really the biggest one that's been in the news a lot is office.
Even where we are at, where they were constantly talking about, office being, how do I wanna say, “Oh yeah, office is gonna come back, it's gonna come back." We didn't think that it would come back years ago when the pandemic started. We just thought that, there's a lot of stuff queued up there that's going to bring trouble to the office asset class that enables people to work remotely, if they are able to, job-wise, that's gonna just bring future problems. And Covid really accelerated that. And now people don't wanna come back. We can see that with key card stripes. Really if you wanna fight what the data is, that's really hard to do. You can try and convince people, oh no, they're gonna come back.
Look at this leasing or that leasing or things are still leased up. Yeah, that's because people are on the line in office for 5, 6, 7 year leases. But the key card swipes are still around in the forties, the 40 percents, for, I think last I heard it was like 43% for a lot of primary markets for office, so that there's gonna be continued decimation there.
So you wanna look to debt funds that are writing debt in maybe more stable asset classes or in markets where, things are more stable. That's where sometimes if you look at primary markets where you had really low cap rates, think about it. That cap rate is really a gear on what the valuation of that asset is.
So if you have a super low cap rate, let's say going from a cap rate of two or three, three or four, and then, going up one is gonna mean a pretty big difference to the value of that property. Whereas let's say you take a secondary or tertiary market where the cap rate may have been, I don't know, 10, 11, and you go up, one on the cap rate. You're not talking about a large move in that valuation, at least not as large as when you talk about primary markets and those low cap rates. So that's a troubling aspect of some primary market type assets. Constant and consistent revisit of underwriting.
You gotta ask the question about, how often do you revisit your underwriting guidelines? How often do you look at those? How often do you adjust those? Are you trying to look ahead, are you being reactionary after you've had something crash and burn or foreclosure? Have you adjusted LTVs, loan to values, on certain asset classes or, depending on what the risk factors are for the borrowers, you're looking at.
Have you looked at pricing? Am I as an investor in a debt fund, and this is a key question here, am I going to benefit if you're going out on the risk curve or taking a bit riskier loan? Are you pricing that higher? And then are you passing that higher pricing to the investor, to me, as the investor, that's what you want to ask a sponsor so that if you're going in, let's say, making a loan on a little riskier property or with a borrower has had a little trouble in the past. Maybe, it's a higher vacancy on a property and it needs to be leased up. That's a little more risky in this market. Okay, but maybe that's fine. Maybe you feel good about that property as an underwriter.
But let's say that debt fund raises the pricing on say, we got a vacancy. We're gonna charge 50 basis points more. Are they passing that on to you as an investor or are they keeping that? That's a key question to be asking for debt fund sponsors or to debt fund sponsors. The other one, underlying properties or income generating now or very soon.
Look, I am not saying at all that there's not a lot of money to be made in the debt space for ground up construction. There's a ton of money to be made. However, in this market that we're in, just be aware that is an additional risk on top of some debt funds who are just doing, only income generating or only owner occupied, which can be income generating.
They're not looking out 12, 18 months on a construction project and hoping that value's gonna be there and they're gonna be able to lease up or lease out, or whatever it is that needs to be done to get that money and pay it back to the debt fund. Raw land is another one that for a debt fund, honestly, it's not an income generating thing, so it's a little bit more dangerous because you might be able to sell it, but that's your only real exit there. There might be more stuff on the equity side, honestly, for raw land. just because when you've got challenges in the marketplace, what we have now, as an equity investor going and picking up raw land because it's not generating that income, and you've got people on the equity side who are hard pressed to maybe generate some cash and they're selling off.
I can let go of this raw land cuz it's not generating income. There's probably some deals to be had there, on the equity side. But from a debt fund side, I'd say be very careful for debt funds who are, writing debt on those items there.
Senior debt positions, ask, what, are you making seconds? Are you making thirds? Are you doing lines of credit? Where does your debt sit? is it first lien? Are you first in line if something goes wrong to get our investor money back on a debt fund? So are you writing a first lien debt position and on top of it, are you full recourse? If something goes wrong and you are not able to get all the money back from a sale of that property, are you able to go after a borrower personally?
All their assets, their other assets that they hold, are you able to go after them and get that money back? So a deficiency judgment is what it's called. So if you go and you do foreclose on someone, you get a deficiency judgment, from the judge on that piece of property, now you're able to go after that person, those guarantors personally for anything that you weren't able to cover in, selling that property off and still owed to the lender. So that's a good question to ask. Are you getting those personal guarantees? what are they requiring from borrowers? Now classically, if you talk about the old hard money lender, he's the guy or gal who went out boots on the ground, drove by a property. "Yeah, that looks good. I don't need to know anything about the borrower. I'm an asset-based lender." Okay, that's great. You got an asset that's worthwhile, but that's gonna be higher risk. So again, some of this is not saying don't do this. Some of this is really talking to you about risk mitigation.
Or if you choose to go and invest in a lender who's doing this, are you as an investor being rewarded for that extra risk. Don't do liars loans or are you doing liars loans? You remember that from '08? A lot of those loans that went bad on the residential side, the Old Liars loan. Stated income, which was probably no income at all. You barely got a job. We used to joke that, and I was in the business, working for non-bank lenders at the time that look, if a cockroach probably applied for the loan, they could get a hundred percent financing.
There was jokes going around about someone heard that a dog got financed. You don't want that. You don't want an asset based only loan. You want to ask these questions to the debt fund or to the sponsor of the debt fund. Are you requiring full docs? Are you doing criminal background checks, on the borrower?
Are you getting full tax returns? Cuz Lord knows we don't want Uncle Sam coming after, these properties because they didn't pay their taxes. People lie on taxes all the time. How do you even know that you're getting the correct tax returns? So are you doing a 4506 and are you going and getting from the IRS tax transcripts on all of it? Are you checking with the IRS on what their current, today's balance, do they owe anything? Do they pay their taxes? And I can tell you one thing right . And we're seeing a lot of this as a debt fund when we go check, is that people don't pay their taxes when things are pressed.
They'll let Uncle Sam go, they're gonna pay other things. And so we're seeing a rise in the amount of people that they file their taxes, but they didn't pay their taxes. So this could be a big problem, particularly with real estate investors who a lot of times they're not like a W2 person who gets taxes taken out every month, and usually Uncle Sam owes them at the end of the year for a lot of self-employed, for a lot of real estate investors when April 15 comes around, they owe thousands and tens of thousands of dollars of taxes, which they may have not paid. Are you getting, bank statements? Are you really getting that full picture of the borrower in order to reduce risk, even if the property may look good? This is not an exhaustive list, by any means, but we wanted to give you some things to look for if you're considering to invest in a debt fund, looking for lowering your risk or looking for that lower volatility, that steady income coming in, what are these things to look for? So I hope this has been helpful for you.
Chad: Good stuff guys. Appreciate the detail and the info share. Here's your, information to connect to. We'll put it open for questions for a little bit. We've got a little bit of time. If there's any questions that pop up. But again, really appreciate you guys coming on, sharing information, just I guess a reintroduction of you guys to the community really more than anything. But,
Chris: It's been a while since we've talked to your group, so we're happy to be back.
Chad: Yeah, we appreciate that too. But you got the contact information. We will package this up again with the recording, get that out early next week. Feel free to reach out and ask questions directly to each group and, we'll see if we don't, have them come back for, another webinar at another point in time.
But thank you to everybody for participating today and getting to, share your information with our community. We appreciate that.
