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I’ve
occasionally railed against the mainstream media's seemingly incoherent or
inexplicably optimistic coverage of the alleged wonders of new age finance. What
really gauls
me, though, is the lapdog-like reliance on the views of "experts"
with conflicted interests who work for firms that helped create many of the
messes we now see unfolding.
Still, there
are some journalists, at the Financial
Times in particular, as well as at the Wall Street Journal, the New York Times, BusinessWeek and other
publications, who have resisted the urge to kowtow to Wall Street's witless
wunderkinds (and the often sizeable advertising expenditures of their
employers) and have instead chosen to call it like it is.
One
individual who seems to fall into that camp and whose columns and articles I
always enjoy is Floyd Norris, the chief financial correspondent for the Times. In "Credit Crisis? Just Wait for
a Replay," he explores what so many
regulators, pundits, industry insiders, investors, and others (e.g., the
"contained" cretins) have repeatedly failed to grasp in regard to
the current crisis: "What if it’s not just subprime?"
As 2007 ends,
it seems that the financial world shakes every time a company reveals some
new exposure to the disastrous world of subprime
mortgage lending.
But just how
different was subprime lending from other lending
in the days of easy money that prevailed until this summer? The smug confidence
that nothing could go wrong, and that credit quality did not matter, could be
seen in the many other markets as well.
That was
particularly true in the corporate loan market. Loans were cheap, and anyone
worried about losses could buy insurance for almost nothing. It was not an
environment that encouraged careful lending.
“The
severity of the subprime debacle may be only a
prologue to the main act, a tragedy on the grand stage in the corporate
credit markets,” Ted Seides, the director of
investments at Protégé Partners, a hedge fund of funds, wrote
in Economics & Portfolio Strategy.
“Over
the past decade, the exponential growth of credit derivatives has created
unprecedented amounts of financial leverage on corporate credit,” he
added. “Similar to the growth of subprime
mortgages, the rapid rise of credit products required ideal economic
conditions and disconnected the assessors of risk from those bearing
it.”
There are
differences, of course, and they may be critical in averting a crisis. To
start, there are virtually no defaults
in corporate lending now, and even if Moody’s is accurate in its
forecast that defaults will
quadruple in 2008, the default
rate on speculative loans and bonds would still be below the long-term
average. That hardly sounds like a crisis.
And there is
no reason to think that fraud was
a big factor in the corporate loan market, as it seems to have been in subprime.
But the
history of junk bonds provides a warning that defaults
start to rise a few years after credit gets very easy. By that standard, says
Martin Fridson of the research firm FridsonVision, a new wave of defaults
is overdue. Already, even without defaults,
he says, about a tenth of high-yield bonds are trading at distress levels
— levels that provide yields of at least 10 percentage points more than
Treasuries.
If a
recession does occur, one can easily foresee a wave of defaults in junk bonds and their bank-loan cousins,
leveraged loans. With highly leveraged structures supported by some of those
loans, the surprises could be greater. It is sobering to realize that the
issuing of leveraged loans set a record in 2007, even though the market
contracted sharply late in the year.
If this was
the year that many readers — not to mention financial reporters —
learned what C.D.O., M.B.S. and SIV stood for, 2008 could be the year of
C.D.S. and C.L.O. (For those who came in late, those abbreviations from 2007
are shorthand for collateralized debt obligations, mortgage-backed securities
and structured investment vehicles. The new ones are credit default swaps and collateralized loan obligations
— a special kind of C.D.O. backed by corporate loans.)
We have
learned in the last month that credit insurers took big risks in backing C.D.O.’s and other exotic things. Some are
scrambling to raise more capital to stay in business. One, ACA, may well go
out of business.
But if the
credit insurers turn out to have had inadequate reserves, what are we to make
of the credit default swap market?
Mr. Seides calls it “an insurance market with
no loss reserves,” and points out that $45 trillion in such swaps are
now outstanding. That is, he notes, almost five times the United States national debt.
Many of those
swaps cancel each other out — or will if everyone meets their obligations.
The big banks say they run balanced books, in which they sell insurance to
one customer and buy insurance on the same borrower from another customer. But
if some customers cannot pay what they owe, this could be another shock for
bank investors. As it is, financial stocks have underperformed other stocks
by record amounts this year.
One of the
more remarkable facts about the subprime crisis is
that total losses to the financial system may be about equal to the amount of
subprime loans that were issued. On the face of it,
that appears absurd, since many such loans will be paid off, and those that
default will not be total losses. But,
Mr. Seides said in an interview, “the
financial leverage placed on the underlying assets was so high” that
the losses multiplied, as the profits did when times were good.
“When
there is more leverage” and things go wrong, he said, “there are
more losses.”
The corporate
credit market is vastly larger than the subprime
market, and there are plenty of dubious loans outstanding that probably could
not be refinanced in the current market. If some of those companies run into
problems, defaults could soar and
fears about C.L.O. valuations and C.D.S. defaults
could spread long before there are large actual losses on loans.
There are
other areas of potential weakness in 2008. Commercial real estate is one area
where some see disaster looming. Others worry that some emerging markets
could run into big problems because
many borrowers there have taken out loans denominated in foreign currency and
could be devastated if local currencies lose value.
It was the
greatest credit party in history, made possible by a new financial
architecture that moved much of the activities out of regulated institutions
and into financial instruments that emphasized leverage over safety. The next
year may be the one when we learn whether the subprime
crisis was a relatively isolated problem in that system, or just the first
indication of a systemic crisis.
By :
Michael J. Panzner
Editor, Financial Armageddon
financialarmageddon.com
Michael
J. Panzner is a
25-year veteran of the global stock, bond, and currency markets and the author of Financial Armageddon: Protecting Your Future from Four Impending
Catastrophes, published by Kaplan
Publishing.
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