More Signs of Frothiness in the Debt Markets

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Although it’s the Dow’s new highs that get the headlines, the really speculative action is taking place in the debt markets. As we have discussed in past posts, lenders and bondholders have abandoned their customary caution and are accepting yields that many feel are inadequate for the risks involved, and are also waiving customary covenants, which are another form of borrower protection.

Why is this of concern? When periods of overzealous lending end, the hangover is much worse than from a stock market bubble (in fact, the reason stock market bubbles aren’t so damaging is that in the wake of the 1929 crash, borrowing against stock was restricted to a comparatively modest 50% of the security’s value).

Consider the difference between the end of the 1980s boom and the dot com bubble. In the 1980s, banks had been involved in two types of lax lending: the LBO boom and the S&L crisis. The 1990-1991 recession was nasty and it wasn’t until 1994 that the economy was solidly back on track. By contrast, the 2000-2001 recession wasn’t very severe (although 9/11 delayed the recovery).

The scary bit about the current lending mania is that the excesses are pervasive. They aren’t contained to a market or two as in the past. We have reckless credit practices in junk bonds, commercial real estate, emerging markets, LBOs, and collateralized debt obligations (CDOs). Then we have hedge funds. They are often highly leveraged because many use derivatives or invest in instruments that can be margined to a greater degree than stocks. And some investors participate in the hedge fund market via hedge fund of funds, some of which apply another layer of leverage.

Central bankers assure us that this brave new world of finance is safe because investors are far more diversified than before and new instruments permit them to parse risks better than before. Nobel prize winner Robert Merton makes a succinct counterargument to Gillian Tett of the Financial Times:

[I]f you invent an advanced braking system for a car, it can reduce road accidents – but it only works if drivers do not react by driving faster.

Merton ought to know. He was one of the partners of Long Term Capital Management, whose collapse nearly took down the financial system with it.

Now to the latest credit market risk sightings. The weekend Wall Street Journal tells us that credit terms are being relaxed in the emerging markets:

With so many investors looking for bigger returns, emerging-market companies — like their high-yield counterparts in the U.S. — are finding that they don’t have to offer as much protection to bondholders in the form of covenants….

Covenants on corporate bonds can restrict a company’s capital expenditures and ability to take on additional debt, or require management to maintain a certain level of free cash flow. These restrictions are traditionally present in bank loans, and a growing number of emerging-market companies are choosing to issue bonds, because they can now raise capital with more flexible terms.

Alfredo Chang, portfolio manager at GE Asset Management, said…that bondholders are appearing to “take on faith” that they will escape relatively unscathed from negative credit events.

The Financial Times, in “A headache is in store when the credit party fizzles out,” worries that competitive pressures have undermined good practice:

A few days ago in London, a senior banker made a striking admission to me: in his long career, he had almost never seen such bubble-like conditions in the credit markets as exist now. “Perhaps back in the 1980s – just before the collapse,” he muttered, with a despairing chuckle, over an elegant (and expensive) lunch.

That is alarming stuff. But worse is to follow: this very same banker makes a living by arranging loans and bonds to risky companies – and he freely admits there is little chance that his institution is about to switch off this financial tap.

On the contrary, last week his bank, like its peers, arranged even more finance for buy-out funds, which will enable them to conduct ever bigger deals, thus driving an acquisition frenzy that is helping to keep equity prices high.

Welcome to the fin-de-siècle mood that is gripping high finance. In recent weeks, high-profile figures have started publicly warning that markets are looking overstretched…. But right now, nobody appears ready to take away the punchbowl from the credit party. On the contrary, as Mr Bolton [of Fidelity] noted, the standards used to lend money to the private equity world are becoming weaker by the day, as new innovations keep appearing such as “cov-lite” loans (instruments on which the normal covenants protecting investors have been stripped away).

Why? One factor is what the Bank of England coyly calls “strong incentives [at banks] to match performance by competitors” – perhaps better described as “the banking rat race”. When times are good, bankers make large bonuses by arranging deals. But they rarely get paid for pulling them. While some financiers and investors have tried to argue that credit conditions looked over-exuberant in recent years, the credit cycle has stubbornly refused to turn. As a result, most bankers are now terrified of refusing deals, particularly at a time when the European economy is picking up. No one gets rewarded for taking the risk of crying wolf – yet again.

But there is another important reason why the credit party powers on: the changing face of the financial world. A decade ago, banks in Europe (and, to a lesser extent, the US) were expected to assume all the risk that their loans would go bad. But they have recently been distributing this so-called “credit risk” to other investors, such as hedge funds, on a massive scale. They do this either by selling loans or writing derivatives contracts that insure against default.

In many ways, this is a marvellous development. If banks – and hedge funds – take out insurance against credit risk, they will be less vulnerable if a big crisis hits. That should make the financial system safer, with fewer spectacular collapses. But there are two catches. First, the financial world has started spreading credit risk around on this scale only recently – which means that no one knows exactly how markets might behave if (or when) the world goes into a major downturn. Thus far, the existing evidence looks good: so far this decade, the financial world has absorbed several mini-blows, such as the Enron crisis, very smoothly, apparently because financial innovation has spread risk. But whether derivatives would keep playing a benign role if a mega-shock erupted remains an open bet.

The very fact that institutions now believe that financial innovation has made them safer might actually be making them more cavalier about lending risk….

Similarly, derivatives usage should reduce risk – but not if banks respond to their perceived new-found safety by arranging even more risky finance and investors keep gobbling this up. That, however, is precisely what now seems to be under way: financiers furtively mutter that the markets look overstretched, but then reassure themselves that financial innovation has made life safer – and rush to book their bonuses….After all, it is a cast-iron rule of the City, or Wall Street, that the longer any party lasts and the wilder it becomes, the greater the risk of a future hangover.

And in the CDO market, many investors are not recognizing their losses (this is a big breach of what is considered to be good practice. And on a pragmatic level, if they took a hit, they’d have some explaining to do, which would likely lead to more restraint). From “I knew it was bad, but…” in Minyanville:

I asked a large broker firm to send over its smartest math person on Collateralized Debt Obligations (CDO) structuring. I wanted to know what I am missing: why is the market so sanguine in the face of deteriorating collateral values in the mortgage market? One of my firm’s theses has been that, as the mortgage market deteriorates, investors holding CDO as an investment would realize losses and this would feed into other risky asset classes. Why aren’t losses being seen when the market is clearly deteriorating?

The team that came over was headed by a very smart gentleman. He was very good at math and very straightforward. Working for a broker I was prepared for some sugar coating. I didn’t get any.

The answer is simple and scary: conflict of interest.

He explained that due to the many layers of today’s complicated credit products, the assumptions used to dictate the pricing and outcome of CDO are extremely subjective. The process is so subjective in fact that in order to make the market work an “impartial” pricing mechanism must exist that the entire market relies upon. Enter the credit agencies. They use their models, which are not sensitive to current or expected economic activity, but are based almost entirely on past and current default rates and cash flow to price the risk. This of course raises two issues.

First, it is questionable whether “recent” experienced losses over the last few years really represent the worst of the credit market (conservative). But even more importantly, it raises a huge conflict of interest: the credit agency’s customers are the very issuers of the tranches they rate. The credit agencies, therefore, need to compete for business based at least in part on the ratings they are willing to give these tranches. As a result, they will only downgrade when forced to by experienced losses; not rising default rates, not a worsening economy, but only actual, experienced losses. Even more disturbing, they will be most reluctant to downgrade the riskiest tranches (the equity tranches) since those continue to be owned by the issuers even after the deal is sold.

So even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized simply because the rating agencies have not changed their ratings for all the above reasons. Accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices. For example, below is a chart of the actual BBB minus tranch of the mortgage-backed securities pool from November ’06 to present. Actual prices where traders can really buy and sell is substantially lower than where investors are marking their positions.

The levels at which investors are carrying the paper is not reflecting underlying reality as the holders simply hold their collective breath and the rating agencies ignore a worsening environment.

I asked them what would force the rating agencies to change their ratings and the response was “it’s just a matter of time if the market continues to deteriorate, for the agencies at some point will be forced by the cumulative losses to acquiesce.” Because these losses have been compressed, any re-adjusting of ratings by these agencies are likely to result in a massive repricing of risk.

See here for more information on the rating agencies’ skill limitations and conflicts of interest.

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