First and foremost, our hearts go out to all who have been impacted by the California wildfires, whether directly or through the experience of loved ones.
This week, Cumberland made the decision to eliminate our limited exposure to Los Angeles Department of Water and Power (LA DWP) and, as of Friday morning Jan 24, we had no remaining exposure. This decision was made after extensive internal debate and independent research. We concluded that preserving capital and trust is paramount to holding for a limited potential recovery.
Due to the nature of the evolving and opaque situation in California, and the inverse condemnation regulations in place, a ‘hold’ would be a decision to accept risk that an atypical significant liability may or may not be applied to a holding in the portfolios of our clients. The hope that liability does not ultimately fall on LA DWP, to us, is not sufficient reason to maintain the risk, particularly as we do not believe a full recovery is possible - even in a more positive scenario.
A sell, conversely, was the removal of an uncommon potential risk from portfolios, at the acceptance of a loss, in order to avoid a potentially greater negative outcome. We have taken the tax losses for our clients. Our rationale is as follows:
· While we have remained hopeful and believe the breadth and importance of LA DWP to be significant, the possibility of liability is uncertain, and there are unprecedented estimates for fire damage in a state with inverse condemnation. In analyzing scenarios for potential outcomes, we determined the amount of recovery in a more positive outcome does not exceed the risk or cost of a negative outcome in this situation. Hence, the prudent decision in our view was to book the tax loss.
· LA DWP traded at approximately -15 to -20bps through the mmd scale before the fires in California began, to roughly +60/mmd now (~75bps wider). We believe that at least 30-35 basis points is a sunk cost, and regardless of official liability or blame, LA DWP will not fully recover in the near to mid term. The issuer will be facing ongoing litigation, additional scrutiny of the sector by rating agencies, and a greater risk premium due to potential for future fires. We do not believe the name will see pre-fire levels even in a relatively positive outcome, unless significant improvements are made to infrastructure, changes are made to California liability law, improvements in ratings outlooks, or a combination thereof. These would take significant time to achieve.
· Without resolution to infrastructure, the ongoing environmental credit risk associated with the name will be a drag. Therefore we believe, even if not deemed to have liability months from now, the market will have repriced LA DWP at a wider relative spread to high-grade CA paper than has been historically held by the issuer, and therefore the recovery upside potential over the coming 12-18 months has a ceiling of roughly 45 basis points tighter from current levels. We see that as a best-case scenario, not our base case.
· On the contrary, if liability for ignition is deemed to rest with LA DWP, the ongoing litigation, costs, and concerns around the credit will be significant for some time. Litigation extends beyond ignition of the fire to water issues or lack of preparation and upkeep. Multi-notch downgrades would be probable, uncertainty will likely increase, risk will reprice, and some forced selling may occur. Acknowledging the size and scope of the utility, we believe there could be some securitization, but this too is speculation and the timing, strings, headlines, and politics involved could add to market uncertainty. We do not believe default to be a likely scenario, however, we see potential downgrade risk, another gap out in spread widening, and illiquidity to be very possible in a liability outcome.
· We have concerns about future liquidity if LA DWP is deemed liable, particularly in the face of further downgrades. Currently, our research suggests very few dealers are committing capital to the name. Those who are tend to be very limited, seeking discount structures, and selectively engaging in small blocks where they already have interest or an order in hand. The two-sided markets we have seen, while orderly, does not have great depth and is reportedly select ETFs & Funds willing to add at adjusted levels. We selected to leverage the buyers that currently exist, as we do not believe the current bid will remain at current levels if LA DWP is deemed liable. We believe the next level of buying would be at significantly higher yields in a liability outcome.
· We are not opposed to adding the name back once there is greater clarity and at levels that pay for quantifiable risks. That will depend on the months ahead and our evolving view of the credit. However, the limited recovery obtainable in the foreseeable future has been deemed insufficient to remain in the credit in the current environment.
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