Where'd all the risk go?

An article i wrote recently... quite generalistic, but it gives a good impression of the way debt markets seem to be behaving at the moment.


SAID Ralph Emerson, “in skating over thin ice our safety is in our speed.”

Global debt markets are indeed, skating at speed. M&A deals topped $3600 billion in volume last year, fuelling the debt free-for-all. The takeoff of complex credit derivative instruments over the past few years has created a staggering global market.

Buying into risky loans, repackaging them and farming out the risk in new and innovative asset classes has been the golden goose since the unnerving effects of the technology bubble in 2000.

Yet something is awry. Bankers talk as if the risk is all but gone, so hedged are their investments. Complexities, however, don’t help with clarity. With debt levels so high, a few lone voices have been cutting an angry and ever more voguish path in the US media. Financial Armageddon, they say, is just around the corner. The outlook from most mainstream analysts, however, is rosy.

The big question between both camps - the elephant in the room that few seem willing to acknowledge - is: where has all the risk gone?

Banking with Ben

Debt, of course, is not necessarily a bad thing and despite leveraged debt levels at the highest they’ve ever been, and rising, most bankers are confident that companies can support their loans.

The US Federal Reserve is confident too. Ben Bernanke once piqued critics when he said that a “helicopter drop of money” from the Fed would be enough to shrug off any sharp deflationary trend.

Helicopter Ben, as his detractors know him, has bigger fish to fry at the moment. Inflation continues to dog him. Debt and risk, for the time being, are thus not pressing issues.

Despite warnings to the worse, the subprime crisis has hardly triggered the broader debt-market panic some thought it would either. Instead, in its wake, institutional investors feel confirmed in their beliefs that the market has the power to weather such storms.

But all this overconfidence might not be such a good thing.

A fistful of dollars…

With all this in the air, doomsayers are quick to jump onto regulators warnings and cast a pall over the market.

Rating agencies predict defaults to rise and the IMF’s stability report points to “fragility” in the face of heavy debt. Leveraged finance is “approaching the limits of prudence” says the UK’s Financial Services Authority, with warnings of a “hard correction” in 2007.

But jeremiahs are indeed overplaying the danger the markets face. Risk has seemed to evaporate from most investors’ minds precisely because in most cases, it has been cut up and sold off so effectively, through complex derivative packages.

Nonetheless, it has not disappeared.

Credit derivatives are no silver bullet – and the doom crew are right in one respect: the market is certainly giddy with its own success.

The market, faced with problems, is not adjusting itself to suit them, but speeding up to outpace them.

According to the FSA, “effective defaults where companies are starting to have difficulty meeting their commitments are being masked by ‘involuntary refinancings’ which are being undertaken when a default is imminent.”

In other words, the rules are being bent to stay ahead of the risk. The IMF’s latest financial stability report also points to a worrying “weakening of loan covenants and credit discipline.” Due diligence is becoming less of an issue too, the fund warns.

Companies are farming out their risk, and their responsibility to boot.

So where has the risk gone? Nowhere, it seems to just be lagging behind. As long as the market stays one step ahead; ever more innovative and ever wilier; the threat of correction is staved off. In the meantime, a lot of money is made.
The cost is that, like the skater on thin ice, there is no option but to go ever faster. An external event; a China market crash, for example, would bring things sharply to a halt. What then?