Archive for July, 2007
It is always risky to call an equity market peak and the beginning of a bear market in equities; so I will not try to do that. But leaving aside equity valuations, it increasingly looks like we are at the peak of a credit/debt cycle, in the US and globally.
Specifically, the crucial macro question that we should ask ourselves today is whether we are at the peak of a Minsky Credit Cycle. Or as the UBS economist George Magnus – an expert of financial instability – put it: “Have we reached a Minsky moment?”
Hyman Minsky was an American economist who died in 1996. His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.
The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions.
Minsky’s ideas and model fit nicely the last two US credit booms and asset bubbles that ended up in a recession: the S&L-based real estate boom and bust in the late 1980s; and the tech bubble and bust in the late 1990s. But the experiences of the last few years suggest another Minsky Credit Cycle that has probably now reached its peak. First, it was the US households (and households in some other countries) that releveraged excessively: rising consumption, falling and negative savings, increased in debt burdens and overborrowing, especially in housing but also in other categories of consumer credit, an increase in leverage that was supported by rising asset prices (housing and, more recently, equity). We know now that many sub-prime borrowers, near-prime borrowers and many condo-flippers were exactly the Minsky “Ponzi borrowers”: think of all the “negative amortization mortgages” and no down-payment and no verification of income and assets and interest rate only loans and teaser rates. About 50% of all mortgage originations in 2005-2006 had such characteristics. Also, many other households (near prime and subprime borrowers) were Minsky “speculative borrowers” who expected to be able to refinance their mortgages and debts rather than paying a significant part of their principal.
The Minsky idea of loosening of credit/lending standards among mortgage lenders – and the phenomenon of supervisors/regulators falling asleep at the wheel while the reckless credit bubble occurs – is also now evident in the recent mortgage credit cycle. A supervisory ideology that tried to minimize any prudential supervision and regulation and totally reckless lending practices by mortgage lenders led to a massive housing and mortgage bubble that has now gone bust. The toxic waste aftermath of this bust includes more than fifty subprime lenders gone out of business this years, soaring rates of delinquency, default and foreclosure on subprime, near prime and non-conventional mortgages, and the biggest housing recession in the last few decades with now home prices falling for the first time – year over year – since the Great Depression of the 1930s.
While the process of releveraging started in the household sector – that is the most financially stretched sector of the US economy – the releveraging more recently spread to the corporate and financial system: in the financial system the rise of hedge funds, private equity and speculative prop desks led to a sharp rise in the financial system leverage. In the corporate sector given the cheapness – until recently – of credit we observed a massive process of switch from equity to debt that took the form of leveraged buyouts, share buybacks and privatization of formerly public companies. This releveraging fed that equity/asset bubble: as expectations of more LBOs occurred equity valuation of many firms went higher and higher. The excesses took recently the form of premia of 40-50% or higher on the stock price of firms that were a leveraged takeover target. Specifically, CLO demand for corporate debt helped fuel the private equity sponsored LBO wave over the past few years, and thus contributed to the recent bull market in equities. Notice also that the amount of issuance of low grade corporate bonds (below investment grade “junk bonds”) had been rapidly rising in the last few years.
While pure “Ponzi” borrowers were not as common in the corporate system, there is wide evidence of “speculative borrowers” who relied and still rely on continued refinancing of their debts. Ed Altman, a colleague of mine at Stern, is recognized as the leading world academic expert on corporate defaults and distress. He has argued that we have observed in the last few years record low default rates for corporations in the U.S. and other advanced economies (1.4% for the G7 countries this year). The historical average default rate for US corporations is 3% per year; and given current economic and corporate fundamentals the default rate should be – in his view – 2.5%. But last year such corporate default rates were only 0.6%, one fifth of what they should be given fundamentals. He also noted that recovery rates – given default – have been high relative to historical standards.
These low default rates are driven in part by solid corporate profitability and improved balance sheets. In Altman’s view, however, they have also been crucially driven – among other factors – by the unprecedented growth in liquidity from non traditional lenders, such as hedge fund and private equity. Until recently, their demand for corporate bonds kept risk spreads low, reduced the cost of debt financing for corporations and reduced the rate of defaults. Earlier this year Altman argued that this year “hot money” from non traditional lenders could move to other uses for a number of reasons, including a repricing of risk. If that were to occur, he argued that the historical patterns of default rates – based on firms’ fundamentals – would reassert itself. I.e. we are not in a new brave world of permanently low default rates. He said: “If we observe disappointing returns to highly leveraged and rescue financing packages, some of the hedge funds may find it difficult to cover their own loan requirements as well as the likely fund withdrawals. And broker-dealers who are not only providing the leverage to the hedge funds but whom are also investing in similar strategy deals will recede from these activities.” The same could be said of the consequences of the unraveling of some leveraged buyouts. Altman suggested that triggers of the repricing of credit risk could also be “disappointing returns to highly leveraged and rescue financing packages”. So he argued that the unraveling of the low spreads in the corporate bond market could occur even in the absence of changes in US and/or global liquidity conditions.
Thus, until recently the Minsky “speculative bo
rrowers” in the corporate sectors included corporations that could service their debt only by refinancing such debt payments at very low interest rates and financially favorable conditions. While “Ponzi borrowers” were those firms that, under normal liquidity conditions, would have been forced into distress and debt default (either of the Chapter 7 liquidation form or Chapter 11 debt restructuring form) but were instead able to obtain out-of-court rescue and refinancing packages because of the most easy credit and liquidity conditions in bubbly markets.
The Minsky phenomenon of loosening credit and lending standards during a credit bubble included both the corporate borrowers and financial institutions. First, there are clear parallels between the mortgage market and the leveraged loan markets. These include corporate borrowers’ high leverage ratios, declining credit standards (“cov-lite” loans instead of subprime), PIK (or payment-in-kind) deals (variants of negative amortization), insufficient monitoring by lenders due to the “originate and distribute” model (loans repackaged into CLOs instead of CDOs), banks’ retained exposure (bridge loans as opposed to CDO equity tranche). In the financial system, margin requirement for hedge funds and other leveraged speculators became lower and lower as the competition for prime brokerage services for hedge funds among lenders became fierce.
Housing bubble, mortgage bubble, credit bubble, debt bubble and asset prices (equities, housing, prices of corporate debt and other risky loans) rising well below what could be justified by the economic and credit fundamentals. It certainly looked like a typical Minsky Credit Cycle. The first crack in this cycle was the bust of housing and of subprime mortgages in the US. The second crack was the spread of the subprime carnage to near prime and prime mortgages and to subprime credit cards and auto loans. The third crack is the most recent repricing of risk in a variety of credit markets and the beginning of a credit crunch in the LBO and corporate credit markets.
We are clearly now observing a significant worsening in US financial conditions and a peaking of the Minsky Credit Cycle in a variety of markets:
- a housing recession that is getting worse by the day and home prices now falling (for the first time since the Great Depression) as the housing asset bubble has now burst.
- a credit crunch in subprime that is now spreading to near prime (Alt-A) and prime mortgages (see the Countrywide financial results) and to subprime credit cards and subprime auto loans;
- massive losses – at least $100b in subprime alone and most likely to end up higher – in the mortgage markets;
- a significant recent increase in corporate yield spreads (by 100 to 150 bps);
- the beginning of a liquidity crunch in capital markets that starts to look like the one experienced during the LTCM crisis (10 year swap spreads are – at 70bps – at their highest levels since 2002 and close to the levels that triggered the 1998 LTCM crisis);
- the effective shut down of the CDO and CLO markets as investors risk aversion towards complex derivative instruments – whose official ratings are clearly bogus given the subprime ratings debacle – is sharply up;
- the overall increasing stresses in a variety of credit markets (“a constipated owl” where “absolutely nothing is moving” is how Bill Gross of Pimco described the effective recent shutdown of the CDO market);
- the ABX, TABX, LDCX, CMBX, CDX, iTraxx indices all showing rising risk aversion of investors, sharply rising credit default spreads and significant concerns about credit risk in a variety of credit markets (US, Europe and Japan corporate, high yield corporate, commercial real estate, leveraged loans), not just in subprime or in mortgage markets.
Note also that, as Minsky – as well as more recently the BIS – have warned the deflation of such credit-driven asset bubbles is historically painful and associated with economic downturns and recessions. So “Have we reached a Minsky moment?” It certainly looks like it. Let me now explain why…
The U.S. Growth Weakness Will Persist in the Second Half of 2007…And Financial Markets Are Signaling a Credit Crunch Ahead
The first estimate of US Q2 GDP growth will be out tomorrow Friday. After a dismal “growth recession” in Q1 (0.7%) Q2 growth is expected by the consensus to recover towards 3% (plus or minus a 0.3%) as net exports, inventories and capex spending may have partially recovered in Q2 in spite of a sharp [...]
You gotta give credit to Bill Gross of Pimco not just for the substance of what he says – always thoughtful – but also for his lively and fun writing style. Last month he referred to rating agencies’ AAA ratings of CDOs tranches as “six inch hooker heels”. This month he bashes those who support [...]
If you checked this morning bloomberg.com here are the very first seven stories in its home page: Stocks in U.S. Drop as DuPont, Countrywide Earnings Prompt Growth Concern Countrywide Earnings Slump 33 Percent on Late Mortgages; 2007 Forecast Cut DuPont Profit Falls on Decline in U.S. Housing, Auto Markets: Shares Slide KKR, Homeowners Face [...]
Oil prices are rising again: benchmark crude oil futures finished last week at $75.57 a barrel, up 50% since early 2007. This sharp rise in oil prices suggests several questions: what is driving this increase in prices? How much higher will oil prices go? What is the relation between high oil prices and the weakening US dollar? Will high oil prices hurt US and global economic growth? Let us consider the possible answers to these questions.
First, the reasons for this increase in oil and energy prices are by now well known: demand is rising rapidly as the global economy is growing at a sustained rate and as the BRICs and emerging market economies are growing at a very rapid rate. At the same time, the supply/production of new oil is not rising as rapidly as demand: concerns about how permanent the increase in oil prices are, geostrategic and political constraints to greater investment in exploration and production in a number of unstable countries, constraints to refinery capacity in the US and elsewhere are keeping both oil and gasoline prices high and rising. Also, while rising demand is most driven by economic fundamentals, the possibility of a bubble in oil prices cannot be ruled out: speculative demand for oil and other commodities is high (based on CFTC net speculative long positions) and a potential additional driver of higher prices.
Second, how far higher will oil prices go? The simple answer is that we do not know. However, considering the economic fundamentals is likely that oil prices will rise further for the rest of the year and beyond as conditions of strong demand and tight and inelastic supply are likely to persist. A Goldman Sachs analyst famously predicted in 2005 oil to get to $100 by 2009. This blogger discussed the potential for a secular sharp increase in oil prices towards $100 in a 2005 note. A number of analysts are currently arguing that oil prices may soon rise above $80 (as suggested by Richard Berner of Morgan Stanley today) or even reach $100 this year (as suggested by other analysts and by a variety of prices on oil option contracts; see for example the recent analysis by Jeffrey Rubin at CIBC). The main factor that could lead to a meaningful fall in oil – and other commodity – prices ahead would be a sharp US economic slowdown that leads to a global economic slowdown. While such a US slowdown cannot be ruled out, the issue of whether the rest of the world would decouple from such a US slowdown remains open.
Third, what is the relation between high oil prices and the weakening US dollar? This is a complex issue that has many angles to it. Brad Setser has recently discussed this question pointing out that while oil exporters’ asset preferences are still biased – if less than before – towards dollar assets, their spending/consumption preferences are biased towards European rather that US goods. So, the effect on the US dollar of higher oil prices depends on how much of the oil windfall is saved rather than spent. Richard Berner suggests three channels of interaction between the US dollar and oil prices: a lower dollar reduce the purchasing power of oil exporters over non-US goods; second, oil producers facing such a loss of real income may decide to restrict their production of oil to push up the oil prices (see also today’s FT on this point); third, oil exporters may be diversifying their portfolios away from dollar assets, partly because of return consideration, partly because of the geopolitical risk of directly holding US assets. As he puts it: “we believe that the interplay among oil prices, the dollar, and the responses of oil producers may create a vicious circle in which both oil prices and the dollar overshoot. Brent crude may rise past $80/bbl and the dollar may continue to weaken, and those moves could elevate US inflation. While US Treasuries are rallying as investors focus on the meltdown in credit, the oil-dollar link may limit or reverse the attractiveness of US bonds. Here’s why. The oil-dollar link is impossible to prove because the evidence for it is only circumstantial. However, the logic for each of the three parts in the circle is solid, in our view. First, the orderly decline in the dollar is reducing the non-dollar value of oil producers’ receipts, and thus of their purchasing power. Second, Eric Chaney and I think oil producers are trying to offset that purchasing power lost to a weaker dollar by restraining crude supply, thus keeping prices high. Finally, we and Stephen Jen believe that oil producers likely are diversifying portfolios away from the dollar to hedge returns and, for some, in response to worries about the possibility that USD assets might be frozen or confiscated.”
Indeed, given the rising political constraints in the US towards inward FDI or strategic equity investments, it looks like the Chinese and the Middle East official investors and sovereign wealth funds are now showing greater preference for non-US assets: China and Singapore are financing a chunk of the Barclays acquisition of ABN-Amro; Qatar is planning to increase its strategic investment in a leading UK retailer; Dubai just agreed to purchase a controlling stake in Auckland International Airport. Note that significant diversification by sovereign wealth funds into assets with higher yield than government bonds (such as equities) does not affect the value of such countries’ currencies relative to the US dollar only as long as such diversification still goes into dollar assets or US assets. Conversely, diversifying away from dollar assets will put further downward pressure on the US dollar, for any given rate of reserve accumulation.
Finally, will high oil prices hurt US and global economic growth? The conventional wisdom is that high oil prices are consistent with sustained global growth – as they have been in the 2004-2006 period – if they are driven by high global demand growth. Also, the income windfall of high oil prices for oil exporters – if mostly saved – will keep global interest rates lower than otherwise as the excess of savings of such oil exporters (their current account surpluses) will tend to rise; then, lower real interest rates support global demand.
Those points are correct subject to two caveats that suggest a risk of a US economic slowdown following this spike in oil prices…
The RGE Monitor regularly covers a variety of issues in credit markets and credit derivatives. Here is below the bi-weekly RGE Monitor note that was sent today to our subscribers where we discuss the latest developments and stresses in credit markets. If you like to receive such a bi-weekly note please send a message with [...]
As reported by Bloomberg today U.S. Homebuilder Confidence Drops to 16-Year Low as Housing Slump Persists. This is all consistent with all the other indicators coming from the housing market showing that the housing recession is getting worse: falling home sales, falling starts and permits, rising cancellation rates, increased supply of unsold new and existing [...]
A stronger Euro and concerns about excessive real appreciation and competitiveness loss in the Eurozone
Wolfgang Munchau correctly argues today in his FT column that a stronger Euro will soon start to be painful (“end up in tears”) for Germany as the country significantly relies on net exports for its growth. His argument is valid – at some point a stronger Euro will hurt German exports – but it is [...]
As reported by Bloomberg this morning Retail Sales in U.S. Fall Most in Two Years Amid Fuel Costs, Housing Slump. Sales were very weak – actually falling – across the board: headline, core, ex-automobiles, ex-gasoline. This was not much of a surprise to the readers of this blog as two days ago I wrote: An [...]
At the beginning of 2007 very few – even on Wall Street – had heard of the ABX indices (and very few knew then even what subprime mortgages were). This blog was one of the very first ones in January to warn about the perils and implications of the fall of such ABX indices, even [...]