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Bubble, bubble, when will you burst?

by Jerome a Paris Thu Nov 30th, 2006 at 06:02:25 AM EST

I've been writing regularly about the incrzeasingly imprudent behavior of banks in recent times, which are financing, thanks to cheap liquidity, extremely aggressive transactions in supposedly boring sectors like energy and infrasturcture. Well, Standard & Poors is officially worried:

Fears for transport and utilities 'bubble'

Investment in the global infrastructure sector is inflating into a dotcom-style bubble, suffering the "dual curse" of overvaluation and excessive leverage, Standard & Poor's warned today.

The gloomy prognosis follows expansion of the sector this year, with transactions so far totalling $145bn (£74.5bn) globally - a 180 per cent increase on 2000 - and up to $150bn of funds raised and waiting to be placed, according to the rating agency.

Michael Wilkins, managing director of S&P's European infrastructure finance group, blamed a combination of cheap financing and private equity interest for pushing up asset prices and leverage amid a relative shortage of suitable targets.

(...)

"Talk to anyone in the industry and they all agree that we are getting to a stage where the whole market is overheated."

Infrastructure assets have become popular because they are commonly believed to offer stable, inflation-proof cashflows, making them a good match for pension liabilities. Their cash-generative characteristics means acquisitions can be funded with large amounts of debt.

(...)

He cautioned that private equity's three to five-year investment horizons were unsuitable for infrastructure. Buy-out firms account for 50 per cent of infrastructure deals this year.

Everybody knows it, but people keep on doing it, because others are doing it, and if you don't follow, you don't do deals and you don't get your bonus at the end of the year.

And note that this is not even investment: this is just buying and selling of existing assets, with much less actual construction activity. It's a huge financial bubble waiting to pop. The only thing is - nobody knows who will take the hit, because risk has been sliced, repackaged, resold, resliced again, hedged, and sometimes dumped onto unsuspecting investors.

Ah, but it will give a lot of work to lawyers and bankers - the bankrupcy and workouts kind... They also get nice bonuses.


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One reason why I've been working on offshore windfarms is that this is a new, and thus poorly understood, sector, so most banks are not yet interested.

But I consider that these kinds of risks is where you have value added in being a pioneer; it takes a bit more work to understand what you're doing, but you actually make ot more money for what ends up being a reasonably transaction; whereas in transactions in the onshore sector, the risks are well known - but now in most cases wildly excessive from a sane banker's perspective.

Of course, once we show that it can be done, there will be a rush by other banks.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Nov 30th, 2006 at 06:07:56 AM EST
This is all nice and good, but what about Oil&gas finance ? I may have lost track of the financing structures, but my recollection was that they were also pretty aggressive as were the terms imposed on countries who have no other choice for exploiting their resources than teaming up with "Majors" such as BP, all this to receive a meagre share of the profits

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 07:05:47 AM EST
[ Parent ]
It's the other way around, isn't it? The third world governments control 75 % of all the oil fields and the majors are happy if they manage to siphon of 10-20 % of the profits.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Thu Nov 30th, 2006 at 07:45:02 AM EST
[ Parent ]

countries who have no other choice for exploiting their resources than teaming up with "Majors" such as BP, all this to receive a meagre share of the profits

It's the other way round. The biggest problem of the majors is that they are welcome in so few countries these days that those that are willing to work with them can pretty much call the shots and set the terms (or improve further the terms set in earlier years). Host countries typically get 90% of the marginal revenues these days.

As to the aggressiveness of financial structures, it never got too bad, apart for pricing, which is a lesser problem. And now that the sector is so rich anyway, operations have all but dried up.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Nov 30th, 2006 at 09:30:54 AM EST
[ Parent ]
Okay, point taken. So "poor" Majors manage to get only 10% ? Wonder why they rank among the very small number of corporations boasting a AA to AAA credit rating. <s>

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 10:56:27 AM EST
[ Parent ]
Just for the record, the aggressive structures (mini perm and hence huge refinancing risk) now prevailing in the real toll road financing schemes are directly inspired of the merchant power transactions so notorious a few years ago.

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 07:20:26 AM EST
[ Parent ]
So if there is a bubble and existing infrastructure assets are being bought and sold at inflated prices and with excessive leverage, what happens to the infrastructure when the bubble bursts and there is a credit crisis in the sector?

Those whom the Gods wish to destroy They first make mad. -- Euripides
by Carrie (migeru at eurotrib dot com) on Thu Nov 30th, 2006 at 06:20:52 AM EST
in the mid-nineties with IPPs (Independent Power projects) in Asia, which governments (mostly Indonesia and Pakistan) had put on line with blatant disregard for the real needs of the market.
Same thing that happened to merchant power in the early years of 2000. When you disregard the market, the market fights back.
I know a little about those issues, having worked on the restructuring process of both Asian IPPs and US merchant power plants.


When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 07:13:06 AM EST
[ Parent ]
"Same thing that happened" means nothing if one doesn't know what happened.

Those whom the Gods wish to destroy They first make mad. -- Euripides
by Carrie (migeru at eurotrib dot com) on Thu Nov 30th, 2006 at 07:23:48 AM EST
[ Parent ]
You are right, but that would stretch to diary length. Too happy to oblige.

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 07:35:36 AM EST
[ Parent ]
Well, the underlying assets will still be there, and will still function.

If you have a crisis caused by, to make it simple, higher interest rates, the company becomes unable to service its debt and defaults. The banks can then decide to take over the project (wipe out equity, i.e. the investors lose their money) and/or restructure - reschedule the debt, change the terms to make debt bearable. If it still doesn't fly, then banks will lose some of the money they put in (that can be done in an orderly fashion as part of the restructuring: banks cancel a part of the debt to have a chance to get the rest back). They may also start lobbying to change the underlying economics, i.e. increase prices of the services (tolls, airport fees, etc...) if set contractually rather than by markets.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Nov 30th, 2006 at 09:35:16 AM EST
[ Parent ]
Doesn't rescheduling/restructuring the debt mean that the banks lose money? [Because the present value of the future revenue stream is reduced]

Those whom the Gods wish to destroy They first make mad. -- Euripides
by Carrie (migeru at eurotrib dot com) on Thu Nov 30th, 2006 at 09:53:43 AM EST
[ Parent ]
It does, theoretically at least. However restructuring schemes are built on revised business plans, some of which actually manage to come up with higher profit forecasts on the long term. Market advisors can be very "creative"

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 10:58:49 AM EST
[ Parent ]
Rescheduling can simply mean that principal repayments are pushed into the future, but interest keeps on being paid - thus no losses for banks.

There can be a reduction in interest rates payable to banks - formally no losses, but less revenue for banks than before

Then there can be debt cancellation (write off) - then banks will have formally lost money. What happens in practice is that banks have provisioned amount right from the start, and if a transaction looks to be in trouble, they'll provision more (before even having losses or even negotiating a restructuring). Using these provisions up when restructuring does not create losses for the bank (as they have been "preemptively" booked in earlier periods) Banks typically pile up a lot of provisions in good times (subject to tax authorities, as these provisions reduce profits and thus taxes payable) and can ride out quite significant losses for a while before it really hurts.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Nov 30th, 2006 at 11:15:56 AM EST
[ Parent ]
No idea. Probably, the response is : it depends.

Looking at the chunnel, no, if you have some shareholders for taking the bloodbath.
If I have understand properly, it is a bonanza for the banks having financed it at the right time.

La répartie est dans l'escalier. Elle revient de suite.

by lacordaire on Thu Nov 30th, 2006 at 05:38:37 PM EST
[ Parent ]
as far as tolls are concerned, the potential for their increase is very strictly framed within the concession contract signed btw the public authority and the private operator. The headroom for increase is typically inflation plus peanuts, unless the  authority breaches their contractual obligations for eg. allows for another toll road to be built in order to directly compete with the first one. Lobbying is in this area a waste of time, unless the project gets to the point of no return and then it's banks' bargain power against that of public authorities. Would not place bets...
For airport fees, it is even more complicated, as the bulk of it is regulated by the IATA.


When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 11:05:57 AM EST
[ Parent ]
One would think that the fact that this warning is coming from S&P would be significant, wouldn't one.

Is this an indication that they are starting to integrate this aspect in their rating process?

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman

by dvx (dvx.clt ät gmail dotcom) on Thu Nov 30th, 2006 at 06:41:38 AM EST
see my diary on PPPs

PPPs, the long term perspective and the taxpayer

When through hell, just keep going. W. Churchill

by Agnes a Paris on Thu Nov 30th, 2006 at 07:08:33 AM EST
[ Parent ]
Very good and definitely cross-postable at my favorite American "conservative" oasis, lunatic asylum, and wind farm.

Question is:

How many times does this thing have to play out over the years, with realively minor new twists, before governments and regulatory authorities get a clue?

"When the abyss stares at me, it wets its pants." Brian Hopkins

by EricC on Thu Nov 30th, 2006 at 06:44:19 AM EST
this is an indefinite game : see my previous post : the power bubble, the telcos bubble, the real estate bubble...
I've been around in project finance banking for more than ten years and there is no sight of a change in perspective.

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 07:15:16 AM EST
[ Parent ]
Jerome, no one questions your commitment to "sane" financing structures. But don't tell me that  when the wind power industry really does take off (which will be the case or not, depending on whether enough major banks buy the trick that it is low risk), and attracts "reckless" investor, the same practises you blame will not prevail ?

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 07:18:32 AM EST
Wind power HAS taken off, and these reckless practises ARE prevailing. That's what I said in my diary.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Thu Nov 30th, 2006 at 09:39:06 AM EST
[ Parent ]
and what when they spread to off shore wind finance ? Are you considering a dramatic shift in career course ? ;-) I suggest micro-credit.  Just kidding you.

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 10:49:25 AM EST
[ Parent ]
Will "brownouts or huge price spikes" magically disappear once we move towards sustainable energy sources, or will we also need to manage these market manipulation and regulation?

Reading this thread reminded me of what you wrote in Guillotines, da Vinci, peak oil and discount rates:

We're all familiar with business cycles: there is growing demand for one product; prices can be very high; people rush to provide the good and offer the suppy that will fulfill that demand; the first comers get excellent prices; as new sellers come in and supply increases, prices goes down and more demand is created; the sector booms and more suppliers poor in; but at some point, prices become too low and new sellers are discouraged, and some of the existing ones drop out until demand can catch up, and prices can go back up.

In particular, I was wondering if this passage could eventually apply to wind power (and alternative energy in general):

Same thing in the power sector in the late 90s, when an investment boom in gas-fired power plants created a glut of power and rock-bottom prices that left a lot of investors (and their financiers) in the dust. Demand is now catching up after several years of little investment, and we again get brownouts or huge price spikes.

Based on your comments above, it seems that the mad rush for onshore wind power has already started.  Could that mad rush extend to other sectors, such as offshore windpower?  If and when it does, will there be destructive boom and bust cycles there as well?

If so, at that point will we have to take into consideration the recommendations that you made in that other diary (if I understood it correctly?):

Markets are unable to anticipate the sea change that stagnant production at a time of sharply increasing demand will mean, and the requisite demand destruction, which could be brought about in an organised fashion via a combination of market manipulation (taxes to increase the apparent price) and regulation (to encourage or impose energy efficiency, for instance), will happen brutally, via huge price increases and the serious economic dislocation that will entail.


Truth unfolds in time through a communal process.
by marco on Thu Nov 30th, 2006 at 10:15:12 PM EST
[ Parent ]
Hate to say this, but the only "sane" financing structure is one where "Credit Institutions" such as  Banks do not create credit as a multiple of their Capital base (so-called "fractional reserve banking") but rather manage:
(a)the mutual guarantee of bilateral "peer to peer" credit aka "Time to Pay" on the one hand; and
(b)the bringing together of investors with investment in productive assets of all kinds, on the other.

The "Deficit-based" Money created by Credit Institutions is IMHO:
(a) by definition inflationary, of asset prices directly, and other prices indirectly; and
(b) directly responsible for driving the "Economic Growth" which is sending us all "to hell in a hand-basket".

That, I believe, is the Inconvenient Truth.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Nov 30th, 2006 at 01:48:22 PM EST
[ Parent ]
supposedly boring sectors like energy and infrasturcture.

I can't imagine more exciting sectors. I must be a total nerd. :)

While you hear about the liquidity bubble now and then, I had no idea about it going into energy and infrastructure. If there is one sector that has been subject to systematic underinvestment during the last 20 years it's these sectors.

Or am I wrong?

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Thu Nov 30th, 2006 at 07:41:11 AM EST
I guess it depends on whether this is investment or just "investment".

The bit about


private equity's three to five-year investment horizons

Seems to imply that the buyers are just looking to flip their asset at the point of maximum return.

The fact is that what we're experiencing right now is a top-down disaster. -Paul Krugman

by dvx (dvx.clt ät gmail dotcom) on Thu Nov 30th, 2006 at 08:06:56 AM EST
[ Parent ]
When this bubble pops, which financial institutions will take the loss?

I'm thinking of what Agnes wrote: that this is a game with winners and losers, and until everyone is a guaranteed loser they'll keep playing it.  But I may have got that all sideways and backwards.

Don't fight forces, use them R. Buckminster Fuller.

by rg (leopold dot lepster at google mail dot com) on Thu Nov 30th, 2006 at 07:52:41 AM EST
When this bubble pops, which financial institutions will take the loss?

The taxpayer, of course. Financial institutions cannot be allowed to fail.

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Carrie (migeru at eurotrib dot com) on Thu Nov 30th, 2006 at 07:58:54 AM EST
[ Parent ]
 

Technically: Is it possible to think up a law that would protect individual investors while pushing the risk back onto...well...this really isn't my field at all.  Corporate investors?  Investment houses?  Those who invest about £X in a deal?

Politically: Gordon Brown (as an example) seems (or seemed?) to have the ability to understand such issues, and he doesn't seem the type to give tax money to financial institutions unnecessarily, so is there part of the system that ties govts. hands?

Don't fight forces, use them R. Buckminster Fuller.

by rg (leopold dot lepster at google mail dot com) on Thu Nov 30th, 2006 at 08:04:22 AM EST
[ Parent ]
in this case, it's not clear that banks will lose money. As I said, they have often sold on the risk to others (hedge funds, pension funds, etc...) so the losers may pop up in unexpected places. It may be the banks anyway if they finance funds, but it might be pensioneers of private pension funds...

But banks are quite big these days, so they will take a lot of the losses before it costs money to the taxpayer. We'll see.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Nov 30th, 2006 at 09:41:47 AM EST
[ Parent ]
some financial institutions cannot be allowed to fail.
However, by experience when construction companies such as Jarvis plc in the UK or Walter Bau in Germany went bust because of the construction business bubble, banks indeed took the loss.
Passing financial institutions for the worst of evils can do as little good as worshipping them.

When through hell, just keep going. W. Churchill
by Agnes a Paris on Thu Nov 30th, 2006 at 10:53:25 AM EST
[ Parent ]
In the 80's we had a major housing boom where the banks were financing insane speculation. The part that interests me is multi-residential housing. People were buying multi-residential housing on the belief that their assets would be worth more tomorrow than today. The business aspect of multi-residential housing was a distant second. Banks went to the cleaners on multi-residential mortgages when the housing bubble burst.

Today we are in the same predicament with a big change. Banks have put the lid on speculation in the multi-residential housing industry. Not only that, but over the last 5 years it looks to me like the requirements for mortgages have become stricter, not looser.

In general, we try to keep our finger somewhat on the multi-residential housing market because we own one. Because we are interested in buying we have been sampling listings from across the country. Currently multi-residential prices are workable, if not great business investments, and given the restrictive lending practices of the banks, that is unlikely to change. The only exception to this is in Victoria and Vancouver where building prices are high enough that they do not work as a business. It is not clear to me if the banks are loaning more money there (I kind of think not.) or if there is a lot more money available for purchasing - more money down.

A second area that seems similar to what Jerome a Paris is talking about is insurance. Part of that is the insanely low rates people on the shoreline of the Gulf pay. Our insurance company raised our rates substantially over a few years to cover hits on the re-insurance (according to their claim) market. Interestingly we were able to get substantial savings on our rates by changing to a small local mutual company.

My thought is that if the banks try to pass on losses to the consumer - as they did when they started charging for all their services - that there still are alternatives to the major banks. It's why I bank at our local grocery store.


aspiring to genteel poverty

by edwin (eeeeeeee222222rrrrreeeeeaaaaadddddd@@@@yyyyaaaaaaa) on Thu Nov 30th, 2006 at 10:17:09 AM EST
I think we miss something if we look at these sector-specific bubbles one by one and not in the context of a larger cultural/social paradigm now prevailing among the rentier and speculator classes:
Ingenious and precarious schemes in the world economy today have great legitimacy, and they profit in the sense that classical economics is fast becoming irrelevant. It is the era of the fast talker and buccaneer-snake-oil salesmen in suits. Nothing old-fashioned has credibility. Joseph Schumpeter and other economists worried about pirates, but they are more important today than ever before, including than during the late 19th century when they were immortalized in Charles Francis Adams Jr's Chapters of Erie.

The leitmotif is "innovation", and many respectables are extremely worried. I argued in Counterpunch earlier (June 15 and July 26) that gloom prevailed among experts responsible for overseeing national and global financial affairs, especially the Bank for International Settlements, but I grossly underestimated the extent of anxieties among those who know the most about these matters.

More important, over the past months officials at much higher levels have also become much more articulate and concerned about the dominant trends in global finance and the fact that risks are quickly growing and are now enormous. Generally, people who think of themselves as leftists know precious little of those questions, questions that are vital to the very health of the status quo. But those most au courant with global financial trends have been sounding the alarm louder and louder.

The problem is that capitalism has become more aberrant, improvised, and self-destructive than ever. It is the age of the predator and gamblers, people who want to get very rich very quickly and are wholly oblivious to the larger consequences. Power exists but the theory to describe the economy that was inherited from the 19th century bears no relationship whatsoever to the way it operates in practice, a fact more and more recognized by those who favor a system of privilege and inequality.

Even some senior officials at the International Monetary Fund (IMF) now acknowledge that the theory that powerful organizations cherish is based on outmoded 19th-century illusions. "Reconstructing economic theory virtually from scratch" and purging economics of "neoclassical idiocies", or that its "demonstrably false conceptual core is sustained by inertia alone", is now the subject of very acute articles in none other than the Financial Times, the most influential and widely read daily in the capitalist world.

Kolko in Asia Times Online

overextension, overcapitalisation, a mania for liquidity, compression of traditional financial cycles, expectation of ridiculously inflated returns, etc. are epidemic and not limited to one sector;  increasing shortages of commodities from fuel to food to water only increase the opportunities for short-term looting and gouging, which in turn exacerbate shortages (cf earlier thread on the crash of world fisheries).  an insane dogma of unlimited growth and contraphysical rates of return has led to insane expectations (some of which are realisable in the near term for a very limited number of players) which lead to insane behaviour including irresponsible risk taking (on every front -- financial, geopolitical, physical).

I note in passing that behavioural researchers have discovered that inconsistent, intermittent or arbitrary reward is more conditioning than predictable reward.  people and other animals will exert more effort and take higher risks to obtain a reward which is less predictable or certain than one which is predictable, even if the two rewards are of apparently equal value.  which is why gambling is addictive;  and there is a good reason why we call it "casino capitalism".


The difference between theory and practise in practise ...

by DeAnander (de_at_daclarke_dot_org) on Thu Nov 30th, 2006 at 05:03:17 PM EST
The bubble is all pervasive, but this was a good article about an alarm being sounded in the sector I (and Agnes) know well, and it was a good illustration of the phenomenon.

As you point out, those in the know are deeply worried.

I have actually used this argument with a good client, which appreciates us, but has received more aggressive financing offers from other banks than from us on a recent deal. I told them quite directly that if they took these offers, they'd get a better return, but they would threaten the likelihood that the financing would ever be repaid in full. They'd lose very little money, but it would still destroy their reputation as a prudent investor. Since then, they've failed to take a decision, and seem to be taking steps to make the transaction more complex - which looks to me like they are looking for excuses to take a less aggressive offer. Maybe I'm kidding myself that we ca nstill win the deal, but it would fit with their disciplined business practice, and their reputation not to overbid for assets (and thus to often lose bidding contests). But many others do not have such scruples.

Casino capitalism it is - except that with low interest rates and lots of liquidity, all players win ... until (blank not filled yet).

Good to see you around here, De.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Nov 30th, 2006 at 06:07:59 PM EST
[ Parent ]
"all players win, until..."

is the definition of a Ponzi Scheme.

but you knew that :-)

The difference between theory and practise in practise ...

by DeAnander (de_at_daclarke_dot_org) on Thu Nov 30th, 2006 at 06:49:15 PM EST
[ Parent ]
As discussed at La République des Blogs, I'd love to know who currently holds the potato for Credit derivatives.
by Laurent GUERBY on Fri Dec 1st, 2006 at 08:01:14 PM EST
[ Parent ]


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