I am late to this good comment in the Financial Times, “Hold tight: a bumpy credit ride is only just beginning,” by Avinash Persaud. Between the bumpy markets of the day and arcane workings of Conde Nast’s blog entry system, I’ve been a bit distracted.
Admittedly, one of the reasons I view Persaud’s piece favorably is that he shares my view that we are only in the early stages of this credit contraction. And he points out the downside of securitization: investors, unlike banks, don’t tend to hold on to credits that may be deteriorating. And they don’t have workout departments for the seriously distressed.
Space constraints may have prevented Persaud from mentioning another factor that works against a “ride it out” strategy, namely, mark to market. Banks are now required to revalue their loans based on changes in both interest rates and credit prospects. In the old days, banks did not have to revalue loans to reflect the impact of interest rate moves and could also fudge their reserves a bit. This gave them some latitude in the downturn of an economic cycle. But now that loans are treated, for balance sheet purposes, just like bonds, banks have far less incentive to come to the aid of borrowers.
Persaud is also skeptical that the new regime of securitized credit has reduced risks; we seem to be having market meltdowns as frequently as before. And he believes that injecting liquidity to prevent a repricing of risk does no good in the long haul.
From the FT:
Central bank intervention last Friday to inject liquidity into the global financial system did not mark the beginning of the end of financial market turmoil. It was merely the end of the beginning. Liquidity injections will not deliver lengthy respite. The next phase of market volatility will be more vicious than before, led by downgraded ratings on credit instruments and followed by further dislocation in the credit markets that will spill over to equity markets.
Credit markets are the big brother of equity markets. In the US and Europe, capitalisation of private debt securities is a combined $28,000bn (€21,000bn, £14,000bn), compared with $23,000bn in equity markets. Although rating downgrades will be a consequence of existing anxieties about credit quality, they will have knock-on effects. Substantial parts of the credit markets are priced off these ratings. This presents rating agencies with serious conflicts of interest that will move centre stage when investors start looking for a scapegoat. Rating downgrades will convert risks into losses. Lossmaking credit funds will suffer redemptions, forcing fund managers to dump well-performing parts of their portfolios as well. Loan covenants will require rated entities to inject liquidity on a downgrade. Where central banks are pushed to ease liquidity more aggressively than their inflation objectives may suggest, currencies will weaken. The yen will rebound.
Those who are older than the trading floor average will have seen this before. But what makes this credit cycle more complicated and perhaps more hazardous is the very thing that the former Federal Reserve chairman Alan Greenspan and others argued had made financial systems safer: the securitisation of credit. Securitisation brings benefits. But in these circumstances it will make the down cycle more severe and will transmit systemic risks along untraditional paths that may prove less sensitive to interest rate cuts than in the past.
Before securitisation, whenever the credit cycle turned down, a bank’s loan officer could conclude, through his long relationship with the credit or a portfolio of them, that the market was under-pricing that credit. He could use the bank’s balance sheet to hold on to out-of-favour credits until the market stabilised. Banks have since earned fees for securitising credits and selling them on. Now, when credit prices fall and daily risk management systems scream that that risk should be sold, the fund manager with only a passing knowledge of the underlying credit and without a large balance sheet cannot hold on to it.
Over the past 20 years, governments built regulatory systems to avoid credit problems at one bank becoming systemic. These systems succeeded, but only by shifting risks elsewhere. A measure of this failure is that the instances of emergency rate cuts have become no less frequent. Think of 1987, 1989-92, 1995, 1998 and 2001-03. Today, the principal avenues of systemic risk are via investment losses, not bank runs. The example from Japan in the 1980s and emerging Asia in the 1990s is that large and widespread investment losses will lead to big reductions in consumption and investment.
Can lower interest rates temper investor losses? Yes, if the problem is caused by a temporary lack of liquidity; no, if it is caused by a “de-rating” of asset quality, as is occurring today. Cutting interest rates for everyone does not encourage investors to take more care in the future. Each of the emergency rate cuts referred to above spawned an asset bubble.
Higher credit costs will hurt those equity sectors dependent on leverage. Much focus has been on the removal of debt-financed private equity bids for companies. Last year, this was worth $700bn in the US alone. But the effects of higher credit costs run deeper. Some old private equity transactions will be forced to issue equity and companies will have to halt share buyback programmes. It is tempting to think that emerging equity markets can continue to show high and uncorrelated returns. But while many private equity funds are based in the US and northern Europe, they have been big buyers of Asian equities, especially the Chinese and Indian markets.
The crash of 2007-08 need not have occurred. It was the result of poor investment decisions that were supported by the monetary and regulatory background. There is not a great deal that can be done about that today. But in responding to the anguish of this crash, policymakers must not lay the foundations for the next one.