Tuesday, November 27, 2007

A different kind of credit cycle

Back in June, the following comment(slightly edited by me) was posted to a thread at Calculated Risk:

“A tougher market for LBO bonds/CLO's means less bank capacity(investment or commercial?) for additional lending, which means less deals. All this should remind us why this cycle is so different: the marginal dollar of credit is coming from levered lenders with concentrated portfolios and unstable sources of funding, or from "non-natural" buyers such as the hand-over-fist Chinese buying of Agencies. The nature of these creditors is that their provision of credit is a) correlated with one another and b) highly variable.

And yet we continue to compare this cycle to 2001, 1998, 1991, and 1981.

They are as different from today as chalk and cheese. It’s not about assets, it’s about how they are funded. We should prepare to see a different type of credit cycle, perhaps more similar to the "Golden Age" late 1800's downturns we experienced before the advent of regulated financial institutions.” David Pearson | 06.27.07 - 1:44 pm |

I agree with Pearson’s conclusion that this credit cycle will be different than any in the US since the establishment of the Federal Reserve system. None of the crises that Pearson mentions were brought about by asset overvaluations based on issuance of CDOs. According to the July 2007 issue of Bloomberg magazine, “Worldwide sales of CDOs—which are packages of securities backed by bonds, mortgages and other loans—have soared since 2003, reaching $503 billion last year, a fivefold increase in four years..” One aspect of CDO issuance is that these securities were designed so that illiquidity and low transparency were selling points; i.e. the risk due to those two factors implied that yields would naturally be higher than traditional asset classes. Given that in the post dot com bust recovery most asset classes were providing relatively low yields, the popularity of CDOs is not surprising. Of course, very few were paying much attention to what might happen should these investments run into trouble. People were ignoring the risk side of the risk-return equation.

Pearson comments a couple of days later at Calculated Risk along these lines

”I believe the opacity is very much by design, and that these securities are a direct analog to Enron's opaque "Special-Purpose Entities". The hedgies need securities which they can "mark to model" (again like Enron) so as to support claims of huge short-term profits from which to take their 20% cut.”

I don’t think there is any question that hedge funds have been a primary target market for securitizers. However, I believe that just about every type of investment vehicle out there has purchased some type of CDO during this boom.

To elaborate on Pearson’s comment above that this credit cycle will be similar to those that occurred pre-Federal Reserve, there is no regulatory agency in the US with the specific ability to manage debt securitization activity. One of the Fed’s purposes was to reduce the volatility of business cycles by regulating the creation of credit. Now that a major portion of credit creation has been occurring outside the control of the Fed, we have seen a massive explosion of credit and are likely to now see a massive implosion of credit.

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