Credit crunch will 'shred investment portfolios to ribbons'

By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, July 4, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/02/bcncru...

The near collapse of two Bear Stearns hedge funds has lifted the rock on our 21st century mutant capitalism, exposing the bugs beneath to a rare shock of naked light.

When creditors led by Merrill Lynch forced a fire sale of assets, they inadvertently revealed that up to $2 trillion of debt linked to the crumbling US sub-prime and "Alt A" property market was falsely priced on books.

Even A-rated securities fetched just 85 percent of face value. B-grades fell off a cliff. The banks halted the sale before "price discovery" set off a wider chain reaction.

"It was a cover-up," says Charles Dumas, global strategist at Lombard Street Research. He believes that the banks alone have $750 billion in exposure. They may have to call in loans.

Not even the Bank for International Settlements (BIS) has a handle on the "opaque" instruments taking over world finance.

"Who now holds these risks, and can they manage them adequately? The honest answer is that we do not know," it said.

Markets have been wobbly since the surge in yields on 10-year US Treasuries, the world's benchmark price of money. Yields have jumped 55 basis points since early May on inflation scares, the steepest rise since 1994. It infects everything; hence that ugly "double top" on Wall Street and Morgan Stanley's "triple sell signal" on equities.

Wobbles are turning to fear. Just $3 billion of the $20 billion junk bonds planned for issue last week were actually sold. Lenders are refusing "covenant-lite" deals for leveraged buyouts, especially those with "toggles" that allow debtors to pay bills with fresh bonds. Carlyle, Arcelor, MISC, and US Food Services are all shelving plans to raise money. This is how a credit crunch starts.

"This is the big one: All investment portfolios will be shredded to ribbons," said Albert Edwards from Dresdner Kleinwort.

The BIS had warned days earlier that markets were febrile: "more risk-taking, more leverage, more funding, higher prices, more collateral, and, in turn, more risk taking. The danger with such endogenous market processes is that they can -- indeed must -- eventually go into reverse if the fundamentals have been over-priced. Such cycles have been seen many times in the past," it said.

The last few months look like the final blow-off peak of an enormous credit balloon. Global merger and acquisition deals reached $2,278 billion in the first half, up 50 percent on a year. Corporate debt jumped $1,450 billion, up 32 percent. Private equity buyouts reached $568.7 billion, up 23 percent. Collateralised debt obligations (CDOs) rose $251 billion in the first quarter, double last year's record rate.

Leveraged deals are running at 5.4 debt/cash flow ratio, an all-time high. As the BIS warns, this debt will prove a killer when the cycle turns. "The strategy depends on the availability of cheap funding," it said.

Why has such excess happened? Because global liquidity flooded the bond markets in 2005, 2006, and early 2007, compressing yields to wafer-thin levels. It created an irresistible incentive to use debt.

What is the source of this liquidity? Take your pick. Goldman Sachs says oil exporters armed with $1,250 billion in annual revenues have been the silent force, sinking wealth into bonds; China is recycling $1.3 trillion of reserves into global credit, a byproduct of its policy to cap the yuan; Japan's near-zero rates have spawned a "carry trade," injecting $500 billion of Japanese money into Anglo-Saxon bonds and such; the Swiss franc carry trade has juiced Europe, financing property booms in the ex-Communist bloc. And, all the while, cheap Asian manufactures have doused inflation, masking the monetary bubble.

The deeper reason is the ultra-loose policy of the world's central banks over a decade. They "fixed" the price of money too low in the 1990s, prevented a liquidation purge to clear the dot-com excesses, then kept rates too low again from 2003 to 2006. Belated tightening has yet to catch up.

Don't blame capitalism. This is a 100-percent-proof government-created monster. Bureaucrats (yes, Alan Greenspan) have distorted market signals, leading to the warped behaviour we see all around us.

As the BIS notes tartly in its warning on the nexus of excess, this blunder has official fingerprints all over it. "Behind each set of concerns lurks the common factor of highly accommodating financial conditions," it said.

Rebuking the Fed, the BIS said Japan and Europe have turned sceptical of the orthodoxy that central banks can safely let asset booms run wild, merely stepping in afterward to "clean up."

The strategy leads to serial bubbles, creates an addiction to easy money, and transfers wealth from savers to debtors, "sowing the seeds for more serious problems further ahead."

If you think we are too clever now to let a full-blown slump occur, read the BIS report.

"Virtually nobody foresaw the Great Depression of the 1930s, or the crises that affected Japan and southeast Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived," the BIS said.

The subtext is that you bake slumps into the pie when you let credit booms run wild. You can put off the day of reckoning, as the Fed did in 2003, but not forever, and not without other costs.

So the oldest and most venerable global watchdog is worried enough to evoke the dangers of depression. It will not happen. Fed chief Ben Bernanke made his name studying depressions. He will slash rates to zero if necessary, and then -- in his own words -- drop cash from helicopters. But his solution is somebody else's dollar crisis.

On it goes. Perhaps governments should simply stop trying to rig the price of money in the first place.

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