It’s far too soon to tell whether the credit-market turmoil is over, despite the relative calm over the last week. As a prime broker at one of the big investment banks put it to me, paraphrasing Donald Rumsfeld, “the market has so far digested all the known knowns and all the known unknowns. But what might still trip it up are the unknown unknowns”. These might include a hedge-fund blow-up in another area of the credit markets unrelated to the US mortgage market, or news that an insurance company or mid-size bank was in difficulties, or even a misplaced comment by a central banker.
An event like this would certainly spook the markets, triggering a further widening of credit spreads. What makes the situation precarious is that wider credit spreads feed through to the value of illiquid assets, such as Collateralised Debt Obligations (CDOs) and Collateralised Loan Obligations (CLOs). These are packages of loans held by banks and hedge funds. These structures were designed to be held to maturity rather than traded. This is why they are usually “marked to model” – ie, valued for the purposes of setting margin requirements and published fund returns according to a set of agreed assumptions on future cash flows and default rates.
But once you start getting forced sellers – usually hedge funds forced to dump assets to meet investor redemptions or margin calls – all bets are off. They have to take what they can get for their assets, creating a market price that is sure to be some way below the “mark to model” price. This then becomes the price used by prime brokers in the investment banks to value similar assets – even though there has been no change in the quality of loan portfolio. That leads to further margin calls, more forced sales and even lower market prices. We’ve already seen some evidence of this when Macquarie last week reported big losses in two of its credit funds, even though it had suffered no defaults in any of its underlying loans.
The good news is that this vicious spiral is largely a technical problem. The bad news is that technical problems can quickly turn into economic problems if they are allowed to spiral out of control. To prevent this, someone has to catch the falling knife. Traditionally, this role is performed by investment banks, or more recently hedge funds. During the Banker’s Panic of 1907, JP Morgan famously walked onto the floor of the New York Stock Exchange and ostentatiously started buying up shares. This display of confidence brought the panic to an end. The reason the markets have been calmer this week is that people increasingly believe that, while the problems remain largely confined to the US housing market, hedge funds and investment banks have enough firepower to soak up the forced sellers. But the reason no one is relaxing yet is those unknown unknowns. If the problem spreads to other parts of the credit markets, the scale of soaking up required may be too great for banks and hedge funds alone. Then the market will have to look elsewhere for its latter-day JP Morgan – perhaps to Asia or the Middle East. Ultimately, the Fed could bail out the markets with rate cuts. But chairman Ben Bernanke has rightly signalled he is reluctant to do this except as a last resort.
I still think we are likely to come through this crisis. But no one can definitively call the end until the investment banks finally disgorge the billions of dollars of buyout loans sitting on their books that they were left holding when the music stopped. At the moment, there is a stand-off with the markets, because if the banks were to sell this debt at a big discount, it could trigger precisely the kind of vicious spiral everyone is trying to avoid. Much will depend on the mood of the leading players when they return from their summer holidays. Whatever happens, the banks have had a scare: when this is over, there will be no quick return to the reckless lending of a few months ago. For investors prepared to look beyond the current turmoil, that is the most positive “known known” of all.
Hypocritical Brits
The other day, I met the boss of one of Europe’s biggest energy companies. He has recently attracted a certain amount of comment for agreeing some big deals in Russia. I asked him why he felt so confident he could trust the Putin regime when so many other energy companies, including Shell and BP, have had their agreements torn up on dubious legal pretexts and been forced to sell stakes to state-owned Russian groups.
His response was interesting. First, all governments try to renegotiate energy contracts when oil prices are high. That’s a fact of life in the oil industry. Second, which government has been by far the worst offender? Only one country has overnight, with no consultation, raided the oil industry for a whopping slice of its revenues – the UK when Gordon Brown hiked petroleum revenue tax two years ago. That move has since backfired – it led to a sharp drop in North Sea oil production and a consequent fall in tax receipts. It’s a salutary reminder that for centuries the gravest charge levelled against the British has been that of hypocrisy.