Party Time! Wall Street Back to Its Old Highly Levered Ways

Bloomberg reports that Wall Street is back to its free-wheeling, high-levered ways. This is a classic example of moral hazard in action. Why worry about blowing up the bank when you know the taxpayer will bail you out?

From Bloomberg (hat tip DoctoRx):

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

Yves here. That is a big increase in repo lending. Greenspan used to look at repos as a proxy for hedge fund leverage. And when repo lending contracts, as it did in the crisis, it tends to do so across a wide range of collateral as banks increase haircuts, leading to synchronized downturns.

And we get these tidbits:

The increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments….

Yields on top-ranked debt backed by auto loans and credit cards have fallen by as much as 2 percentage points relative to benchmark rates. The yield premium has shrunk to less than 1 percentage point since TALF began in March, according to Charlotte, North Carolina-based Bank of America Corp. data. The average interest rate on loans for new cars declined to 3.88 percent in June, from 8.23 percent in January, Fed data show.

Yves again. Note how auto lenders, who are mainly out to subsidize sales, are passing on the improvement in terms, while banks are instead using the fatter margins on credit cards to boost profits.

We clearly have not learned the lessons of the crisis, that leverage increases risk and fragility, period. We’ve thrown massive backstops against the financial system with no checks on risk-taking, and we are getting precisely the sort of behavior you’d expect. Worse, everyone assumes any problems would arise gradually, when shifts tend to be suddenly, more like phase changes. As an op-e, “This Economy Does Not Compute,” by Mark Buchanan in the New York Times last year noted:

For example, an agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

Now this is admittedly just a model, but it seems far more descriptive of what we’ve just been through than anything the Fed appears to be using. And if it proves valid, relevering will proceed until we hit a trigger point again.

Print Friendly, PDF & Email


  1. zeropointfield

    The model offers no new insight in my view.
    The threshold is the moment at which there is more debt in the system than there is an ability to pay it down. That's the point of no return.

    However, we already know enough about Ponzi schemes to know that they collapse at some point they all do.
    The best way to avoid this is not to participate in one.
    Also the ability to predict the exact moment of collapse won't help you because everyone else will have the same knowledge.
    The best move here is not to play.

  2. T.

    This confirms the slow train wreck is headed for another disaster, rinse and repeat, with the end game destruction of the currency as Mises predicts.

    "The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

    Voluntary abandonment is out without a violent counter-revolution, not something to wish for. When this corrupt Fed and Wall Street cabal will get us to the end game is unclear, but hard to find a surer bet. But the dollar carry trade is getting crowded, and I'm scared to place big bets since one could get burned with the blowups along the way.

  3. Pxztwy

    Scotia Capital of Canada, eh?

    I guess they didn't read the article "Secret of Canadian Bank Resilience Explained".

  4. ndk

    We clearly have not learned the lessons of the crisis, that leverage increases risk and fragility, period.

    We can't afford to learn that lesson in this environment. We can again invoke St. Augustine: "Lord, grant me chastity and continence, but not just yet."

    But the American consumer's redeveloping that Puritan spirit. Without endogenous growth in wages and revenues, or any desire to borrow by credit-worthy corporations and consumers who see little opportunity of wage and revenue growth in the future, there is really no way to boost money supply other than to increase leverage and government debt. If we want money supply to increase and inflation to happen, fiscal deficits and the financial markets are about the only hammers we've got. Unsurprisingly, they're happy enough to cooperate.

    All of this is exactly what I would expect from an economy with negative equilibrium real interest rates. We're settling very comfortably into Japan's world. Krugman demonstrated in his better days that government spending in that situation is at best just a palliative.

    As a result, I still expect to see nominal interest rates and economic activity continue to drift lower as releveraging lowers real interest rates as well. Asset prices, squished between those two forces, will do their thing.

    And if it proves valid, relevering will proceed until we hit a trigger point again.

    Yep. A guest on some show made the interesting point that poorly stored commodities, like natural gas, are plunging, while those easily stored like gold and oil are surging. Again, exactly what would be expected from an economy with lowering real interest rates and depressed economic activity.

    The good news is that releveraging and the associated drop in nominal yields will boost the value of boring securities like Treasury bonds as well, and those are likely to again be the assets of choice when that trigger point is hit. This gives me a very comfortable place to hurry up and wait for awhile.

  5. ndk

    Unsurprisingly, they're happy enough to cooperate.

    I should elaborate on why I find this unsurprising.

    It's not just the moral hazard and implicit backing of the Government, although those are back and bigger than ever.

    It's also the selective pressures that have been at work in our financial system since 1982. Time and time again, under the gentle guidance of Greenspan and Bernanke, and Treasuries such as Summers', aggressive risk-seeking has been actively rewarded.

    Closing your eyes, pinching your nose, and just buying has been the key to success for years. This has two complimentary effects.

    1) Excessively cautious money managers leave the business, as they are unable to match marks with their exuberant competition.
    2) Systemwide, capital is gradually allocated towards risk-takers. Their vote becomes more and more important with time.

    A full generation is plenty of time to firmly entrench risk-taking in both the institutions and individuals who have the power and influence. We have just extinguished another nascent wildfire.

    Until the next, may these brave redwoods grow to the sky: we got the capital where we got it, and we got the managers we got, so I anticipate courage will be the order of the day for a long while yet to come.

  6. PascalMtl

    Unreal. We are headed for a brick wall with probability approcaching 1. As I expected, there was still ammunitions left for one last "shot in the arm" and we are all Bonzai on it… and the next downturn will present an impossible wall to pass, because the runner will drop dead.

    Change We Can???? RIIIGHT. What FUNDAMENTAL and BINDING change has been made to US or international financial markets and banking? Nill. Way to go, Barack the Saviour! You sure drove the last nail of cynicism into the coffin of hope! Not that the GOP would have done any better, by the way…

    Zero, you say "The best move here is not to play"… but we ALL play indirectly via bailouts (future taxes) or pension funds! This Ponzi scheme is strictly impossible to avert for most people.

  7. ronald

    The weekly unemployment claims are a reminder that something terrible is wrong with the economy and backstopping the financial sector to increase risk taking does nothing to cure the problem.

  8. kackermann

    The model sounds intuitive.

    The ideal market has a buyer for every seller instantly – total liquidity. When too many look to trade in the same direction, price either soars, or collapses..

    Aggregating and packaging up boxes of debt to sell, I think, has some not-so-obvious negative side effects.

    As a commodity, it is decoupled from the normal price signals of whatever the debt is funding. Inwestors just see the coupon and want more and more. They want 3 box of high yield, 10 boxes of AAA (cough) and whatever. The stuff becomes so popular, that in order to manufacture more boxes of debt, they have to actively go out and set traps to snare loans. Free House (assuming prices rise) – no questions asked, no signature required, don't delay, act now.

    House prices were rising like crazy, but the price on a box of debt looks like it might even be going down. The more demand, the cheaper it gets.

    What's in that box of debt? Don't know, don't care. It's what's on the outside of the boxes that inwestors like. It's covered in coupons. Coupons from Pyramid Investment Corp, and signed by a Mr. Ponzi Scheme. If not completely satisfied, return unused portion to US Government for full redemption. No questions asked.

    The debt is impervious to market signals.

  9. dd

    Doesn't it seem we are headed to a new model tapping the human capacity for imaginary constructs? The current construct assumes that the debt/repayment lifetime model is inviolate when theoretical math and physics have demonstrated the duration construct is a human convention.
    I think we make it out of this morass on a sea of debit and credit cards. The nature of money is changing yet again and the current generation is already comfortable with the ease of plastic money and direct deposit income.
    The electronic chit is the future the only issue is whether labor finally demands parity.

  10. Richard Kline

    With the US Guvmint guaranteeing anything that isn't visibly on fire, of course lending to toxic waste dumps is high. And the only way to make money is to borrow lots of someone else's, so, sure; where's the risk with the government guarantee? But the plain fact is that the Guvmint and its minders o' the nonce _don't want deleveraging_, a lot or a little. Because, y'know, high leverage and it's innovations were 'so good to the country.' What we really have is the flowering of the Paulson-Summers Reflation Act, crappy loans against decomposing poor assets in a frantic attempt to restart the zombies' hearts and restore 'normalcy' to the bastions of wealth.

    "The instability doesn’t grow in the market gradually, but arrives suddenly." This is basic information for dynamical systems which has been understood for, in fact, several generations. Now, it's nice to have this demonstrated in a reasonable simulation for _financial activities_, because without such a demonstration purportedly 'empirical' economists would never believe it possible. Despite the fact that we had a perfect example, realworld in real time, of just this phenomenon in late July-early August 07. Then, the market for short-term financing on any and all ABSs froze in a very few working days. And nothing the industry or the Guvmint did made a whit of difference for many, many months.

    I expect a repeat, even with the guarantees. Not necessarily for the same kinds of credit, but when we get a state change, it will likely again be abrupt, systemic, and deleterious.

  11. PascalMtl

    dd has a very interesting point. Look at Japan and its now-standard multi-generation mortgages. The fact that 50% debt-to-gdp seemed high 100 years ago and low today is a case in point. Perhaps we can just shovel out way ahead forever, just changing the social norm of the "normal" debt roll-over horizon… very good point dd. Quite insightful of you.

  12. Siggy

    While DD offers an interesting insight, I fear that certain things are immutable. If you owe you must, at sometime, pay it back unless, of course, your debt takes the form of a perpetuity. If you owe in perpetuity you have become a slave to your debt.

    If you cannot service your debt, your only recourse is to repudiate the debt by bankruptcy. Hopefully your debt is non-recourse. The purchases being reported here strike me as a delay of the inevitable repudiation of the debt at hand.

    If these sales are being supported or guaranteed by the Fed and/or the Treasury; then, you and I and our children will end up bearing the loss.

    This all leads me to conclude that a complete collapse of our financial system is necessary if we are to solve our problem of profilgate reliance on debt.

  13. dd

    Nothing that concerns the human imagination is immutable. There is no reason for the financial system to collapse as long as it functions within expectations.
    Restructuring the debt in some new capacity is the solution. A very foreseeable outcome is gathering the bad chits within the government structure (Fed, Fannie, Freddie, Ginnie, FDIC, FHA) consolidate to the SS “lockbox” and do a duration match over the long haul. Maybe if things get complex offset pension/401k against SS. There are innumerable ways out of the box. And with electronic money there are many inventive ways to proceed.
    Once joked that Paulson’s job was to supply the zeroes and now it’s Tim’s job.
    Not saying it’s agreeable; but the finance wizards ain’t going down without using every tool.

Comments are closed.