Is this really the end of the credit cycle? A lot of people in the City are seriously rattled. Earlier this week, I spoke to the founder of one of London’s top hedge funds, who has been consistently bullish about the outlook for the fixed-income markets.
But while he is usually happy to chat, this time he was nervous and defensive. He said he still believes the cycle has some way to run, but he thinks that parts of the press were trying to whip up hysteria, which could be damaging, and he didn’t want to add to the speculation. Another hedge-fund manager told me that he thought the chances of a serious setback in the credit markets in the next six to nine months had risen from 20% to 40%. Given that he, too, is unlikely to talk down his own market, you can assume the true probability is even higher.
This credit cycle has been, in its way, every bit as dramatic as the dotcom boom in the last decade. Access to cheap, plentiful debt has fuelled the buyout and hedge-fund boom, paving London’s streets with gold. It’s driven up share prices, commodity prices and, above all, house prices. Many people have been predicting for a long time that it would end in tears, but it has persisted for two reasons. First, the emergence of China and other developing countries has helped keep inflation down and, thanks to the decision by these countries to invest their trade surpluses in US Treasuries has held down US interest rates as well. Second, because of the development of new financial technologies that allow bankers to package up debts that are then sliced and diced and flogged off to millions of investors. The result has been to increase the amount of borrowing while apparently reducing risk.
It’s this second bit that has everyone worried. On the face of it, the outlook is still pretty good. The global economy is growing, inflation more or less under control, company balance sheets are strong and defaults close to record lows. There have been none of the big company blow-ups that normally herald the end of the cycle.
But all that cheap money of the last few years led to some reckless lending, particularly in US housing. With US interest rates having risen from 1% to 5%, people are now defaulting on their mortgages, and the hedge funds that bought up all this debt are in trouble. Many invested huge amounts of borrowed money in mortgage-backed securities and now that defaults are rising, their equity is being wiped out and the banks are demanding they put in fresh equity, which they can only raise by selling assets into a falling market.
So how big a risk is this? Taken in isolation, the subprime mortgage debacle should be containable. The best guess is that there are about $500bn of these loans outstanding, but not all will default. Say 20% went wrong – that’s $100bn, which is a big hit, but not a disastrous one in the context of a banking system with over $1,000bn of capital. The much bigger risk is that a hit on this scale causes the market to lose its nerve. There is already some evidence of bankers becoming more wary about all kinds of lending, with a couple of high-profile loans to finance big buyouts running into resistance. If investors lose confidence in all the new-fangled hedge funds that specialise in buying these loans, the crisis in subprime could quickly spread.
It comes down to psychology: does greed outweigh fear? I’m not sure we’re there yet. Huge deals are still being done. This week, Blackstone bid $26bn for Hilton Hotels, and Australia’s Wesmart bid $15bn for department store Coles. When I go around the City, I see lots of very greedy people, but not many frightened ones. So I think the credit cycle has a bit further to run and we’ll get through this latest squall. But as one of the hedge-fund managers put it, the market is like a boxer who has already been knocked down twice this year – once in February and March, and again in June. It’s not clear whether it can survive another punch.
The Square Mile likes Gordon’s style
Our new prime minister thought better than to take my advice and make Ed Balls chancellor. But the man who did get the job seems to have taken my advice as to what to do with it. Alastair Darling told the FT his aim was to create a simpler tax system, which presumably means reversing some of the complexity introduced by Brown. It was music to the City’s ears and caps a pretty spectacular first week for Brown.
Around the Square Mile, I’ve heard nothing but admiration for the business-friendly moves he has made. Persuading top business figures to join his advisory council was a stunning coup, and his appointment of Blairite John Hutton to head a reformed DTI and his creation of a department focused on skills were all welcomed. Where this leaves the Tories, who have largely abandoned the City, business and tax as issues, I don’t know. But assuming this week translates into a sustained poll lead, perhaps the best investment available right now is the 11/1 on offer at the bookies on a snap election later this year.
Simon Nixon is executive editor of Breakingviews.com