If at first you don’t succeed
Mar 13th 2008
From The Economist print edition
THIRD time lucky? The credit markets almost seized up in August, December and again this month and on each occasion the Federal Reserve has led a rescue attempt. Its latest effort led to a bout of euphoria on Wall Street, with the S&P 500 index managing its biggest one-day increase in over five years on March 11th. But every time the Fed has unblocked the drains somewhere in the credit markets, they have bunged up elsewhere. Sure enough, on March 13th panicky investors sent the dollar tumbling below ¥100 and pushed gold above $1,000 an ounce.
The fear is that the financial markets have entered a negative spiral, the obverse of the kind of euphoria that drove dotcom stocks to absurd valuations in 1999 and early 2000. Back then, investors scrambled to buy shares regardless of their price. This time round, they are being forced to sell bonds and loans, whether or not they believe the borrowers will eventually repay. The problems are exacerbated by the demise of the securitisation market, and fears about counterparty risk. Both those factors are making banks less willing to lend—even to worthy borrowers. They will become ever more cautious the deeper America’s economy tips into recession.
Debt, such an exalted financing tool a little more than a year ago, is now a four-letter word. In the boom, banks were able to lend money via bonds and loans and then unload the debts in the form of structured products. Even when yield spreads narrowed, investors simply spiced up their portfolios with more debt to produce higher returns. But once the problems in the subprime market became clear, the appetite for structured products collapsed, and the process went into reverse.
Oddly enough, the problem is particularly intense in an area of the market that, in theory, should have been the safest; paper given AAA-like ratings by the agencies. There are no longer end buyers for this paper. The yields on such assets are too low to make them of interest except to geared investors. And there is scant lending available, even if investors wanted to gear up their portfolios in these volatile times.
Also, the investment banks that deal with hedge funds are tightening lending standards. This may involve higher margin payments or a bigger “haircut” shaved off the value of assets pledged as collateral. According to one banker, even government bonds pledged as collateral are facing haircuts for the first time in 15 years.
That may make sense for each individual bank, but at the systemic level it makes matters worse for everyone. Hedge funds are being forced to sell their best assets to meet their debts, adding to the air of crisis. A dramatic case is Carlyle Capital, a bond fund run by the Carlyle Group, a private-equity firm (see article). On March 12th it said it had defaulted on $16.6 billion of debt and expected to default on the rest, after failing to reach an agreement with its creditors. The fund used gearing of 32 times to buy AAA-rated paper and has had to sell assets to meet margin calls. Some of that debt was issued by Fannie Mae and Freddie Mac, the two quasi-governmental agencies that guarantee mortgage debt. As Carlyle sold, the prices of their debt fell, increasing concern about their finances. In early March the spread between yields on Fannie Mae debt and Treasury bonds was higher than at any time since 1986.
This helps explain why the new Fed facility allows primary dealers to pledge AAA-rated mortgage securities as collateral for borrowings. If confidence can be restored in that part of the market, perhaps the negative spiral can be broken.
Analysts were by no means convinced, however. Rob Carnell of ING described the measures as a “palliative to market fragility, rather than a cure.” Nor was the initial reaction in parts of the credit markets particularly encouraging. The cost of insuring against corporate-bond defaults did not fall sharply. Meanwhile, the interbank rate needed to borrow euros for three months hit 4.6%, the highest level since January and more than half a percentage point above official euro-zone rates. That indicated banks still preferred to hold cash rather than lend it.
The hoarding is a natural consequence of the breakdown of the securitisation market. Banks know that it will be more difficult to offload any new loans. They are also saddled with old loans, either because they have been unable to sell them, or because they have taken structured investment vehicles onto their balance sheets to protect their reputations.
When banks get more nervous about lending, that tends to have wider consequences. Companies will find it more difficult to borrow; weaker ones will accordingly get into trouble. According to Matt King, a credit strategist at Citigroup, the single biggest factor influencing corporate default rates is banks’ willingness to extend credit—as measured by the lending surveys of the Fed and the European Central Bank. Nor is it likely that the full impact of tighter lending standards on consumer demand has been felt.
David Bowers of Absolute Strategy Research, a consultancy, reckons that the credit crisis has also undermined the willingness of foreigners to finance America’s current-account deficit. Data show that overseas investors own some $1.5 trillion of asset-backed debt, investments that have gone badly wrong. They will not be willing to lend in the same way again.
And the effects of the crisis are showing up in some unexpected places. One of the latest casualties is the sewer system of Jefferson county, Alabama. The county, which includes the city of Birmingham, had agreed to interest-rate swaps worth a remarkable $5.4 billion in an attempt to limit its financing costs. But the rationale for the deal was undermined by the credit problems of the “monolines”, which insured the sewer system’s bonds. The result was a sharp rise in financing costs. A group of banks led by JPMorgan Chase is asking it to put up a further $184m in collateral; the county is refusing.
As the dispute rumbles on, the sewer system’s debt has been downgraded all the way to CCC by Standard & Poor’s, a rating agency. One thing is certain. If the credit crunch continues, the residents of Jefferson County won’t be the only ones holding their noses at the stink.