Back in March 2017, a bearish trade emerged which quickly gained popularity on Wall Street, and promptly received the moniker "The Next Big Short."
As we reported at the time, similar to the run-up to the housing debacle, a small but growing group of firms were positioning to profit from a "retail apocalypse" that could spur a wave of defaults. Their target: securities backed not by subprime mortgages, but by loans taken out by beleaguered mall and shopping center operators which had fallen victim to the Amazon juggernaut. And as bad news piled up for anchor chains like Macy’s and J.C. Penney, bearish bets against commercial mortgage-backed securities kept rising.
The trade was simple: shorting malls by going long default risk via CMBX or otherwise shorting the CMBS complex.
One of the firms that had put the "Big Short 2" trade on was hedge fund Alder Hill Management - an outfit started by protégés of hedge-fund billionaire David Tepper - which ramped up wagers against the mall bonds. Alder Hill joined other traders which in early 2017 bought a net $985 million contracts that targeted the two riskiest types of CMBS.
“These malls are dying, and we see very limited prospect of a turnaround in performance,” said a January 2017 report from Alder Hill, which began shorting the securities. “We expect 2017 to be a tipping point.”
Alas, Alder Hill was wrong, because while the deluge of retail bankruptcies...
... and mall vacancies accelerated since then hitting an all time high in 2019...
... not only was 2017 not a tipping point, but the trade failed to generate the kinds of desired mass defaults that the shorters were betting on, while the negative carry associated with the short hurt many of those who were hoping for quick riches.
Fast forward to today, when the WSJ reports that Alder Hill Management, which as we reported two and a half years ago was among the firm hoping to profit by betting against debt tied to America's malls, ended this trade over the summer.
Not only that, but Eric Yip, the founder of the New York-based hedge fund, is also winding down the entire $300 million hedge fund, the WSJ source said. And while some of Alder Hill’s other trades were profitable, its 2½ years of losses shorting mall debt convinced Yip to shut down, ostensibly long before many of the malls he was betting against.
Why? Because as the WSJ notes, "Alder Hill and other short sellers—or traders who bet that the price of a bond, stock or other asset will fall—have found that their wagers against commercial mortgage-backed securities tied to retail property didn’t go as planned."
That is largely because "the rise in retailer bankruptcies and store closures since 2017 didn’t produce a significant increase in missed loan payments by mall owners", according to commercial mortgage tracker Trepp.
As Dylan Wall, a Trepp research analyst explained, since a significant number of these loans required interest-only payments, or have a partial interest-only payment schedule until they mature, property owners were able to stay current on their loans despite weaker rents.
As a result, the CMBX trade, specifically the CMBX BBB- 6 tranche, which most bears loaded up on, failed to plunge in the 30 months since it was put on, leading to a quiet capitulation as one after another hedge fund was forced to cover. As the WSJ notes, prices on the CMBX tranche "fell in 2017. But then they rebounded in 2018. This year, it has continued to rise and is now close to levels when Alder Hill published its first report in early 2017 laying out his mall short, according to data from IHS Markit.
Throw in the high cost of carry - the CMBX required an annual 3% coupon to be paid by the shorts - and one can see why all the funds who were hoping for a quick profit had no choice but to throw in the towel.
As Trepp adds, only three of the roughly 40 malls tied to the CMBX 6: Fashion Outlets of Las Vegas in Primm, Nev., Salem Center in Salem, Ore., and Westgate Mall in Brainerd, Minn., had delinquent loans. Occupancy in these centers hovers between 58% to 79%.
Meanwhile, as we reported recently, the trade remains directionally right, as vacancy across all US malls rose to 9.4% in the third quarter, the highest it has been since 2011, and up from 9.1% from the same period a year ago. However, while the endgame is clear, the question is how long will it take before a critical mass of mall loans default. As the past two years have shown, for IO loans, the game of extend and pretend is being squarely won by the malls for now thanks to record low interest rates.
To avoid a grizzly death predicted by short sellers, mall landlords had to become more flexible in negotiations with tenants over lease terms. They filled vacated space with more nontraditional tenants, such as medical offices, churches, health clubs and offices. This helped to keep many of them still occupied. Weaker malls also take a long time to close, as they have locked in many retail tenants with leases that have staggered maturity dates.
Ironically, those short sellers who focused on the stock of listed mall owners did much better than those focused on the debt: total returns from mall landlords fell 2.7% and 7% in 2017 and 2018, respectively. In the first nine months, they are down 4.6%, according to data from Nareit.
Finally, it's worth noting that Alder Hill isn’t along among hedge funds who have suffered disappointing returns. For the 10th year in a row, hedge funds have underperformed the S&P, recording less than half the returns of the stock market in the first half of 2019.
Ironically, just as Jon Corzine would have eventually been proven right - and very profitably so - with his long bet on Italian bonds in 2011, yet which cost the bankruptcy of his firm MF Global when the Italian bonds crashed, so all the hedge funds who had bet on the collapse of the US mall industry will be right... eventually. They were just early.