Resilient fragility

Alexandre Lamfalussy's keynote speech to the ICMA conference ("Resilience or fragility") raised a few eyebrows today - Banks, said Lamfalussy, were "succumbing to the temptation of herd behaviour."

We've had warnings from people like Anthony Bolton and Warren Buffett, but for Lamfalussy to speak out perhaps throws things into starker light, not least when it comes a few days after Ben Bernanke's warning to US hedge funds.

"You can be sure that this golden era, will come to an end," Lamfalussy told the conference. He accused banks of being "irresponsible" and walking blind into an "opaque, uncharted and dangerous market." While risk may have been spread around, markets have become increasingly correlated, he said. And the risk of a systemic crisis had not changed. Lamfalussy is, I think right.

What's happened is that the threshold for individual crises to significantly affect the market has been raised. Credit derivatives have enabled risk to be more broadly spread, and thus made markets more resilient. But should a crisis big enough come along, then the markets will be affected in a way far worse than ever before. Such crisis always come along, says Lamfalussy - but we still think we can predict them. Bernanke voiced a similar concern when he warned of hedge funds behaving just like LTCM did.

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The buck stops where?

Some of the hysteria around the current mergers boom is making headway in the national press. Since Anthony Bolton's speech a couple of weeks ago, there's suddenly been a lot of interest in covenant-lite loans.

But I think a lot of the coverage has done them a disservice. For a start, it won't be the banks that suffer if a default occurs, contrary to what the business pages are saying. Most covenant-lite loans are syndicated - sold on - by the banks in lucrative deals that allow for arbitrage. "We don’t hold onto any of ours. Of the deals done so far? 100%, they’re all syndicated,” I was told by the head of loan syndication at one of the big US banks.
The buyers of this loan debt aren't exactly unaware of the risks, however. They're hedge funds, CDOs, pensions funds and the like, who actively seek out risks to make money from the high-yields. As yield spreads go down, they're looking for new areas to invest in.

Covenant-lite loans are senior debt anyway, which means in relative terms they're less risky that a lot of the debt products out there that have been available for a long time. From senior debt you can expect an average 78% return of your investment in the event of a bankruptcy. If you'd invested in second-lien loans, bonds, mezzanine debt or equity, you could expect between 0-30%.

Sure covenant-lite loans are risky, but I don't think they're the "iconic catchphase for the peak, or near-peak, of an over-exuberant buy-out boom" the FT says they are.

The real problem with all of this, is that the banks' own desks are getting too involved in the secondary market themselves. Through their hedge-funds, they're making a lot of money, but they're also exposing themselves to the risks they're supposed to have diced up and safely resold on their syndication desks. It's all got the ring of systemic failure to it. Like the reinsurance crisis that brought down Lloyds, I wonder whether the banks are being a little too naive about the state of risk in the market at the moment. Someone has to be holding it.

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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?

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