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Overvalued Credit and Minsky Moments

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An excellent piece today by John Authers in the Financial Times, “Look to US for clues on whether sky is about to fall.” It’s not that he covers new ground, but he does a very good job of characterizing the current state of affairs. However, the piece falls just short of something you could share with a lay reader, which is a shame. As much as I like the phase “credit is overvalued,” most people outside the markets need to be reminded that bond prices being high means interest rates are low. They take a borrower’s viewpoint, and think of a static principal obligation, so “credit is too cheap,” which can then be translated into, “Borrowers aren’t demanding enough for the risk,” would fit their perspective better.

I’ll also grant him that the credit markets are vastly more precarious than the equity markets. However, I’m not certain that risk, or the perception of risk, isn’t fungible. Markets move together to a greater degree than ever before. The credit markets were precarious before last week. The subprime meltdown was already underway. But the equity markets, for the moment, took the brunt of the damage.

He also has some pithy illustrative data, particularly of the magnitude of derivatives relative to the underlying instruments, and discusses the concept of a Minsky moment. Economist Hyman Minsky observed that creditors become more lax about lending standards during times of stability. He divided borrowers into three types: the upstanding sort that can pay principal and interest; speculative borrowers (or “units”), who can pay interest but have to keep rolling the principal into new loans; and “Ponzi units” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender. Minsky’s comment:

Over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight of units engaged in ­speculative and Ponzi finance.

What happens? As growth continues, central banks become more concerned about inflation and start to tighten monetary policy,

….speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently units with cash flow shortfalls will be forced to try to make positions by selling out positions. That is likely to lead to a collapse of asset values.

Ouch.

But again, it’s hard to know where things stand. The markets that are most dodgy are generally the most opaque (not a good sign). But some of the apparent risks may be overstated. For example, Authers cites the fact that the “value” of swaps outstanding on a company’s bonds can dwarf the total value of the bonds themselves many times over. But is that the notional amount of the derivatives (that is, the amount they are “insuring”), or their actual market value? The market value is small, sometimes very small, fraction of the face value. So while we may well have cause for concern, it’s impossible to know how deeply concerned we should be.

From Auther’s article:

It is time to switch fairy tales. For years, market talk has revolved around Goldilocks – shorthand for the belief that economic growth will be “not too hot, not too cold”, and allow world markets to move ahead healthily without a big jolt.

After two weeks of heavy volatility, we have switched from Goldilocks to Chicken Little: is the sky about to fall on our heads? Are the many troubling aspects of the world markets going to be enough to generate a systemic collapse, taking the economy with it?

Whether or not this is likely, the fear of it has much to do with the volatility. So, if a Chicken Little event happens, how will it come to pass?

First, its roots would not be in China, or anywhere in the emerging markets, but in the world’s continuing consumer of last resort – the US. It was US consumer discretionary stocks that led world markets during their recovery in the latter half of last year and emerging markets continue to rely in large part on their exports to the US. If the US economic motor is switched off for any reason, then the assets most affected by it – such as industrial materials and emerging markets stocks – stand to suffer most. But the problem would lie in the US.

Next, it is hard to come up with Chicken Little scenarios for the US stock market in itself. Some of the arguments US equity strategists have produced in the past few days look disingenuous. It is pointed out that price/earnings ratios for US stocks are well below their average for the past 10 years, for example – ignoring the fact that multiples are too high on a cyclically adjusted basis. But stocks are not in the grip of an absurd overvaluation, such as that of 2000.

That cannot be said for the credit market, where valuations look as over-stretched as equity valuations looked seven years ago. Until the recent turbulence, the extra “spreads” in interest that risky loans had to pay compared with relatively safe treasury bonds were at all-time lows.

Unlike equities, many credit instruments are recent inventions and do not have the lengthy history that provides guidance on what to expect in the future. Many decisions on lending that were once taken by banks are now effectively taken by the “invisible hand” operating behind the credit markets.

The growth of credit derivatives, which are opaque and often package debt of different qualities into one instrument, has added to the confusion. Hedge fund managers betting on a credit collapse point out that the value of derivative swaps related to a company’s debt can easily outstrip the actual value of the debt many times over.

Thus, even though the derivatives market evolved to make it easier for lenders to spread their risks, a relatively small number of defaults could have a disproportionate impact.

Further, there is evidence that credit is overvalued, given the stage we have reached in the economic cycle. Research by Jim Reid of Deutsche Bank in London puts this in perspective. Particularly for high-yield bonds (where investors receive higher interest rates in return for taking a higher risk of default), credit has been persistently too expensive over time.

The valuations of low-quality “single-B” bonds are currently such that they will lose money compared with Treasuries unless their default rate over the next five years is better than for any previous five-year period over the past 30 years.

As the market has expanded drastically over that period, with many more companies gaining access, the probability in any case is that the default rate could be higher than has been seen historically. There are greater fears for lending to individuals. Americans spent more than they earned in 2005, for the first time ever, implying heavy borrowing.

They increasingly did so using adjustable rate mortgages, a new phenomenon in the US. There is no experience on what will happen to defaults when interest rates rise.

US banks are tightening their mortgage-lending standards at the fastest pace in 16 years, according to analysis by Odey Asset Management in London.

That in the past has been a leading indicator for an increase in defaults.

Greatest concern adheres to subprime lending – loans to people with bad credit histories. More than 25 subprime lenders have gone bust in the past few months. Such loans last autumn could be financed on the market for only 2.5 percentage points above the standard interbank lending rate. They now cost 14 percentage points more.

Do these problems put us in Chicken Little territory? George Magnus, economist at UBS in London, raises the possibility of a “Minsky moment”. Named after the late US economist Hyman Minsky, this refers to the tendency for leverage to increase as long periods of economic stability make leverage easier to justify. This has happened.

As growth continues, normal lending discipline gives way to “Ponzi” structures – pyramid schemes where newinvestors are paid with money from exist-ing investors. These collapse when the supply of willing new investors dries up.

The “Minsky moment” comes, says Magnus, when “lenders become increasingly cautious or restrictive, and when it isn’t only over-leveraged structures that encounter financing difficulties . . The risks of systemic economic contraction and asset depreciation become all too vivid.” This is the worst-case Chicken Little scenario. Any new evidence that it will come to pass would lead to more market drama.

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