Stressing Credit Stress
How bad will the credit crunch be? Will it last into 2008? Will it be worse than LTCM? Is this the end of structured finance as we know it? My quick answers: Yes, maybe, and no. Structured finance is too useful of a concept to regulate too heavily. Ratings are also difficult to do without from a regulatory standpoint. The concept of “buyer beware” must apply to fixed income managers inside regulated financial institutions. Ratings are ratings and not guarantees; they supply useful summary data, but are no substitute for due diligence.
Now, the ratings agencies’ stocks have been pinched by the crisis. I think that they will bounce back, and on more weakness, I could be a buyer. That said, it is interesting to see them edge away from their aggressive ratings on CPDOs [constant proportion debt obligations], particularly as the prices sink.
There may be some upward drivers for the ratings agencies. After all, investment grade bonds are being issued like mad. (Another reason to favor high quality companies at present.) The head of Deutsche Bank sees the market normalizing. (And maybe if you borrow in euros, it is.) On the other hand, high yield spreads are at a new record for the past few years, and distressed debt is finally arriving in size. (Maybe enough to choke all the vultures?) Risk is real for junk grade companies, and residential real estate related assets. The willingness to take financial risk has normalized; now it is time for the market to go beyond normal to petrified. Now, who can help us more with petrified than Jeremy Grantham? He sounds the alarm on real estate related assets, junk obligations, and the equity markets.
Finally, I should have included this in my last post, but the short term debt markets are rough in the UK as well. UK LIBOR hit a 10-year high recently. When many of the various LIBORs of the world are showing signs of fear, it is possible that a larger trouble is at hand. Until recently, all of the major central banks of the world were tightening, all at once. With the exception of Japan, I expect them all to begin loosening soon, and begin accepting higher rates of inflation. Perhaps I have my next investing theme?
Full Disclosure: long DB
