Why Don’t They Understand the Brave New World of Credit?

There are two reasons this item, picked up in Felix Salmon’s blog, is noteworthy. The first is that investment banks happily extending their balance sheets to help get M&A transactions done is a classic sign of the end of a cycle. The second is that Salmon, who is vastly more sanguine about the state of play than I am (I have a sneaking suspicion he wasn’t living in the financial markets in either the 1980-1981 or the 1991-1992 recessions) actually used the phrase “systemic risk,” admittedly in a very watered-down way.

What bothers me about his discussion, and that of other otherwise generally well-informed people, is that they still seem to be operating from the old model and see commercial banks as central to credit issuance. By extension, that means it’s OK if some investment banks or a whole bunch of hedge funds fail. That is no longer true.

Even when commercial banks seemed to rule the world, investment banks were important in the credit business. Goldman Sachs was the 5th biggest bank in the US in 1980 based on its commercial paper outstandings. And today, banks are secondary players.

Three-quarters of all loans to companies with junk bond ratings come from hedge funds and non-banks, according to S&P. The President of the Federal Reserve Bank of New York, Timothy Geithner, said in a recent speech “Credit Market Innovations and Their Implications,”

Credit market innovations have transformed the financial system from one in which most credit risk is in the form of loans, held to maturity on the balance sheets of banks, to a system in which most credit risk now takes an incredibly diverse array of different forms, much of it held by nonbank financial institutions that mark to market and can take on substantial leverage.

In the same speech Geithner said that only 15% of the nonfarm nonfinacial debt in the US was held by US financial institutions. Frankly, that means that the comfort that Salmon takes in debt being held by hedge funds isn’t comforting at all.

Let’s walk through the steps. The first is the way hedge funds behave on a business as usual basis. They are known for being rapacious lenders. When a company gets in trouble, they don’t tend to renegotiate or extend new credit. They go for the jugular and often push for liquidation or bankruptcy. So they are not supportive lenders, and in a down economic cycle, could exacerbate a recession by pushing marginal companies out of business.

Second, as unregulated institutions (as far as their investments go), they have no one looking over their shoulder to make sure they hold a prudent amount of equity against their assets. And if you are a hedge fund operator, and take huge profits out in a good year, and the losses don’t redound to you (and they don’t except in the case of fraud) you have every reason to swing for the fences. It’s called performance pressure. And hedge funds don’t have access to the Fed window in emergencies. So they are more failure prone than banks.

So if we have a meaningful number of hedge funds going under, there will be less corporate, small business, and residential lending. These guys are buying that paper. A contraction in credit has the same effect as an increase in interest rates (note you don’t have to have a rise in rates to have less credit on offer. In the 1991-1992 recession, the Fed finally loosened up on credit but the banks wouldn’t lend, at least for a while. So rates appeared pretty good but in practice you couldn’t get a loan approved unless you were a very strong borrower.

Mind you, this isn’t a theoretical risk. We’ve heard comments from informed people of widespread cavalier behavior among hedge funds regarding risk. We were also told that if there had been a second ratchet down the week of Februsry 27, there would have been hedge fund closures, enough to hurt some of their prime brokers.

So this out-of-step paradigm, of many commentators not recognizing the importance of hedge funds (and investment banks) and still regarding commercial banks as central is leading to some serious misreadings of what is going on. Read the Geithner speech. We took a hard look at it here. He in essence admits that even the Fed doesn’t have a grasp on the brave new world of credit.

To Salmon in his post “How much risk are PE shops offloading onto their advisers?“:

Do you ever get the impression that risk just goes around in circles? I’m relatively sanguine about a lot of the risk being created in the financial system right now largely because so much of the risk has been moved off banks’ balance sheets and into the portfolio of investors such as private-equity shops and hedge funds whose very raison d’être is to take on that kind of risk. But then today I see a Q&A with Jeff Raich, head of global M&A at UBS:

DJ: How can [KKR] handle such a big deal [as First Data] alone?
Raich: It’s partly a function of the investment banks becoming their partners. This is a continuing trend. You not only need to show up with debt, but equity and possibly an equity bridge as well. That’s the current ante for banks to play in mega-LBOs.

In other words, the investment banks have long since ceased to be fee-based advisers, and are now primarily valued for their ability to bring their own risk appetite to the table. And they’re not just taking on senior debt, they’re taking on equity bridges and even outright equity risk.

I would hope that the banks concerned are good at placing that kind of risk in internal hedge funds or PE funds where it belongs, and not on their own balance sheets. But I have a feeling that if and when a blow-up occurs, more than one investment bank will find itself severely damaged by the repercussions.

The good news, of course, is that a damaged investment bank is hardly the end of the world. But it’s the beginnings of a hint of a possibility of some systemic risk, all the same.

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