Credit Bubbles Redux

Central banks insist that there is no credit bubble. But like politicians, where a central banker denies something vigorously and repeatedly, it is usually true.

To resurrect the global economy from the Great Recession, central banks implemented a policy of ultra-low interest rates and quantitative easing (“QE”) to restore growth. The policy relies, in part, on the asset inflation and portfolio rebalancing channel. In effect, low rates and abundant liquidity drive up asset values and also encourage switching to riskier investments.

Given that the same policies were central to problems of 2008, the authorities seem to corroborate John Kenneth Galbraith’s observation: “Nothing is so admirable in politics as a short memory”.

The justification was that the policy would encourage additional consumption increasing economic activity. But the effect on the real economy has been limited.

Only around 1-2% of higher wealth of American households (up more than $25 trillion since early 2009 from increased house and equity prices) has flowed through into added consumption. This is well below the 3-4% average between 1952 and 2009. One explanation might be that the increase in wealth has accrued to better off sections of the population with a lower propensity to increase spending incrementally. In the Euro-Zone and UK, the effect of higher asset prices on consumption has also been low.

Instead, monetary methamphetamine has driven a desperate dash for trash, which threatens financial stability.

Equity markets have risen strongly. Desperate for capital appreciation, investors are chasing ‘blue sky’ technology and bio-technology stocks, which promise earnings and/or revenue growth that is faster than the industry or overall market.

Established technology companies are using their highly priced stock as currency to acquire smaller start-ups, further inflating values. Facebook’s acquisition of WhatsApp, a messaging service, for US$19 billion is a case in point.

Facebook paid around 8% of its market value for WhatsApp. The high price was justified as giving Facebook presence in mobile devices. The price assumes optimistic future growth rates and profitability, projecting a doubling of the application user base to 1 billion and a doubling or tripling in Smartphone numbers which would further broaden its clientele.

In fact, the acquisition and the price paid underlined Facebook’s strategic dilemmas, raising questions about the social media network’s own high valuation.

Many companies have borrowed at low current rates to finance buybacks of their own shares. In the US, 2013 buyback authorizations totalled US$755 billion, the second largest year on record, further supporting share prices.

Property prices have risen, supported by low financing costs and the absence of yields from other assets. In market like the US and UK, property prices have recovered and in some cases reached or exceeded 2008 levels. In other markets, like Germany, Switzerland, Canada, Australia, New Zealand and a number of emerging markets, especially in Asia, property prices have reached record levels.

Sovereign bond interest rates are at historically lows, fuelled by central bank buying and an artificially created shortage of safe assets. The most striking change has been the fall in rates for government bonds of beleaguered Euro-zone countries, such as Greece, Ireland, Portugal and Spain, which, in some cases, have returned to pre-crisis levels.

In April 2014, Greece issued Euro 3 billion of 5 year bonds at a yield of 4.95%, below market expectations. There was over Euro 20 billion in investor demand. It was a return rivalling the biblical tale of Lazarus’s rise from the dead.

The successful issue belied that Greece had defaulted on its debt merely 2 years ago. Greece’s debt levels remain unsustainably high, even before adjusting for unpaid government bills or potential recapitalisation needs of the banking sector. A further debt restructuring cannot be ruled out.

The evidence supporting a ‘narrative’ of Greece’s recovery is weak, with the economy having shrunk by around 25% and with around 25% of the workforce unemployed. The issue itself will worsen Greece’s position significantly adding to interest costs.

Investors bet that Greece is too big to fail and Germany and France’s continued support of both Greece and the Euro. They believe that they will earn higher returns than those available on bonds by core Euro-zone nations, with minimal risk.

Demand for risky debt has increased, driving down the additional return available to historical lows. In 2013, the issuance of US non-investment grade bonds reached US$378 billion, up from US$154 billion in 2007. The strongest increase was in the speculative ‘B’ and ‘CCC’ rating categories. Leveraged loans (a riskier form of lending) reached US$455 billion, up from US$389 billion in 2007. Transactions with low underwriting standards and weaker credit conditions have recovered to 2007 levels.

Even volumes of notorious Collateralised Debt Obligations (“CDOs”) have almost recovered to 2007 levels, with sub-prime auto loans taking the place of sub-prime mortgages.

With around 40-50% of government bonds returning less than 1%, bonds investors desperate for yield have moved beyond emerging to frontier markets, embracing less well known African and Asian borrowers. The reasoning is that these countries have better growth rates and prospects than the BRICS and other better known emerging nations that face significant challenges.

In 2013, Rwanda, a country remembered mainly for a horrific genocidal civil war, issued 10 year bonds to raise US$400 million, around 5% of its gross domestic product. Attracted by the 6.875% coupon, investor demand was 9 to 10 times the issue size. Other African issuers have included Nigeria, Zambia, Tanzania, Kenya and Mozambique.

Asian borrowers have also taken advantage of the “all you can eat” debt buffet. In January 2014, Sri Lanka, rated non-investment grade, raised US$1 billion in US dollars a yield of 6%. Demand was three times the amount offered. Subsequently in April 2014, Sri Lanka undertook a U$500 million 5 year bond issue at a yield of 5.125%. In the secondary market, the bond is now trading at below 5%. A Bangladeshi telecom operator (rated B+ or highly speculative) raised U$300 million for 5 years at 8.625%. Demand was over three times the issue size.

A key driver has been the phenomenon of the ‘index tourist’ whereby inclusion in major bond indices forces investor to purchase the relevant securities.

Investor enthusiasm is inconsistent with many issuers’ reliance on foreign aid, volatile commodity export revenues, political instability and governance issues (a euphemism covering lack of institutional infrastructure, grandiose projects, corruption and misuse of funds).

The market’s animal spirits are supported by a belief that authorities have no option but to maintain abundant liquidity conditions in the face of low growth and the risk of disinflation or deflation. In effect, there is a deep rooted belief that central bankers cannot and will not risk a sharp fall in asset prices in the current fragile conditions. There is also belief that default on borrowings are unlikely as the available liquidity will not be withdrawn allowing even weak borrowers to refinance or increase borrowings as required.

Markets are now “priced for perfection”, that is, investors are assuming that nothing can or will be allowed to go wrong and there will be no unexpected developments.

In the worst case, investors have faith in their ability to anticipate changes in the environment and exit positions. Purchasers of flirty technology and bio-tech stocks, Greek debt and CCC rated bonds assume that they can flip them at will.

But failures, industry consolidation and reduction in trading activities mean that the number of dealers and market-makers in financial securities is lower today. Higher capital and liquidity requirements as well as regulations such as the Volcker rule mean that the ability of dealers to hold inventory of unsold securities has reduced sharply.

According to some estimates, inventory levels are down 50-100% depending on the asset class.

Dealer inventory levels of emerging market bonds, an asset class which has attracted increased investment, are down as much as 80%. In 2007, a 50% outflow from US mutual funds invested in credit products would equate to 100% increase in the additional inventory required to be held by dealers. Today, only a 5% outflow would have the same effect.

The ability of investors to exit positions without creating sharp price falls and volatility is now heavily constrained, increasing risk.

Economist Herbert Stein’s law states that if something cannot continue, then it will eventually stop. The end will inevitably be sudden and unexpected reflecting author Alexander Pope’s description of the collapse of the 1720 South Sea Bubble: “Most people thought it wou’d come but no man prepar’d for it; no man consider’d it would come like a thief in the night, exactly as it happens in the case of death.”

© 2014 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

One Response to "Credit Bubbles Redux"

  1. kiers   June 24, 2014 at 11:33 pm

    You mention "The policy relies, in part, on the asset inflation and portfolio rebalancing channel".

    Have you missed the BIGGEST giveaway of QE of all: The treasury bonds that lie in the Fed's cupboard DO NOT HAVE TO BE REPAID BY UNCLE SAM!

    This is precisely the period (the maturity schedule of the Fed owned bonds) that the inflationary kick is realized from QE! Other than that, QE was, by misplacing public uninformed expectations, in fact DEFLATIONARY.

    Please correct me if i'm wrong.