Cheap credit cannot restore broken illusions
Hans Christian Andersen’s fairy tale about the “The Emperor’s New Clothes” is a good explanation for the spectacular expansion and implosion of the bubble economy in the 2000s.
For a time, a collective suspension of disbelief allowed markets and investors to ignore risks produced by cheap credit, subprime mortgages, securitisation and the shadow banking system.
The system worked until someone impolitely shouted out the risk had not gone away, it was just hidden in plain sight, and many institutions were insolvent.
But how many people remember how the fairy tale ends?
“‘But he has nothing on at all,’ said a little child at last. ‘Good heavens! Listen to the voice of an innocent child,’ said the father, and one whispered to the other what the child had said. ‘But he has nothing on at all,’ cried at last the whole people.
“That made a deep impression upon the emperor, for it seemed to him that they were right; but he thought to himself ‘Now I must bear up to the end.’ And the chamberlains walked with still greater dignity, as if they carried the train which did not exist.”
The emperor decided it was too embarrassing to admit he had been fooled. But that is where monetary policy and the fairy tale part company.
Lessons from the credit crisis debacle
- Steven Miller is managing director of Standard & Poor’s LCD, a unit not part of Standard & Poor’s ratings business. The opinions are his own and not those of S&P.-
As the worst credit crisis since the 1930s recedes, investors are starting to boil down the lessons of the past two and a half years.
With time, we’ll get smarter about how to interpret the recent upheaval but for now, it comes down to these: (1) financial covenants, which test the financial health of a borrower each quarter, can be used to reset loan spreads when times are tough, (2) collateral is indeed resilient, (3) bubbles work in both directions, (4) models are better at predicting the past than the future and (5) “black swans” –- those big unexpected events and their consequences — take many forms.
Covenants This first item is hardly a surprise. Lenders knew going in that by foregoing covenants, which would have allowed them to re-price loans to struggling issuers, they were giving up the power to force borrowers to pay more as their financial profile deteriorated. The extent of that omission is now clear: By the end of 2009, loans with covenant tests paid an average spread over LIBOR of 3.20 percent compared to 2.33 percent for loans that lacked such tests -– the so-called “covenant-lite” loans that proliferated during the height of the boom.
Collateral is resilient From time immemorial, security has been a principal calling card for the loan asset class because it limits an investor’s downside. Despite some high-profile default wipe-outs in the early 2000s from large blue-print telecom issuers, loan recoveries –- the amount a lender gets back when a loan defaults -– have consistently been significant. Between 1997 and 2006, the average initial recovery, or price-at-default, of first lien loans was 66 cents on the dollar. By comparison, unsecured bond recoveries have averaged 45 cents over time, according to New York University professor and credit-markets guru Ed Altman.
In the first half of last year, however, the floor fell in. With default rates soaring and credit prohibitively expensive, the average price-at-default fell to just 37 cents on the dollar, an all-time low. In the second half, however, the worm turned. With economic conditions improving, default volume dropping and liquidity seeping back into the markets, the average climbed to 63 cents in the second half of last year. Still, the average price-at-default in 2008 and 2009 was 53 cents, about 10 percent lower than the average of 59 cents from the 2001/2002 default spike. Then, like now, the average is below-trend during periods of distress when there is a flood of defaulted supply and the economy is weak.
Given the recent trends, however, that gap seems likely to close in the year ahead. In fact, the prospects for recoveries are getting better and better. Just look at the average price of loans exiting bankruptcy as seen on the S&P/LSTA Leverage Loan Index. In the fourth quarter, 10 S&P/LSTA loans exited bankruptcy at an average final pre-emergence price of 68 cents. Those numbers are just inside the historical average recovery of 71 cents on the dollar, according to Standard & Poor’s Global Fixed Income Research Group. And the story appears to be improving: Five others in the final stages of exiting – LyondellBassell and Smurfit-Stone, for instance – are trading at an average of 96.
Trouble in private equity paradise
– Neil Unmack is a Reuters columnist. The opinions expressed are his own —
The masters of the universe seem to be losing control of their own destiny.
Jon Moulton, founder of private equity firm Alchemy Partners, has walked out acrimoniously amid a succession and strategic spat with his partners, and Dominique Megret, chairman at PAI, has been ousted. Both cases could trigger so-called “key-man” clauses in the groups’ funds, a nuclear option that allows investors to halt new investment, or in extreme cases even liquidate the fund.
Both Alchemy and PAI’s bust-ups are unique, but we’re likely to see more like them as the private equity model comes under pressure in the aftermath of a global credit crisis.
Key-man risk has always been an issue in private equity. Because investors commit to tie up their capital for several years, they need some kind of fallback mechanism in case a key partner walks out. The clauses also typically have a “level 2″ layer, which is triggered if a certain number of senior managing directors leave. More than 90 percent of buy-out funds include some form of key-man clause, according to Preqin, an alternative assets research firm.
In the good years such clauses are less of a problem because managers are typically locked in by their share of the funds’ profits, or carry, which is paid out over time once a hurdle rate is reached.
The fact key-man risk is now emerging illustrates the precarious and bloated state of the private equity industry as it grapples with the post-crisis financial world. The logjam in the leveraged finance market makes deals harder to do, and defaults are climbing, forcing managers to write down investments. Valuations are depressed, exits are likely to be fewer and at lower multiples than originally expected.
Winning back the public’s trust
– Aron Cramer is president and CEO of BSR, a global business network and consultancy focused on sustainability. The opinions expressed are his own. –
The fall of Lehman Brothers last September triggered a collapse in financial markets, and then the real economy. It also signaled a further decline in the public’s trust in business. One year on, has anything changed?
At the start of 2009, only 36 percent of the U.S. public trusted business to “do what is right”—down dramatically from 59 percent one year before—according to surveys from the PR firm Edelman. But as of this July, trust levels in business had recovered somewhat, to 48 percent. Yet just as with the economic recovery overall, it is far too early to declare victory.
This is about more than winning a popularity contest. Without the public’s trust, business faces cynical consumers, unhappy employees, and public officials that tap into this mood with punitive legislation: hardly the conditions most companies want and need.
Before considering how to make further progress, it’s best to diagnose how this happened.
Inevitably, an economic decline brings a fall in trust. When large swaths of the public feel insecure economically, business suffers, too. We like the private sector a lot more when unemployment is at 5 percent than we do when it nears 10 percent.
Business is also represented by some rather unsavory figures in the public mind right now. Bernie Madoff and John Thain symbolize this economic downturn, and for some, they symbolize the entire business community, regardless of whether their sins are widely practiced.
Tarp Two: New deal or no deal?
The U.S. Treasury Department on Tuesday unveiled a revamped financial rescue plan to cleanse up to $500 billion in spoiled assets from banks’ books and support $1 trillion in new lending through an expanded Federal Reserve program. But initial market reaction reflected investors’ doubts about the plan, with stocks falling around 3 percent after the announcement by Treasury Secretary Timothy Geithner.
“For all the rhetoric that this is a new plan, they’ve done nothing but rehash and expand the old procedures,” said Steven Ricchiuto, chief economist at Mizuho Securities USA.
Carl Lantz, U.S. interest rate strategist at Credit Suisse in New York, said details of a proposed public-private investment fund for mopping up toxic bank assets were “very vague”.
“It sounds like for this public-private investment fund they are still exploring a range of different structures for the program or seeking input from market participants,” he said. “That’s the the kind of stuff we heard on TARP One and suggests that given all this time they still don’t have anything very specific nailed down.”
James Ellman, president of Seacliff Capital in San Francisco, criticized the proposals. “Investors want clarity, simplicity, and resolution. This plan is seen as convoluted, obfuscating, and clouded. We know that Geithner was able to overrule many other Obama administration people, and said we should not be tough on bank equity holders or bank management. So equity holders got a better deal, and it’s still not a good deal.”
Do you have confidence in Geithner’s plans? Debate the announcement below. We’ll update this post with fresh comments from analysts and other market participants as we get them.
I think we should give the new plan a try. All the naysayers are just sitting on their hands, but not putting up any money.
Buy the bad debt, sell it at fire sale prices, and get the lost money from future bank profits. Maybe the taxpayer can get some of their money back before the money lenders take it for bonuses.
Get the lobbyists out of the picture in Washington. They are the people who bought the votes to get us into this mess, and get the senators and representatives out of office who got us into this mess. We can get this thing fixed, but the same people who screwed up the system surely do not have the brains to fix it.
Do we need a credit policy?
– John Kemp is a Reuters columnist. The views expressed are his own –
The last eighteen months have witnessed a revolution in financial regulation — if by that we mean a fundamental reconstruction, total change or turn round from the previous orthodoxy occurring in a relatively compressed time.
In particular, the sheer scale of recent policy interventions in the banking system is throwing up very uncomfortable questions about the government’s role in the economy, centered on its function as the ultimate re-insurer of risk and its function via the central bank as “lender of last resort” (LOLR) to the banking system.
The classic statement of LOLR operations set out in Walter Bagehot’s “Lombard Street” is to “lend freely, at penal rates, against good collateral”.
But in the aftermath of recent rescues, not much remains of the original doctrine. The Fed and other central banks are now lending freely, but to a wider range of institutions never envisaged before, against poor collateral, on increasingly generous terms, and providing support for solvency as well as liquidity.
Central banks and finance ministries are shouldering losses that properly belong to private shareholders and creditors. In the process they are protecting almost all depositors, and helping bail out shareholders. Walter Bagehot would be amazed at how far his doctrine has evolved.
The broadening of the lender of last resort guarantee was probably inevitable. But it makes explicit what was always implicit: in an integrated financial system the liabilities of the whole system are contingent liabilities of the central bank and ultimately the taxpayer.
John,
To address the credit crisis in the US, we must recognize one of its root causes: chronic trade deficits.
Furthermore, we must address one of the most dangerous consequences of the credit expansion: weapons of mass financial destruction such as credit default swaps
According to Free Market Fundamentalists (FMF), chronic trade deficits simply shouldn’t exist, yet obviously they do.
According to FMF, the politically correct way to deal with a chronic trade deficit is to do nothing. They think currency exchange rates will automatically adjust to restore equilibrium. Yet obviously this hasn’t happened.
Their backup argument is: “So what? If trade surplus nations want to loan our own currency back to us at artificially low interest rates, let them. We can always print money to pay back the debt if need be. Doing so would be both inflationary and it would bring down the value of the dollar, which will eventually restore equilibrium, So, let the debt pile up! If we need to inflate our way out of debt, no problem. The inflation hurts foreign lenders and helps domestic borrowers.”
Of course, what the FMF don’t mention is that borrowing from trade surplus countries also fuels asset bubbles, which in turn trigger financial crises such as the one we’re currently in.
FMF also believe that when someone lends money to capitalists they will invest it wisely and rationally. Yet is this the case. Take housing for example. For many years now, US citizens have been saving less and less, but “investing” more and more in houses.
So if no one is saving, then where is the money coming from to finance our “investment” in housing. Obviously, its coming from foreign lenders who are running trade surpluses.
So, ultimately how do we use our investments in houses to pay off foreign lenders. For many years we seemed to think we could pay off foreign lenders by continuing to inflate the housing asset bubble.
But paying off lenders by getting them to lend you even more money is essentially a Ponzi scheme. Perhaps Obama should make Bernie Madoff the new treasury secretary!
Of course, housing price inflation can’t exceed the overall rate of inflation for very long. So now the bubble has burst, but the banks seem to be the ones in trouble, not foreign lenders.
If homeowners default on the loans, then why don’t we let bank stock holders and bond holders simply take it on the chin. The government insures savings accounts up to a certain dollar limit.
So, if bank stock holders and bond holders haven’t been wiped out yet, why are taxpayers on the hook. Once the stock holders and bond holders have been wiped out, the taxpayers will own the houses that are in foreclosure. Then the taxpayers can rent or sell these houses back to other taxpayers who want to rent or buy them, and the proceeds will be used to pay interest to the depositors insured by the FDIC.
The reason why taxpayers are now obliged to bail out bank bond holders and stock holders can be explained with three words: Credit Default Swaps.
Sometime CDS are described as a form of an insurance policy, which may be why insurance companies like AIG were selling them.
But unlike fire insurance, there was no regulation of the CDS “market.” We have our Free Market Fundamentalist friends to thank for this.
Now why do you suppose we have always regulated other forms of insurance, such as fire insurance. Let’s see … if I could take out a big fire insurance policy on my neighbor’s house, then if his house happens to burn down then I could make a lot of money. But why stop at one house. If I could take out a fire insurance policy on all the houses in town, and then the entire town burned down, then gee I could be super rich!!!
Since we are at least wise enough not to let people take out fire insurance unless the have an insurable risk (i.e. they own the house that might burn down), we are able to minimize the problem of arson.
But not so with our financial industry. It seems that in the infinite wisdom of the FMF we have let people take out financial fire insurance policies on our entire banking system. So if the banking industry burns to the ground, then these policy holders will get super rich, right. Well, not so fast. As it turns out the insurance companies who have been issuing financial fire insurance don’t have enough money to pay off.
So, now the taxpayers are on the hook for trillions and trillions of dollars if the financial industry burns down. These are the weapons of mass financial destruction that Warren Buffet warned us about.
So, we need to do two thinks:
1. We need to defuse the weapons of mass destruction in CDS market. The first step in doing this will be to regulate the market so that all existing and all new CDS policies will have to be registered. Then the government will have to take a drastic step. All policies that do not have an insurable risk will be declared null and void. The tax payers and the government will not be blackmailed.
2. We need to fix the trade imbalance. Warren Buffet has shown the way here as well. Since exchange rates obviously don’t adjust automatically, the US has two options: (1) we inflate our way out of debt or (2) we establish trade barriers. Technically, when your currency devalues it acts like a generalized tariff on all imports and a generalized subsidy on all exports. Market buffs like generalized tariffs and subsidies, and in this case I tend to agree with them (I would make an exception in the case of oil, which we should tax to help save the planet).
Unfortunately, exchange rates don’t work unilaterally. Other nations can refuse to let their rates adjust by loaning us money at artificially low interest rates.
So, is there another approach to generalized tariffs and subsidies that the US can take unilaterally. The answer is YES. Buffet and others have been proposing Import Certificates for years.
What’s an import certificate. Well, you can read up on the idea at wikipedia (see link below), but in brief the government would award import certificates to domestic exporters (i.e. for every dollar of foreign exchange generated by an exporter, he would get a certain number of import certificates). Importers would need to buy certificates to import goods and services. So, the importer would in effect pay a tariff and the proceeds would go to the exporter. This would not entail tariffs on specific goods and services. Since there would be a market in import certifications, there would be a generalized tariff on all imports, and a generalized subsidy on all exports.
So, are import certificates a form of protectionism. Well, yes. But if we inflate our currency to bring down exchange rates, then that too could be considered a form of protectionism.
If we don’t want our chronic trade deficit to eventually become a financial crisis, and we don’t want to inflate our way out of debt, would also create a financial crisis, then we have to do something. I say we use import certificates.
http://en.wikipedia.org/wiki/Import_Cert ificates
Obama’s radical environmental strategy
– John Kemp is a Reuters columnist. The opinions expressed are his own –
Most successful elected leaders must disappoint their most ardent supporters at some point, as the bright hopes of an election campaign give way to the complex realities and constraints of governing, and need to occupy and retain the political center-ground to win re-election.
The trick of really successful leaders is to let supporters down gently to avoid turning disappointment into frustration and anger, retaining allegiance and support even when the maximum agenda goes unfulfilled and compromises must be made. Political supporters have to be given enough policy gains to be kept loyal, even as some cherished objectives fall by the wayside.
Despite the enormous outpouring of goodwill to the incoming president, or perhaps because of it, President-elect Barack Obama will be no exception to this iron rule.
The high hopes for the administration (cultural reconciliation between left and right, poverty alleviation, fairer distribution of economic rewards, renewed growth, financial reform, decisive action on climate change and “peace in our time”, to name but a few) have run far ahead of even the most successful president’s ability to deliver them in four or even eight years.
So the real question as the new administration prepares to take office is where will it dare and be able to be radical, and where will it be forced by circumstances to be more conservative.
Early indications suggest the administration may disappoint its progressive supporters with a cautious approach to foreign policy, the economy and finance, but its moves in climate change and energy efficiency could be far bolder. CHOOSING BATTLES CAREFULLY
“..this non-critical issue…”
What total lunacy. Climate change is only a “non-critical issue” in that its effects are not, in the old D.C. sense of “don’t do anything unless it’s a crisis,” a crisis situation right now.
But guess what? If “this non-critical issue” continues to be deferred (after eight years of complete denial) even further, then by the time it becomes a “real” crisis it will be too late.
The United States is not, in point of fact, “on the brink of collapse” at the moment. There are plenty of issues which need work, but nothing so pressing that it makes sense to say “climate change is a non-critical issue; let’s just skip that until it gets really bad.
Honestly, if your physician used that kind of reasoning, you would be out the door and running to report him to the board of health.
Brace yourself: Political-market risks in 2009
– Preston Keat is director of research at Eurasia Group, a global political risk consultancy, and author of the forthcoming book “The Fat Tail: The Power of Political Knowledge for Strategic Investors” (with Ian Bremmer). Any views expressed are his own. For the related story, click here.
There are a number of macro risks that will continue to grab headlines in 2009, including the conflicts in Afghanistan and Iraq, cross-border tensions and state instability in Pakistan, and Iran’s ongoing quest to develop advanced nuclear technologies.
These risks are real, and will not be resolved easily or quickly. But there are two other general groups of political risks that could be defining both for investors and policy makers: first, the prospect of a number of interrelated market risks in developed and emerging Europe, and second, the challenges faced by the United States regarding multilateral leadership (particularly in the area of financial regulatory reform).
Political risks have historically mattered much more in emerging markets, but political risk in the developed, industrial democracies is rising more quickly than anyone would have predicted a year ago.
Europe
Political-market risk in emerging Europe is significantly higher now than any time in the past decade. Russia and Ukraine, and even recent star “emerging Europe” performers such as Turkey, Hungary, and Romania face serious vulnerabilities in the coming year. In addition, western financial institutions based in countries like Germany, Italy and Austria are particularly vulnerable to a credit crisis in Eastern Europe, where they have large loan exposures. Russia’s growing anti-westernism, its state intervention in strategic economic sectors, and its assertive posture regarding Georgia have been widely discussed, and will remain concerns in 2009.
This also plays into one of the most problematic country risk stories right now: Ukraine. Its steel-centric economy is in free fall due to dramatically reduced global demand, many of its companies have large foreign debt financing needs that they will struggle to meet, and its domestic politics are gridlocked and bordering on dysfunctional.
Some good points about where direction should come from in the next stage of this downturn.
Lets have an open mind about the framework and be thankful that the international economy and political will is diverse enough to absorb multiple ideas. Ultimately some political and economic choices are going to have to be made, some will join the new framework and some will resist due to a lack of political or economic capacity, often due to a lack of public/ market confidence. Lets put some greater emphasis on the quality of an economy (strong institutions and productivity of intelligence), rather than pure economic growth.
Great U.S debt engine slips into reverse
– John Kemp is a Reuters columnist. The views expressed are his own –
After six decades of uninterrupted credit creation and an unprecedented era of consumption and prosperity, the credit process has come to an abrupt halt. If credit has been the locomotive of the modern economy, the third quarter of 2008 marked the point when the engine stalled and the economy began to roll back down the hill.
For decades, financial activities have grown much faster than the real economy. Between 1952 and 2007, U.S. nominal GDP grew by a factor of 39 times, while total credit market debt outstanding surged 101 times.
Finance has become even more dominant in the last 25 years, as subdued business cycles, improvements in technology and communications, deregulation and pension privatization have fueled a massive increase in the issuance of debt and other financial assets.
In 1952, the U.S. economy had just $1.28 of debt for every dollar of GDP, and as late as 1980 this figure was still as low as $1.61. But beginning in the 1980s, financial services underwent a revolution that saw credit instruments per dollar of GDP rise to $2.28 in 1990, $2.67 in 2000 and a staggering $3.55 by the end of 2007.
Increasing debt, much of it bought in recent years by China and oil-producing countries of the Middle East, has allowed the United States to have both guns and butter. It financed a huge expansion of consumption, home-building and business investment, while allowing the federal government to cut taxes and still fight two major wars in the Middle East.
But in the three months between July and September, the miracle of modern finance came crashing down.
The only way forward , is forward” Brad. Read the article below and stop talking negative. Buffet didn’t become the wealthiest man on the planet by looking backwards, did he? I’ve said it before and I’ll say it again, the Electric Car is a winner in so many ways for the US. To name a few: Cheaper Fuel, Cleaner Fuel, New industry, Many new jobs in Detroit, New friends in the Global community for doing something constructive. It will leave the BIG 3 carmakers for dead. Time to move on Yankees. Many people have the money to buy the plug-in electric vehicle, we are just waiting for you to build it for an affordable price. Better hurry up or we wil have to buy Chinese (Again).Read Buffets story below:
Buffet Into Chinese Electric Future cars and Batteries
These finance guys always amaze me. Here is Warren Buffet, who of course is one of the richest men in the world, invests $230 in a Chinese future cars manufacturer. Of course, china is the up and coming industrial powerhouse, but still it takes a lot of guts because the economy there is extremely volatile.
In September, Warren Buffet invested $230 to by ten percent of BYD, a Chinese electric car and battery manufacturer. BYD could soon become a major leader in electric future cars and battery production. BYD is reportedly planning to start selling electric cars in America by the end of 2009
The electrical future car will present storage challenges which BYD may be able to answer. Our aging electric grid and our wall sockets are not equipped to deal with recharging car batteries should the electric car become mainstream. There will need to new developments such as swapping stations where cars can come in and swap batteries. Maybe this will be Buffet’s new line of investment.
- Posted by Brad
Finance throws sand in wheels of trade
– James Saft is a Reuters columnist. The opinions expressed are his own. –
Trade finance, a basic lubricant for the global economy, is becoming much more expensive and tougher to get, accelerating an already harrowing downturn.
Banks are reluctant to allocate scarce capital to trade finance, which funds cross-border buying and selling, and are very wary about being caught short by defaults by other banks which write letters of credit or by the importers and exporters themselves.
While not the prime cause of a slowdown in global trade, which is being buffeted by declining consumption and tighter finance to households and businesses, tough conditions for the obscure but crucial corner of finance that funds goods and commodities between dispatch and delivery is sand in the wheels.
Stunningly bad trade figures from China underlined the problem. China had been expected to show double digit growth in trade last month as compared to November 2007, but the data showed exports falling 2.2 percent from a year ago and imports down 17.9 percent.
“Global demand for Chinese products is vanishing,” said Gene Ma, an economist at China Economic Monitor, a Beijing consultancy. “Secondly, the credit freeze in importing countries has made it hard for Chinese exporters to sell abroad. I heard some Chinese exporters had to cancel shipments as they were worried about getting paid by their buyers.”
Chinese banks have been very nervous about accepting letters of credit from abroad, making it tougher for imports to China to get the needed financing. China and the U.S. pledged $20 billion to fund trade with developing countries last week, but that is a tiny balm for a huge market.
Seems like Bernanke is gonna be Bernankesan going the Japanese way – Zero Rates – quantitative easing – injecting more reserves.
Quote Bloomberg: ” The Bank of Japan has been the only major central bank in modern times to mix a policy of steep rate reductions with quantitative easing, or the strategy of injecting more reserves into the banking system than needed to keep the target rate at zero. Spur Growth – Japan’s central bank kept its main rate at zero from 2001 to 2006 while flooding the banking system with extra cash to encourage lending, spur growth and overcome deflation. The abundant funds failed to prompt lending by commercial banks, which expanded their reserves at the central bank almost nine times by early 2004.”
Good article, except Wall Street investors do seem to believe we’re going back to the pre 2007 ‘emperor’s clothes’ system, if you judge by still elevated stock prices.
I wonder who invented the new myth that US corporations are sitting on trillions of cash? -
FYI, US corporations normally sit on trillions of debt, because that’s what keeping them going.
In real life, for every company that has some excess cash there’s a dozen struggling to keep their heads above the water.