20 Years Later

February, 2007 Dr. Hans Black and Malcolm Thomas

Will history repeat itself? It is now seven years since the collapse of the last major investment bubble, and financial markets are again displaying many tell-tale signs of over-exuberance. But it may be a little different this time. Instead of a public swept away by internet mania and the dream of huge equity returns, the spotlight has turned on the so-called “professionals”, the investment managers that currently dominate the business, who are heavily engaged in something more reminiscent of an earlier exuberant time, back in 1986/1987. Equities may not be flying quite as wildly, and perpetual floating notes may not have made a comeback — nor portfolio insurance in a form as easily recognizable — but similar market frenzy is building, encouraged by confidence in financial innovation and the illusion of risk-free return in an environment of apparently boundless liquidity. The craze is reflected in unbridled euphoria in emerging markets, record low spreads on the most speculative of all debt, and massive increases in leverage. And it is being sustained by a proliferation of complex financial structures in an ever-expanding derivative universe that now offers the “ultimate” chance of insuring, well, anything against default.

Thus, despite a depressing flow of news that includes the renewed prospect of higher global interest rates, increased volatility in energy prices, rising instability in the Middle East, more evidence of H5N1 avian flu, signs of revolt against foreign investors in emerging countries from Russia to Ecuador, the still-unfolding shake-out in the US housing market (which may soon be joined by others)…despite all this and much more, the world of high finance is booming. The derivative market now amounts to almost $500 trillion; it was “only” $200 trillion two years ago (for comparison, the entire World Equity capitalization is around $50 trillion). Corporate mergers and acquisitions are at all-time records. Credit for all types of “deals” is more readily available than ever before. The “carry trade”, a lucrative funding source using low-cost interest yen and Swiss francs, is flourishing. Hedge (capital around $1.5 trillion) and private equity funds ($500 billion) are expanding exponentially. And everywhere, the professionals are rushing to employ and gear up huge pools of capital entrusted to them, flush with recent massive bonuses and emboldened by conceptually tempting arguments that their actions are protected by instruments “redistributing” risk.

Well, some may be, but many are not. “A typical hedge fund (is) two times levered” runs a comment in the Financial Times. “That looks modest until you realize it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralized debt obligations which are nine times levered. Thus every $1million of bonds is effectively supported by less than $20,000 of end-investors’ capital — a 2 percent price decline in the paper wipes out the capital supporting it.” Fortunately, volatility is low, but this has only whetted the appetite for risk-taking. A few days ago, Bloomberg noted, “the riskiest borrowers are having little trouble raising money. Aramark Corp, the Philadelphia-based operator of concessions in arenas including New York’s Shea Stadium that had its credit ratings cut twice since August, last week sold $1.78 billion of debt that were as much as half a percentage point less than it proposed.” Along these lines S&P says that the percentage of bonds in distress (defined as those with yields in excess of 10 percentage points over Treasuries) has just fallen to a record low of 1.3 percent, while the face value of Merrill Lynch’s distressed bond index has collapsed to $6.5 billion (it was $161 billion in 2002). In Europe, the risk of owning corporate bonds, as measured by the increasingly popular credit default market, has dropped to its lowest ever.

This widespread confidence is also captured in recent developments in emerging debt after Thailand introduced capital controls and Venezuela and Ecuador announced proposals to nationalize key industries. After the briefest shrug, business in the sector quickly got back to normal, and yields resumed their 5-year-old slide. In 2001, emerging market spreads were 1000 basis points over Treasuries; now they are just 167. At the World Economic Forum in Davos last week, a few cognoscenti dared voice some concern, noting that with spreads at the narrowest ever, “investors are simply not being paid for the risks they’re taking.” However, most dismissed worries on this score. “The mood has been totally upbeat,” said an Indian billionaire; in fact “I’ve never seen a mood like this.” Morgan Stanley’s chief global economist added, “the consensus here is everybody’s thinking it will be another booming year.”

We think not. With the US Fed and Treasury stepping up their Study of Financial Leverage ahead of what is likely to be another round of G7 (and Chinese) monetary tightening, the market may be entering a more dangerous phase. As Jean-Claude Trichet of the European Central Bank said on January 27th, investors “have to be prepared for a re-appreciation of risk” which is now “likely.” This transition, he notes, may be “smooth” or “disorderly.” Axel Weber, head of the Bundesbank, summarized: “It is time for financial markets to move back to more adequate risk pricing,” adding, “there’s a danger of a rush to the exit.” But if there is, he warned, “don’t come looking to us for a bailout.”