The dramatic pull back by buyers of credit has dominated m* mindshare for well over a week now. So far, the magnitude of spread widening, the breadth of credit markets effected, the spillover into equity markets and hard assets driven at the margin by speculative players (think gold and uranium) and the rally of traditional safety trades - US treasuries and the Yen, feel like a pretty run of the mill normalization with respect to the size and duration of the credit inflation that has been in place since 2002.
The global economy is still running hot, with central banks around the world in tightening mode. Corporate earnings are coming off peaks but are still healthy. Corporate balance sheets are supposedly in good shape. Hungry trillion dollar pools of liquidity at sovereign wealth funds are waiting in the wings. It is plausible that this bout of indigestion on the part of the credit consuming investor will soon pass, with some capital exchanged for yet another lesson in the tradeoff between risk and reward, and calls for more stringent rating agency definitions.
Then again, the underlying tone of the US economy is weakening, not strengthening. Soon enough, export driven economies should start to see weakness in exports, and m* will find out exactly how much "decoupling" really has been achieved. One suspects, not enough. At the same time, central banks globally are reluctant to ease financial conditions with the current global inflationary pressures. It is also unclear how the US central bank would incorporate a continuing slide in the dollar into the picture.
Meanwhile, we are getting a real-time lesson in how the post-bank credit system manages a credit contraction. In the credit system of yore, risk was concentrated at banks, who specialized in evaluating loan(default) risk and warehoused portfolios of loans, earning a spread on their funding and borrowing rates, less losses for bad debts. The world has moved on.
Banks today are middle-men, preferring to provide advice and intermediation services between borrowers and lenders for a fee, rather than provide term capital. Certainly banks provide tremendous amounts of what you might call liquidity capital in the short term, for transactions and trading. But in the traditional sense of the word, they lend only reluctantly, as the recent pile-up of LBO commitments on bank balance sheets demonstrates. When your loan only brushes cheeks with the bank's balance sheet on it's way to a nice fee generating CLO structure with willing buyers, banks will fall over themselves to "lend." Without that CLO buyer, however, today's deal flow can exhaust already highly levered bank balance sheets very quickly.
Much has been made of the ability of derivatives and structured credit products in particular to repackage and transfer risk, in effect democratizing access and dispersing it to greater numbers of willing holders. This would seem on balance a good thing. The risk of default is spread across a wider range of investors, each safer for holding just a sliver of each individual loan.
However, a dispersed market for default risk introduces another more volatile problem in the way of market risk. In this marketplace with everyone long credit, the spillover from even relatively isolated credit events, much less a wholesale re-evaluation of the price of risk, can effect a wide cross section of participants. Avoiding (possibly temporary) losses then compels participants to seek more liquidity simultaneously leading to dramatic prices fluctuations such as we have seen over the last several days. The ability of participants, especially levered ones, to withstand even temporary markdowns becomes a primary concern for everyone. Because everyone is everyone else's counterparty, the dispersal of risk makes the system more vulnerable, not less, to seizures and crises caused by credit events, or fear of credit events.
The Fed of course as the "lender of last resort" has great power to re-liquify the system by cutting over night borrowing rates for member banks. By lowering bank funding costs for short term liquidity capital, the Fed provides headroom for banks to ease their credit terms to levered buyers, ie: prime brokerage financing for hedge funds, making it less necessary to raise capital by selling positions. The LTCM crisis was an early test of this mechanism.
Another feature of this new financial system is an increase in the supply of credit. With the new financial technology, banks are able to radically increase the number of times they recycle their capital, (their inventory turns in effect), multiplying the amount of credit in the system. The extent of that credit at this point in time is staggering and unprecedented. According to a tabulation done by the FT, the pipeline for announced deals is half a trillion dollars, equivalent to roughly the market capitalizations of Citigroup, Bank of America, and JPMorganChase combined, (or one year of operations in Iraq - but that's another story). And the vast majority of that financing is going to fund corporate acquisitions, not capital investment.
Surprisingly, central banks have failed completely to address this usurpation of their power to control the credit in the system, choosing to focus instead on the more mundane and technical issues of money supply. Meanwhile over-abundant credit has driven speculative bubbles in technology spending, residential real estate, consumer spending, and now corporate buyouts. Some might attribute tactical policy errors for one or two of these, but the nearly uninterrupted fall in long term interest rates and credit spreads and the concurrent rise in asset prices over this period ought to have raised questions. m* is still looking for that discussion.
Where do we stand now? Is this the beginning of the long unwind? It is hard to conceive how the system proceeds any differently from here. The bank sector is still of primary importance in processing these risk transfers. In the short term, until there is some visibility on how much unsold deal debt ends up on bank balance sheets, and what markdowns it takes to move it, the financial sector will remain under pressure. In the longer term, corporate fundamentals matter. If international development continues to support corporate fundamentals, buyers will return, capital will be freed up, and the credit cycle can continue a while longer as part of the globalization trade. This will have been a "contained" financial hiccup.
The bearish view depends on a number of perceived linkages about which m* is less sure, though no less concerned with. In this view, the US housing recession leads to a consumer recession which leads to a China recession which leads to a corporate recession which leads to falling financial assets. In this scenario, Fed rate cuts have limited ability to stimulate the consumer or corporates and the dollar falls to new lows, and long term rates rise with reduced inflows overseas capital and the return of long term risk premiums. It is an easy jump from here to there for the economic moralists, and they may be right, in the end. As m* enjoys the blues hour www.wbgo.org, he is just hoping it does not rain all weekend.
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