Here We Go Again

Capitalformation2.pngBy John Richardson

EVERYONE should read the following section from this Economist article with great concern. Central bank stimulus might well be doing more harm than good.

“When Americans borrow money to buy a car or a house, their debts are often repackaged as the backing for a bond,” writes the Economist.

“Before 2007 investors believed that such bonds were safe investments because large numbers of car buyers and homeowners were unlikely to default at once. But low–“subprime”–credit standards made default more likely. When the penny dropped, the prices of subprime securities plummeted.

“So far this year $5.7 billion of subprime car loans have been issued, a 30% increase on last year. And there has also been a revival in the issuance of collateralised loan obligations (CLOs). These act like mutual funds, buying a portfolio of loans and then selling portions of the portfolio (tranches) to investors. The different tranches reflect the different risks; the riskiest portions bear the first loss if the loans default. In the first quarter of 2013 CLO issuance reached $27 billion, half the entire total for 2012–around the levels of 2007, and higher than many would have imagined in the days after the crisis, when CLO was a dirty word.

“A further sign of an appetite for financial risk is the willingness of investors to buy loans with minimal protection in the case of a deterioration in the debtor’s financial position–so-called covenant-lite loans.

“More than half of loans sold to non-bank lenders in January were covenant-lite, the highest proportion ever, said Morgan Stanley, a bank. Leveraged loans (those made to highly indebted borrowers) have also bounced back; issuance in the first quarter of 2013 was a record $286.6 billion, according to Thomson Reuters.

“Another product to regain popularity is the commercial mortgage-backed security. JP Morgan has raised its forecast for issuance this year to $70 billion, compared with $45 billion last year, citing high investor demand and confidence that the property market is recovering. Typically, property performs well when rental yields (currently around 5.8%) are high relative to the cost of finance.”

The same article also points out that, despite being flush with cash, big Western companies remain reluctant to invest because of concerns over budget deficit problems in the US and the lingering possibility of a Eurozone break-up.

Meanwhile, small companies remain starved of lending because banks are still exceptionally risk-averse following 2008, and face much-tougher capital adequacy requirements.

Thus, investment as a proportion of GDP is lower in the US, Britain and the Euro area than before the 2008 financial crisis (see the above chart).  

This underlines our argument that what benefits Wall Street, and other financial markets including the Nikkei, is not necessarily benefiting Main Street. 

Central bank stimulus has failed to do the trick because, as we said, the money has mainly gone to the wrong kind of people – the speculators – and, as the quotes from the article above suggest, we could face a new financial-sector driven crisis when asset values eventually correct.

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