Dancing on the Ceiling

Dear readers,

This week we move away from our macro-economic analysis and focus on a worrisome development in the banking sector that was brought to our attention via a Bloomberg story posted this Friday.

Despite the enormous fiscal cost to the tax payer around the world, the past twelve months have been a treasure for global macro players like us who try to detect imbalances and exploit these opportunities or at least protect our investments against these excesses. We were privileged to sit on the first row to see the Great Credit Crisis unfold and it gave us a massive amount of inspiration to write about it. This even ended up in an invitation from Moorad Choudhry to contribute a chapter on the Origin of a Crisis for the 3rd edition of one of his many books he has published so far. More info on this you will find on http://www.palgrave.com/Products/title.aspx?PID=335493

This throws us immediately into our subject of this week. One can easily sum up more than 10 reasons that can be held responsible for causing this crisis. Each of them has a different weighting. For example despite what populists may argue the bonus culture is not top on the list but is rather a Tier 3 or 4 factor in all this. The combination of leverage and the fact that financial firms chose not to transfer credit risk could be appointed as one of the root causes of the financial crisis.

We are now in the midst of a process that governments and regulators are trying to fix the system and make the rules more robust to prevent this from happening again. Certainly one should hope that we would not return to the old sins that brought us into trouble in the first place. Unfortunately when we read the Bloomberg headline we were shocked that some market players return to their old bad habits. It is as if the party has just started again and everybody is singing Lionel Richie's song " We are dancing on the ceiling."

At this moment banks are gearing up their lending to buyers of high-yield corporate loans and mortgages and this at a pace which is even faster then before the outbreak of the Great Credit Crisis in July 2007. To quote Bob Franz, co-head of syndicated loans at CSFB “I am surprised by how quickly the market has become receptive to leverage again.”

According to data from the Fed one can see that among the 18 prime dealers who bid for US Treasuries there is a total of $ 27.6 billion of securities held as collateral for financings lasting more than one day as of August 12. This is up 75% since the beginning of May!!!

The increase proves money is being used for riskier home loans, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by
Fannie Mae, Freddie Mac and/ or Ginnie Mae.

Furthermore the increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. Fortunately lenders are asking more collateral for the loans.

We have no issues with the technique of using a bit of leverage especially when a fair amount of collateral is behind it. Risk needs to be taken. This is crucial to our financial capitalistic system. It may sound harsh but a market economy needs to some degree bankruptcies as it is a healthy sign of risk taking. A financial system so stable that no bankruptcy would take place would be an indication that risk taking is (too) low and this will negatively affect entrepreneurship.

The only issue we have is that there is a justified political pressure on banks to start lending again, but this would be the last form one would expect to return. To the degree leverage coming back represents a normalization of the markets but the idea it should be part of any permanent residential or commercial mortgage securities portfolio strategy is not clever. It is like a heart patient who just recovered from a heart transplant and is immediately trying to run a marathon again.

The risk now is that this new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to rating agency Moody’s. Then there still is the ticking time bomb of commercial real estate.

The end game of this is very colourful described by Julian Mann, a $ 5 billion fund manager in California, “If you leverage up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable.” We don’t have to remind you what happened from July 2007 onwards…

Stepping back from the experience of the current crisis, and looking forward, it is clear that the issue of financial stability should remain a central focus. The experience of the past few decades in both emerging markets and advanced economies shows the pervasiveness of financial crises. These crises, signals of financial instability and the failure of the proper working of the financial system, have important economic and financial consequences, and usually lead to severe economic contractions that may either be short-lived or persist over time. If the real effects persist, the long-run potential and actual growth rate of an economy may be significantly lowered, negatively affecting long term welfare. (1)


(1) Viral Acharya and Matthew Richardson “Restoring Financial Stability. How to Repair a Failed System.” NYU Stern, 2009