Unsettled Credit Markets Unnerve Investors
August 6th, 2007 - Credit markets remain unsettled, creating lots of uncertainty among investors. As soon as things appear to have settled down, another revelation reminds the markets of the underlying risk. One day we hear of hedge funds that are significantly underperforming, and the next day we are told that several banks are stuck with a lot of loans on their books that can’t be easily sold off on debt markets. There is clear evidence of a reduction of liquidity in the system, but it is too early to characterise it as a credit crunch. What has happened is that we have moved from very easy conditions to somewhat tighter ones and the asset management team at Lines Overseas Management has adjusted their strategy accordingly.
Inevitably, the system will suffer from withdrawal symptoms when the steady diet of plentiful liquidity is restricted. During the go-go years when the central banks opened the taps wide, there was an incentive to take greater risks. The former Fed chairman, Greenspan, has often been blamed for his panache in implementing a loose monetary policy but, really, most central bankers did much the same thing. When there is a lot of liquidity around and borrowing is cheap, investors are encouraged to increase leverage and pile into riskier assets. The plentiful liquidity affects all asset classes. House prices head higher, and in posh areas they are bid up to unseemly levels. The art market takes off because of the flush of cash. It also spills over into every corner, such as fancy wines and super-expensive cars. If, at some point, liquidity begins to diminish we should witness a reversal of some of these excesses. As pointed out earlier, this is not yet a full credit crunch, and the impact is likely to be limited. Of course, it is very difficult to say how far things will unwind.
The commentators, who state confidently that the extent of the credit-market problems will be contained, and there is nothing to worry about, are merely guessing and have no special knowledge of its impact on the financial system and the economy. There have been a large number of innovations in product, distribution and technology in the past few years, and the system has not yet been stress-tested. The market for collateralised debt obligations (CDOs), and a whole slew of other derivative products, has grown enormously. It has been lauded for allowing the spreading of risks and for facilitating the financing of ultimate borrowers. There is truth in this contention, but it is also true that because the CDOs could be packaged and sold so easily, it allowed originators to take greater risk in signing up poorly-qualified borrowers. This has become evident in the sub-prime mortgage debacle in the United States. But, the impact of the problem is not confined to the US. Such CDOs have been sold to financial institutions in every corner of the world. So it doesn’t come as a surprise when we hear news stories about this or that bank or fund that has been hurt in Germany, France or Australia. And these are just the stories that make it to the headlines. Increasingly, banks that had participated in the financing of private equity deals are facing problems in moving the loans off their books. Investors, who were previously content to buy such bonds, are now considerably more cautious. Well, the market has an excellent mechanism for sorting out supply/demand imbalances and that is via price adjustment.
The risk premium rises as liquidity diminishes, ensuring that buyers receive a higher return. What we are witnessing is a re-pricing of risk, and a re-appraisal of debt. As far as the deals are concerned, there is likely to be some negotiation between the private equity firms and the banks on how the higher costs are going to be allocated because of the more challenging market conditions. Considering the financial system as a whole, contagion can occur when assets are re-priced, margin calls are triggered and previously liquid assets lose some of their liquidity. This forces the sale of other, more liquid assets, to raise cash, forcing their price down as well. In this process, some firms will be unable to meet their obligations and a chain reaction is possible affecting many other entities. Credit conditions are not yet tight enough to cause this sort of systemic risk, but it cannot be entirely ruled out either. Central banks are still focussed on heading off a possible rise in inflationary pressures, as global growth remains quite strong. But they also have an eye on deteriorating credit-market conditions and are willing to act if there is a significant threat to the financial system. American households were the first to be affected by tightening credit. As far as mortgages are concerned, there are indications that the problems have spread from the sub-prime sector to the just-below-prime category. The housing market is still deteriorating, but the optimists say that, while true, this is happening at a slower rate. House prices are falling, foreclosures are a problem and builders have a large inventory of unsold houses. The US corporate sector is now also feeling the effects of tighter credit conditions. Spreads over Treasuries, for corporate debt, have widened even for high-grade issues. But the cost of borrowing hasn’t risen dramatically because balance sheets remain robust. In addition, debt loads are relatively light and the cost of refinancing would take time to feed through. As expected, the US economy rebounded in the second quarter.
However, the components of aggregate demand didn’t promise much momentum going into the second half of the year. Growth in consumer spending was weak, and there wasn’t much to cheer about as far as business spending was concerned. Commercial construction was strong but growth in the important category of equipment and software spending was unimpressive. Net exports drove economic growth because of a strong global economy and a cheap dollar. Volatility indicators for the stock and bond markets have jumped higher, as measured by the Vix and Move indices. Over in Europe, the Vdax index is also flying high. And, of course, the Vdax is a volatility indicator for the German stock market, as the Vix is for the US. It hardly needs mentioning that, for traders, the time to buy volatility was a couple of months ago when complacency ruled. Volatility is unlikely to die down soon. Conditions in credit markets are a long way from stabilising and this will keep things quite bumpy. Swings between greed and fear will be more marked than usual.The information in this newsletter is for general use only; it is not intended as specific investment, financial, accounting, legal or tax advice for any individual and should not be relied on as such. LOM makes every effort to ensure that the contents herein have been compiled or derived from sources believed reliable, however LOM does not warrant the accuracy, timeliness, or completeness of this information and material and expressly disclaims liability for errors or omissions in this information.