The Rising Tide of Liquidity

The Financial Times has had three stories on loose credit conditions in three press days: one on Friday the 12th, two on Monday the 15th, all worried in tone. Apologies for getting this to you on a delayed basis, but the FT website was not cooperating from Friday evening through Monday (colleagues had the same experience).

These stories all got prominent placement in the FT. The Friday article was on the first page of the second section. Monday’s items ran on page one and as a full page “Comment and Analysis” feature in the first section. Yet we’ve seen little commentary on this in the US financial media.

From the Friday story:

The issuance of securities linked to debt portfolio funds, known as collateralised debt obligations, swelled dramatically last year – a trend that could be helping to prolong the easy conditions in credit markets.

Some estimates of activity in this notoriously opaque sector suggest that more than $2,500bn ($1,285bn) of CDOs were issued last year. That was six times higher than in 2004, according to the Bank for International Settlements….

However, some analysts suspect that this activity is, in itself, helping to prolong the easy conditions in credit markets. The explosion in CDO issuance is fuelling demand for debt products, helping keep the cost of borrowing in markets relatively low.

From the Monday front-page article:

The amount of debt carrying the highest risk of default is rising as a proportion of the junk bond market, prompting fears the next cycle of corporate failures could be more severe than the last.

In the US, nearly 16 per cent of bonds are rated CCC or below, up from about 13.5 per cent at the end of 2005, as measured by the Merrill Lynch high-yield index.

High-yield or junk debt is rated below the BBB bracket, the lowest investment grade rating. Credit ratings of CCC or below are reserved for junk bonds with the highest risk of default.

The European market has also seen record issuance of CCC-rated paper….

Abundant liquidity in global debt markets has helped push default rates and risk premiums to record lows and feed investor appetite for risky assets.

“I don’t think anyone seriously disputes that a lot of precariously financed deals have been sold into the market in recent years,” said Martin Fridson of research publication Leverage World.

The problem, he warned, is “liquidity is there when you don’t need it in the high-yield market”.

In other words, overstretched companies can survive by borrowing more in friendly markets, but sink when conditions turn sour.

Mr Fridson’s analysis suggests recent high levels of low-quality debt issuance could push default rates sharply higher – from fewer than 2 per cent of high-yield borrowers last year to as much as 17 per cent – if the US were to experience a recession.

And the full-page commentary:

At a glitzy dinner in a Mayfair hotel in London last week, prizes were awarded to the best capital markets performers in 2006. Strikingly, the group that grabbed the tag “best financial borrower” – meaning, most creative in raising funds – was not a bulge-bracket Wall Street or City name. Instead the honour went to Northern Rock, a lender to homebuyers, which is based in north-east England’s gritty Newcastle and has become an enthusiastic issuer of mortgage-backed bonds.

The award points to a much bigger shift gathering pace in the financial world – one creating headaches forpolicy-makers as they try to guess where the next financial crisis might pop up or when to call the turn in the interest rate cycle.

Derivative financial instruments have existed for three decades and some US institutions have been repackaging mortgages into bonds since the 1980s. But what has changed this decade is that these products of so-called structured finance, the banking activity that devises them, have mushroomed in size and become vastly more complex. These days, that often involves not just the issuing of mortgage-backed bonds by lenders such as Northern Rock but also the use of these securities to create new instruments called collateralised debt obligations (CDOs).

In effect, that means one asset – such as a mortgage loan – is being used and reused many times over to create new trading and hedging opportunities. It is akin, in a sense, to how a small amount of sugar can be spun up into a huge cone of candy floss.
As a result, activity is exploding. The gross value of outstanding derivatives contracts, including exchange-traded and over-the-counter derivatives, has reached $453,000bn (£231,000bn, €350,000bn) – a fourfold increase this decade. Meanwhile, US and European asset-backed security issuance has risen four times in this period, while total issuance of CDOs is believed to have topped $2,500bn last year alone…

This trend has been great news for investment bankers, who earn fees from such deals. However, it has also benefited Northern Rock. By going for its funds to the global capital markets, the former building society can raise more finance, more cheaply. The group may also be making itself less vulnerable to future economic shocks. When Northern Rock sells its mortgage-backed bonds, it in effect moves some of the risk of default into the hands of new investors. That implies that if a housing crash occurs, losses will be shared between Northern Rock and bondholders, which could make it easier to absorb the pain.

Risk-sharing also brings an immediate benefit for the lender, in that it can make more loans: regulatory rules permit banks to reduce the reserves of cash held against their loans if these are securitised. That means Northern Rock can create more mortgages, for each pound (or dollar) of capital, than before. “Securitisation has provided us with a sustained source of funding that supports our growth strategy,” says Mr Jones, adding that the company is expanding its lending business at about 20 per cent a year.

Yet, like most innovations, the seeming magic of structured finance has drawbacks too. One is that transferring risk potentially introduces a new element of “moral hazard” into credit lending: if lenders think they are insured against the risk of default, they could be tempted to lend too much – further inflating asset bubbles.
Moreover, the transfer of risk could make it fiendishly difficult to see who might be left holding losses if a credit shock did occur….

Optimists argue that this opacity does not matter. After all, companies rarely know precisely who holds their shares either. However, what worries some policy-makers is that structured finance is often so opaque that dangerous concentrations of credit risk could develop in the system – unseen until a shock. Banks, for example, now seem to be buying each others’ securitised bonds through their investment arms, which could mean they are acquiring risk through the back door even as they appear to be shedding it in their published accounts.

That makes it harder to assess overall leverage in the economy. But it could also make it difficult for central banks to control credit conditions with old-fashioned monetary tools. One problem is that the use of derivatives can affect investor behaviour. If a company has hedged itself against interest rate rises, for example, it may not react to higher rates in quite the same manner as before.

Another issue is that the globalisation of the international financial system is undermining the power of national central banks, whose job it is to curb over-exuberant financial markets by raising rates before inflation and asset bubbles get out of control.

Look, again, at Northern Rock: until this decade, its funding conditions depended heavily on what the Bank of England did – but now two-thirds of its mortgage-backed bonds are issued in dollars. That means its fund-raising ability partly depends on global factors outside the UK central bank’s control, such as an Asian savings glut.
Moreover, some of these factors may appear only indirectly linked to the “real” economy. Right now, for example, bankers are scrambling to find debt assets with which to create CDOs – which helps to create hot demand for the type of securities being issued by Northern Rock.

So does this leave central bankers less powerful than before? Independent Strategy, a research group, points out that the derivatives and structured finance sectors have recently grown so fast that they have come to dwarf traditional measures of liquidity – such as a narrow definition of money (cash and bank reserves) or a broader measure (including bank deposits and loans).

Consequently, these monetary yardsticks no longer provide meaningful guides to liquidity, it claims – while the role that central banks play in money creation is also falling, making it harder for them to shape the credit cycle. That, Independent Strategy concludes, explains one of the great mysteries of the past two years: why the cost of borrowing in the capital markets has remained low even though central banks have been raising rates.

“Rising policy interest rates have had no effect on slowing the expansion of liquidity . . . because increases in short-term rates did not cascade into the pricing of the bigger . . . tranches of the liquidity pyramid,” the group says in a research report. “Now new-fangled financial instruments create liquidity independent of central bank control.”

Such arguments – unsurprisingly – find no great favour among central bankers themselves. Instead, most believe that rate rises can still affect the more esoteric parts of the system, since the different parts of the financial world are ultimately interconnected.

Nevertheless, there is a rising acknowledgement by policy-makers that structured finance could be changing the pattern of the credit cycle and distorting some monetary signals. Ben Bernanke, US Federal Reserve chairman, confessed last month: “The rapid pace of financial innovation in the United States has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables.”

Separately, Mr Tucker conceded in his speech that the Bank of England currently found it hard to interpret M4 (one of the broadest measure of sterling money), because structured finance and hedge fund activity appeared to be distorting the data. Bankers creating CDOs, for example, appear to be generating new, cross-border loans to back their derivatives, in a manner not seen before.

Worse, as Mr Tucker noted, whereas monetary authorities used to track credit conditions by watching banks’ balance sheets, these no longer provide an accurate guide to activity either, because banks are shuffling risk around. That makes it hard to pinpoint how much leverage is in the system – and how financial markets would react to stress. While many investment bankers argue that the evidence is that risk transfer is helping the financial system to absorb blows, this new world has not yet been tested by any really large macroeconomic shock.

Thus what would happen to the financial system in a crisis remains – as Mr Tucker puts it – “unknowable”. After all, in the period since European lenders started securitising bonds – namely this decade – there has been no big housing crash. Or as Jochen Sanio, Germany’s top regulator, noted last week: “Does anyone know who holds the risk [in modern financial deals]? . . . Market participants are operating in terra incognito.”

Thus far, none of this uncertainty seems to trouble the investors who are buying Northern Rock’s bonds. Nor does it deter the bankers who were celebrating at the International Financing Review awards in Mayfair and who generally assume that structured finance will expand further this year.

Meanwhile, groups such as Northern Rock currently have only reasons to celebrate the changes. Its senior management has just been on a road show in the US to sell more mortgage-backed bonds while, back in the UK, it is extending cheap loans to consumers. Its website at the weekend declared: “If your wallet’s taken a bit of beating over the festive season, an unsecured loan from Northern Rock could be the perfect way to sort things out.”

Right now, in other words, there is little sign of any end to the credit boom – nor, it would seem, to the mounting uncertainty about what might happen if or when this frenzied debt dance ends.

Now for years, some commentators have wrung their hands over the growth of the derivatives market, since it is largely opaque, and the size of derivatives positions relative to cash exposures also makes it hard to interpret the balance sheets of large financial services firms. So far, the regulators have been watchful but non-intrusive. And the worriers have been proven wrong.

But a change in degree may be a change in kind. The declining ability of central bankers to staunch liquidity is a new, troubling, development. Financial intermediaries are running proprietary trading desks, which amount to internal hedge funds, and lending to hedge funds via their prime brokerage operations. These hedge funds in turn are leveraging themselves both by borrowing and also by the use of futures and derivatives, themselves levered instruments. The prime brokers lend only against collateral, but in a crisis, like 1987 or the near-meltdown of LTCM, prices don’t decline, they gap downwards. Collateral that appeared adequate may suddenly worth a lot less, or temporarily unsaleable. And while hedge funds make a variety of bets on the asset side, they tend to be herd-like in how they finance themselves.

What could provoke a crisis? The most likely culprit is oil. An article in the current Vanity Fair plays out how further deterioration in Nigeria could take 800,000 barrels of oil per day off the market, and that sort of swing (combined with slightly tighter overall market conditions) could push prices over $100 a barrel. Similarly, if Bush were to launch air strikes on Iran, it’s not hard to imagine that they close the Strait of Hormuz. Look at a map. It’s the only ocean access for the oil exporting Gulf states. Some 20-25% of the world’s oil supply goes through it.

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