Ah, it's that season again. Put on my hairy bear suit and go out into the woods.... before hunting season starts.
From the Latest Economist
Investment banks hold many billions of dollars of debt and have lots of risky loans on their books. One market participant reckons that there is, perhaps, $25 billion at serious risk in the big investment banks’ portfolios. It is conceivable, he says, that among them, they could lose $10 billion of this. If so, the grim reaper seems likeliest to be the telecoms sector—which is fast looking less like the foundations of a glorious Internet future and more like another outing for the emperor’s new clothes.
Deutsche Telekom, France Telecom and British Telecom, to take but three, have had their credit ratings slashed. These would have been cut by even more had the companies not persuaded the rating agencies to hold fire while they try to flog any assets they can. But, done in a hurry, this may be a less lucrative process than they hope. And Credit Suisse Asset Management, for one, reckons that Deutsche Telekom, for example, should already be closer to a BB credit (ie, junk) than its current A rating. That might reveal something about those telecom firms that are already rated as junk.
The sheer volume of high-yield debt is causing spreads over Treasuries to soar. But so, ominously, is the draining of liquidity from the market, which has never really recovered from the drought caused by LTCM. Two things are mostly to blame. The first is that there are fewer investment banks. Now that Credit Suisse has bought DLJ, UBS has snaffled up PaineWebber, and Chase is acquiring J.P. Morgan, the number of banks willing to take risky positions, particularly as middlemen, has fallen sharply. As yet, nobody has entered the market to fill this risky, but potentially lucrative, space.
The second problem is the prevalence of sophisticated risk-management models that increasingly appear to cause more problems than they solve, at least in times of market stress. So-called value-at-risk models (VAR) blend science and art. They estimate how much a portfolio could lose in a single bad day. If that amount gets too large, the VAR model signals that the bank should sell. The trouble is that lots of banks have similar investments and similar VAR models. In periods when markets everywhere decline, the models can tell everybody to sell the same things at the same time, making market conditions much worse. In effect, they can, and often do, create a vicious feedback loop.
Incentives in the junk-underwriting business only make matters worse. Risk-adjusted, this is a terrible business for banks’ shareholders. A large slice of the profits goes to bank employees, who are increasingly prepared to gamble by underwriting low-quality debt which, if they prove unable to offload it, could do serious damage to their bank. “I am happy to tell you that we are continuing to increase market share during this difficult period,” Deutsche Bank’s Edson Mitchell told employees working on high-yield bonds this week. This news should not make his shareholders happy.
If the game is up in the junk market, there will be severe consequences for the equity market, especially those shares that have not already been mauled. No firm would find it easy to raise new finance, however good its prospects. Indeed, today’s loans to telecoms firms may turn out to be much like property lending a decade ago, a fad that caused economic downturn and, for a while, stopped the bull market in its tracks.
For today’s bulls, it is not at all clear where the next good news is going to come from. Still, a gloomy outlook may suit a certain sort of grizzled investor, who believes that the best time to buy is when there is blood on the streets. Such folk have not enjoyed the past few years, when any lucky punter in shares looked like a genius. But their time may be coming soon. |
