by Jerome a Paris
Mon Jun 18th, 2007 at 12:03:25 PM EST
Two simultaneous articles this morning underline the worries of many senior players in the financial markets these days. One is a full page analysis in the Financial Times (from which the graph below is taken); another is a guest Op-Ed by Steven Rattner in the Wall Street Journal. Both suggest that hard times are ahead, as can be seen in their titles:
A fright in the bond markets may end the cheap funds era
The Coming Credit Meltdown
The above reminds us that we have been in a 20 year bull market for bonds, as inflation threats slowly receded - in fact, it's been more than 25 years, a full generation, as it really started after Paul Volcker pushed Fed rates to 20% to kill inflation in the very early 80s).
Describing the interest rates set by the bond market as the “cornerstone” for valuing equities and other securities, [Albert Edwards, Dresdner Kleinwort’s well-known global equity strategist] cautions that if the bond market has truly entered a new era of steadily rising long-term rates, “all investment portfolios will be shredded to ribbons”.
Increasingly cheap money, underpinned by ever more optimistic prognoses about inflation and, more generally, future returns on financial assets, has fuelled the massive financial boom we've been in for most of our lives and which has so transformed our economic landscape. By making high returns possible, it has generalised the requirement for such returns in all economic activities, and thus the need for constant restructuring of businesses, for cost-cutting, offshoring and, often, for the wholesale dismantlement of whole sectors of activity that could not generate the required profitability.
In fact, I'd like to propose to call that the Anglo disease, as a mirror of the so-called 'Dutch disease' which was first identified in the 60s in the Netherlands as other industrial acitvities suffered from the discovery of natural gas in Groningue, which created a new industry with much higher returns which made investment in other sectors relatively unprofitable and eventually generated economic hardship for the country. Today, economic activity and growth in the UK and the US is similarly dominated to a large extent by the City and Wall Street, to the exclusion of many other sectors of activity, as is demonstrated by the skyrocketing deficit in the trade balance for goods in both countries, by various studies that suggest that 40% of company profits in the US come from financial firms:
This month’s sell-off in the bond markets is already a landmark event. The fall in bond prices, both in the US and Europe, has been as sharp as any seen this decade. The consequent rise in yields has forced investors to re-examine the cosy assumptions that have underpinned the cheap financing available across the world for the past few years.
The article notes that inflation fears may slowly tick upwards again; it flags that Asians are moving away from buying US Treasuries and are trying to buy equity and corporate bonds (i.e. slightly more "real" assets than a general claim on the US economy); it also notes that contrary to what triggered the most recent bond market "scares" in 1994 and 2003, the US Federal Reserve has done nothing to surprise or disappoint markets this time. And thus it comes to a simple conclusion:
The best single explanation may be that the bond market suddenly recognised it had grown too complacent about risk.
The markets have been living off easy financing for many years, and it has generated a self-sustaining boom, as companies found it easy to refinance even when in dire straits, they did not have to default on their obligations, thus improving default rates; with easy money, investment has been strong and has boosted economic activity - starting within the financial sector, via an orgy of juicy mergers & acquisitions and refinancings.
But as investment turns out not to have been very wise, or financial transactions driven by the ego of CEOs and fuelled by greedy bankers turn out not to be such great ideas, the machine is beginning to choke on its own excesses. The subprime mortage market has already been wiped out; it's not clear yet whether that will have an impact on the overall economy, but the process that took place in that particular market might very well take place in other markets as well.
The more fearful view is that the contradictions in the US economy are about to come home to roost, as the housing boom required unsustainably cheap finance. On this reading, yields of 5.15 per cent, though low by historic standards, could provoke an economic crash.
Apart from housing, the biggest worry comes from the high-yield market, as noted by Steven Rattner in his WSJ article.
Just like subprime mortgages are loans to the weakest home buyers, high yield debt is lending to the worst companies - it's riskier but it pays better, and when conditions are mild in the overall economy, the risk becomes lower as these companies can do well enough to pay their debts.
The current market has offered such a favorable environment that defaults are a record low levels, and thus high yield debt prices (as measured by the "spread" between the cost of such debt and the cost of risk-free debt like borrowings by the government) are also at record low levels.
The low spreads have been accompanied by less tangible indicia of imprudent lending practices: the easing of loan conditions ("covenants," as they are known in industry parlance), options for borrowers to pay interest in more paper instead of cash, financings to deliver large dividends to shareholders (generally private equity firms) and perhaps most importantly, a general deterioration in the credit quality of borrowers.
In 2006, a record 20.9% of new high-yield lending was to particularly credit-challenged borrowers, those with at least one rating starting with a "C." So far this year, that figure is at 33%. No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.
In other words: today's market conditions are absolutely unprecedented, and nobody has the experience of what might happen next.
Like past bubbles, the current ahistorical performance of high-yield markets has led seers and prognosticators to proclaim yet another new paradigm, one in which (to their thinking) the likelihood of bankruptcy has diminished so much that lenders need not demand the same added yield over the Treasury or "risk-free" rate that they did in the past.
To be sure, the emergence in the past 20 years of more thoughtful policy making may well have sanded the edges off of economic performance -- what some economists call "the Great Moderation" -- thereby reducing the volatility of financial markets and consequently the amount of extra interest that investors need to justify moving away from Treasuries.
But to think that corporate recessions -- and the attendant collateral damage of bankruptcies among overextended companies -- have been outlawed would be as foolhardy as believing that mortgages should be issued to home buyers with no down payments and no verification of financial status.
And just as the unwinding of the subprime market occurred at a time of economic prosperity, the high-yield market could readily unravel before the next recession. With the balance sheets of many leveraged buyouts strung taut, a mild breeze could topple a few, causing the value of many leveraged loans to tumble as shaken lenders reconsider their folly.
Compared to the Dutch disease, the industry that causes activity-substitution (high finance) can appear to be able to grow ad infinitum, without any limitation to actual resources. Just borrow more money to do bigger deals and enjoy the very real income taken along the way. Find another lender to refinance or another buyer to re-purchase, and you're home and dry. Or just do deals where the actual burden to repay is pushed back into the future (and you won't be around anymore if and when they falter). Thus the City and Wall Street can generate more jobs than the industry it kills off destroys (especially when you are also making some of your money off industries in other parts of the world).
And blame it all on "globalisation" and "the freedom of investors to seek out the best returns around".
Bankers provide necessary and useful services. But the runaway juggernaut we have inflicted upon ourselves today has gone far beyond oiling economic activity. It has metastised into something which behaves like a parasite, destroying substance and justifying it by creating an apparently larger, but a lot more fleeting, prosperity increasingly based on our collective belief that it is actually doing so and not on underlying value added. When that illusions shatters, the reckoning will be painful.
Doom and gloomers are often accused of being unduly pessimistic, and making careers out of such announcements that rarely end up being true, but an increasing number of voices seem to see this the same way. As long as the collective delusion is maintained, the system can live on. But when opinion turns, things will move really quickly. As the fall will be smaller the earlier it takes place (although it is already much too late to think we'll avoid any pain), it would be better if it happened sooner rather than later.
Oh, as a final note of irony, it looks like the very top of the bond market was on the day when the USA invaded Iraq. Make of that what you will.