Posted on 06/09/2007 2:15:31 AM PDT by TigerLikesRooster
If a private equity fund collapses, investors could lose part of their wealth, but if Europe's credit bubble implodes, it could completely wipe out many funds and banks in a blink
Wolfgang Munchau, Columnist at Financial Times
posted at 2007.06.08 14:29 / revised at 2007.06.09 04:39
Currently, there are two bubbles in the world. One is the bubble of China's stock market, and the other is Europe's credit bubble. Most people talk about the China's bubble, but in reality, the Europe's bubble is far more dangerous.
The Europe's bubble does not result from excessive bank loans from a corporation or an individual, but from credit derivative market. One of the most actively traded derivatives is CDS (credit default swap) which is intended to protect investors from credit risks. The spread of 'iTraxx Crossover Index'(standardized index of company credit, representing the cost of owning company credit), including junk-rated CDS of Europe, is merely 2%. This is the unusually low spread. It only costs 200,000 Euros to avoid the risk of defaulting portfolio worth 10 million Euros. Even though there is no big recent default, it would be impossible to sustain a spread so low once the business or credit cycle goes into a downturn.
These days, the requirement for getting a loan has been dramatically relaxed, and this makes me more convinced that we are in a bubble. This is akin to America's sub prime mortgage in which people with bad credit can get mortgage loans with higher interest than prime rate. As housing price rises, banks sell more mortgage loans. Banks are under the misconception that the value of housing, which is collateral for such loans, will continue to rise. If these mortgage loans default, they reason, they only have to take over their collateral whose value has risen significantly.
The same thing is happening in credit market. As a rule, a company's credit is decided by financial covenant. As economy is getting better, the default rate is moving to the optimistic side. This led to banks relaxing some constraints in financial covenant. Just as those without personal checking account can get sub prime mortgage loans in U.S., the similar situation is developing in Europe.
Once a bank gives out a loan, the credit can be tradable like a security. Converting credit into a form of security is in principle a good idea which can widely spread loan risk. The problem is that various credit securities are again turned into various credit derivatives, depending on risk rate, and hedge funs get involved in the process. Hedge funds mostly take the strategy of short-selling low-risk credit derivatives and buying high-risk derivatives. Due to narrowed spread of credit derivatives, clients of hedge funds now annually get 20% return for their investment.
Economists calls the current situation a Ponzi Scheme, named after an infamous conman in early 20th century. The Ponzi Scheme yields profit for a while, but eventually collapses.
What would happen in the event of credit cycle downturn? Let us assume that economic and credit cycle goes into customary downturn cycle, not necessarily a dramatic event like recession. Even the small increase in number of corporations in default would enormously widen the spread. It could go back to 4% level which has been applied to sub prime corporations in the past, instead of current low level of 2%.
The widening of credit spread due to defaults won't be incremental but sudden. This would make the Ponzi Scheme difficult to perpetuate, and hedge funds which bought up a lot of high-risk derivatives will be severely hit.
It won't just affect hedge funds. Banks which loaned money could be dragged into as well. Let us review the collapse of LTCM (Long-Term Capital Management) 10 years ago. LTCM is only one of many such funds, but FRB of U.S. feared that its collapse would lead to the crisis of the entire financial system. In the current situation, what would happen if hundreds of hedge funds suddenly find themselves in the 'trap of debts' one day? Investors of hedge funds ten years ago are all wealthy individuals. In comparison, these days, banks, mutual funds, and pension funds are their principal investors. A hedge fund crisis could put many people into huge disaster.
The danger from hedge funds is far graver than the collapse of private equity funds. In case of the latter, even if market is in down cycle, investors would not be wiped out as long as they won't place all their bets on derivatives. Most investors would lose only part of their wealth. However, the implosion of Europe's credit bubble would completely wipe out many funds and banks in a blink, as in the collapse of Ponzi Scheme.
Ping!
I think that China, with almost a TRILLION dollars in bad loans impacting their banking system is a much higher risk.
In any event, I would not invest in China or Europe for that matter.
Where would you invest? V’s wife.
Thanks for the translation.
The more likely scenario is that investors who happily plunged their money on the promise of 20% returns will get a rude awakening that “past performance is no indicator of future performance”.
Assume that Turkey has a problem, so you sell your Danish CMO (collateralized mortgage obligation) holdings - you are dependent on there being another buyer, able to buy up the entirety of your holdings at the price you want. If you have a lot of Danish CMOs, the market might not be able to absorb all the ones you want to sell, meaning either that you will not sell them , or will have to sell them for less.
Yes, thank you. A fascinating article.
I like Big oil, big financials, pharmaceuticals, and medical device makers.
Examples in order: Exxon, JP Morgan Chase, Merck, and Three M (I know, but they make fabulous bandages and other throw away devices).
"There is no free lunch", and "If something is too good to be true, it invariably is."
Where people (and institutions mostly) seem to get into trouble is when in the interest of scoring a big profit, they drop one side of the hedge, pushing the other.
This is what happened in Marin County California a few years ago. The treasurer dropped one side of the derivative hedge and was hailed as a boy genius with all of the money he was making until the market turned on him and he lost about $3 Billion.
What about the fifty varieties of American financial bubbles? What is Europe to presume significance in this arena?
They might have risky hedge funds, but so does USA, and USA has fifty other species of financial devices that are even more dangerous.
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