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“Pay no attention to that man behind the curtain,” pleads the Wizard of Oz as his light-and-sound spectacular comes crashing down and he stands exposed as a rather small and impotent figure cowering in the corner of the room. But his audience aren’t that gullible – they finally realise they’re being strung along by a fraud.
Yet when it comes to financial wizards, most people seem happy to avert their eyes as quickly as possible. Despite compelling evidence that a severe US slowdown is on the way, economic cheerleaders are still talking up their book.
The most we will suffer is a mild slowdown, they say; there’s no prospect of a severe slump followed by a credit crunch. Everything will remain wonderful: now move along please, there’s nothing to see here.
But look more closely and we can already spot a pair of feet poking out from under the curtain. And they’re rather nasty, gnarly feet – the type of feet whose owner might not be very friendly. At this point, we start to wonder whether even the hotshots who claim to be running the show know exactly what’s lurking behind that curtain…
There are a few insiders who clearly have an idea what’s in store. In yesterday’s Daily Telegraph, Ambrose Evans-Pritchard reported that the big City banks are slowly building up their distressed debt teams. Distressed debt operators are in limited demand when everything is going well and companies can meet their debt repayments without trouble. But when the cycle turns, there are big profits to be made from the ensuing meltdown, as companies are forced to restructure, sell assets, or bonds are simply oversold. This is where these ‘vulture teams’ come in.
And this time round, they could have a lot of carcasses to pick over. The leveraged-buyout (LBO) boom has been fuelled by enormous amounts of debt – particularly riskier debt such as junk bonds and leveraged loans.
In a typical LBO, the buyer uses the company’s cash flow to pay off the loans that enabled it to buy the company in the first place. But obviously, the buyer is then reliant on business remaining strong enough to generate these cash flows.
Given the hefty sums that have been paid for companies and the high level of debt to equity used in the current boom, there’s very little wriggle-room in many recent LBOs. Even a mild downturn could see them in a lot of trouble.
But investors are happy to assume the current benign conditions will continue indefinitely and that default rates on debt will remain historically low– the same predictable, reckless behaviour we see towards the peak of every market.
Of course they won’t: the cycle is certain to turn at some point, although exactly when is as always, a tough call. Many distressed debt specialists thought we’d see the first tremors this year, but so far defaults have been scarce. The thinking now seems to be that the markets will get hit in late 2007 or early 2008.
And when the hit comes it will be hard. Junk-bond default rates are presently around 2%, but topped 8% during the last US recession in 2001. The credit spread between junk bonds and US Treasuries – the amount of extra yield investors demand to hold riskier debt instead of safe government bonds – is under 4%, compared with over 10% in 2001.
Investors (including a lot of hedge funds) who have bought into junk bonds and loans in these conditions may be quite shocked by how much defaults go up and the value of their bonds goes down when the cycle turns.
Indeed, this cycle might well be worse than usual because there are factors we’ve not seen before in a credit crunch. Most crucial is the explosive growth in credit derivatives, which we discussed in a recent cover story (subscribers can remind themselves of the piece by clicking here: The dangers of derivatives
The development of credit derivatives has the potential to be a force for good. It’s no exaggeration to say they’ve revolutionised global finance by enabling risk to be shared out much more evenly than in the past – or at least, that’s the theory.
But they have also lead more investors to buy into debt than before, using complex instruments that they may not fully understand. Some of these tools may not be suitable for the purposes to which they’re being put – for example, credit default swaps were originally designed as a way of insuring against a debtor defaulting, but are now often used to bet on whether a company will go bust or not.
Many buyers will have overly-optimistic ideas of just how many companies will get into trouble during a downturn. They will be using sophisticated risk-modelling techniques that work well 90% of the time, but drastically underestimate what will happen in really tough market conditions – in other words, they break down just at the time when you really need them to be accurate. The net result of this might be that the devastation gets spread throughout the financial system, rather than battering a small group of companies and individuals.
The debt magicians’ patter is that it genuinely is different this time. The economy is in great shape, default rates will remain low and investors understand the risks they’re taking. We feel safer keeping an eye on the curtain.
Turning to the markets…
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The FTSE 100 approached a six-year high yesterday, closing 41 points firmer at 5,971. The index was boosted by strong trading on Wall Street and bid talk. Bid speculation saw building materials group Hanson and pallet-maker Brambles Industries make some of the biggest increases of the day, although Royal and Sun Alliance topped the leader board as a result of the sale of its US operation. For a full market report, see: London market close
On the Continent, the Paris CAC-40 gained 6 points to end the day at 5,250, whilst the German DAX-30 closed flat at 5,989.
Across the Atlantic, the major indices enjoyed a fourth straight session of gains. The Dow Jones climbed 29 points to close at 11,718, within four points of its record high close. The Nasdaq was 6 points higher, at 2,270. And the S&P 500 closed at 1,339, a gain of 2 points.
In Asia, the Nikkei followed the US higher overnight to close at 16,127 this morning, a 102 point gain.
Crude oil fell back slightly yesterday, and was last trading at $62.35 in New York. Meanwhile, Brent spot was at $60.94 in London.
Gold fell below $600 an ounce in overnight trading, but rebounded following interest from Japanese speculators this morning. Spot gold was last trading at $603.50.
And in London this morning, publisher of FHM and Grazia, Emap, is expecting to report a 2% fall in first-half underlying revenue as a result of ‘tough’ market conditions. Women’s titles continue to perform well, however, offsetting the weaker men’s and automotive titles. The group is focusing on new product development, particularly digital initiatives, as advertising revenues continue to fall. Emap expects to deliver to full-year expectations.
And our two recommended articles for today…
Is Germany making a comeback?
– After a desultory few years, it look as though the German economy is starting to shift gears, with corporate restructuring and moves towards labour market reform boosting productivity. To find out why Stephen Roach thinks Germany could be the new Japan, read: Is Germany making a comeback?
A beginner’s guide to derivatives
– Derivatives are a fast-growing segment of the financial market – so much so that MoneyWeek recently ran a cover story on the subject – but many investors are unsure of how they work. If you want to know what derivatives are, their risks, and how to determine their prices, this brief introduction is a good place to start. See: A beginner’s guide to derivatives