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To be sure, the CDO market is the tip of a derivatives iceberg when it comes to risk obfuscation and market pricing issues. Arcane instruments, lack of transparency, and tainted markets can (and did) remain non-issues for quite some time. Yet the longer the period of chicanery the more abruptly greed will inevitably succumb to fear. Today, markets are turning fearful. They are fearful of the quality of assets supporting the massive securitization marketplace. They are fearful of mispricing. They are fearful of liquidity. And, importantly, they are fearful of the ramifications of – in today’s overheated financial environment - any meaningful movement away from risk assets. All the fears are justified.
...
How anyone really could have expected such a system to effectively regulate Credit, price risk, and allocate resources is beyond me. Subprime CDOs – yes, the tip of the iceberg. And today’s surging oil prices, widening Credit spreads and weak dollar wouldn’t appear to portend bullishness. It’s official, we’re now on Second-Half Liquidity Problem Watch."
First-Half Global Liquidity WatchBy Doug Noland
June 29, 2007
SourceRunaway global Credit and liquidity excesses fuelled major global equities indexes to solid – and in some cases spectacular - first-half gains. The German DAX surged 21.4%, France’s CAC40 9.3%, Britain’s FTSE 6.2%, Amsterdam’s Exchanges index 10.7%, Stockholm’s OMX index 9.4%, and the Swiss Market Index 4.8%. The Nikkei rose 5.3% and Hong Kong’s Hang Seng jumped 9.1%. Here at home, the Dow Jones Industrials gained 7.6%, the S&P500 6.0%, the S&P400 Mid-Cap index 11.3%, the Russell 2000 5.8%, and the NASDAQ100 10.1%.
The emerging markets boom hardly missed a beat throughout the first half. China’s Shanghai Composite index jumped 42.8%, South Korea’s Kospi 21.6%, Taiwan’s Taiex index 13.5%, Brazil Bovespa 22%, Mexico’s Bolsa 17%, and Chile’s Stock Market Select index 29%. Winners in European emerging equities indices included Prague’s major index up 17.0%, Budapest up 16.4%, Poland’s WIG20 14.4%, and Istanbul’s XU100 index 20.4%. Most markets in the Middle East and Africa also posted strong gains. Global (non-U.S.) real estate and art inflation were in full force.
As for global securities issuance and M&A – the fuel for the equities Bubble - the first half was one for the record book. Record total global debt market issuance of $3.7 TN was up 11% from comparable 2006. Leveraged loans and junk bonds rose to almost a third of total corporate issuance. Announced global M&A jumped 50% to $2.78 TN. It was certainly a case of global financial players working overtime to reap once-in-a-lifetime bounties, in the process ensuring future financial crisis.
The liquidity theme for most of the first half was one of unprecedented global M&A activity financed by increasingly complex and risky debt structures, all made possible by even more astounding financial sector leveraging. Looking back, February’s subprime implosion provided only a brief setback (respite) for a desperately overheated global Credit and speculation infrastructure. The global M&A and securities leveraging booms had already attained critical mass, while Wall Street and the leveraged speculating community had achieved a full head of steam.
Yet late June’s hedge fund and CDO problems appear more all-encompassing and ominous. February was about U.S. subprime mortgages, while the issue gravitated toward the heart of “contemporary finance” as the second quarter winded down. To be sure, the story of the historic first half concludes with serious questions with respect to the sustainability of Global Credit Bubble excess. It has “inflection point” written all over it.
“Repo Agreements,” as reported by the New York Fed, ballooned $455bn during the first half (28% annualized) to $3.904 TN. Inflating Wall Street balance sheets have directly and, by financing clients, indirectly played a major role in financing the M&A boom. To what degree the leveraged strategies we’ve seen turn problematic in subprime have been used to lever up corporate Credits will be a crucial issue going forward. Importantly, the CDO marketplace is now under the microscope and will likely be so for some time to come.
The Financial Times Saskia Scholtes [and Gillian Tett --J.] penned an excellent article in yesterday’s edition, titled “
Does it all add up?”
“
These elaborately constructed securities, called collateralised debt obligations (CDOs), are designed to yield juicy returns while also carrying high credit ratings. They have proved popular with hedge funds as well as with longer-term investors such as pension funds and insurance companies, many of which have bought billions of dollars of such securities in recent years - thus providing the liquidity that was then channelled into mortgage loans. But heavy losses incurred at the two Bear Stearns hedge funds as a result of such financial haute couture have prompted fears that the CDO emperor may turn out to have no clothes. Such a revelation could threaten the value of investor portfolios around the globe - not just in the mortgage sector but in the way many sorts of company fund themselves. This is because unlike stocks listed on an exchange or US Treasury bonds, CDOs are rarely traded. Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these new-fangled instruments have never been priced through market trading.”
It is rather ironic that this “golden age of Capitalism” has increasingly been financed by obscure “marketable” Credit instruments and derivatives that only rarely trade in the marketplace. Moreover, in a marketable securities-based Credit system where gains on securities holdings play such a prominent role, there has been a major shift to instruments, structures and strategies specifically to avoid “marking” to actual market prices when those prices are in decline. Or, from another angle, the CDO market represents some of the potentially weakest debt structures imaginable: lend in gross excess to extremely weak Credits; bundle them in esoteric structures; have these structures be illiquid and difficult to price; sell them for the purpose of speculation/“Credit arbitrage”; and then have highly leveraged securities firms financing the speculators enormous leverage.
It is not by happenstance that risk intermediation practices have turned increasingly to gimmicks, obfuscation and worse. By their very nature, Credit booms demand progressively more challenging risk “intermediation”. The current Global Credit Bubble requires the transformation of unprecedented amounts of risk into “top-rated” securities - in keeping with the highly leveraged portfolios where much of today’s risk is domiciled. Over the past couple of years, the now arduous intermediation process forced all the major players to push the envelope – the investment bankers, the rating agencies, the leveraged speculators, the derivative players, the banks, and the regulators/policymakers.
It was really not that difficult back in February for the bulls to proclaim that mortgage problems were isolated to subprime. This will simply no longer suffice, not now that attention has been focused on CDOs, liquidity, pricing, leveraging and unrecognized risks. Is subprime risk in CDOs the proverbial “tip of the iceberg?” Of course it is. The central issues of problematic liquidity dynamics, fair and accurate pricing, and speculative leveraging excesses today permeate the entire global Credit system.
To be sure, the CDO market is the tip of a derivatives iceberg when it comes to risk obfuscation and market pricing issues. Arcane instruments, lack of transparency, and tainted markets can (and did) remain non-issues for quite some time. Yet the longer the period of chicanery the more abruptly greed will inevitably succumb to fear. Today, markets are turning fearful. They are fearful of the quality of assets supporting the massive securitization marketplace. They are fearful of mispricing. They are fearful of liquidity. And, importantly, they are fearful of the ramifications of – in today’s overheated financial environment - any meaningful movement away from risk assets. All the fears are justified.
Subprime imploded specifically because of “Ponzi Finance” dynamics. As long as Credit was readily available, individuals could borrow and/or refinance to a more accommodating mortgage. But the day the music stops is the day Credit losses begin to explode. And when it comes to runaway Credit booms, subprime was no anomaly. The perpetuation of the subprime boom was the (only) means for an overheated Credit system to finance the marginal borrower - in order to sustain the housing/mortgage finance Bubbles. Enormous festering risks were well-concealed by the illusion of perpetually rising asset prices and limitless market liquidity.
I won’t attempt to make the case that the global M&A Bubble is (quite) as acutely vulnerable to “Ponzi” dynamics as subprime. But we do know that a proliferation of deals has created a current pipeline of hundreds of billions of risky corporate loans that will need to be sold into an increasingly risk-challenged marketplace. Additionally, the M&A boom has been instrumental in inflating global equities markets, both by bidding up prices and fostering general liquidity and speculative excess. A reversal of these dynamics is now a distinct possibility. A serious market liquidity problem will commence with any move by the leveraged speculators to aggressively hedge risk and/or place bearish bets.
In “Ponzi” fashion, problems getting debt sold would pierce a susceptible M&A Bubble, likely initiating a powerfully recursive cycle of declining equity prices, speculator angst, further debt market stress and the specter of deleveraging. This is an inherent predicament of Credit and leveraged speculation-induced asset Bubbles. And while the corporate debt Bubble may not be “subprime,” there are certainly scores of less than prime borrowers, dangerous speculative dynamics, and latent Credit losses vulnerable to any tightening of the Credit and liquidity landscape.
Returning briefly to the “distinct irony of the 21st-century financial world…and the epitome of modern capitalism,” I can comfortably state that Capitalism has never generated such a seductively contemptible boom, one financed by a Credit system so captivatingly free-market challenged. Global central bank reserves will soon surpass $5.5 TN. Fannie and Freddie’s combined “books of business” today exceed $4.1 TN. Untold Trillions of leveraged securities holdings have evolved specifically because the Federal Reserve (and global central bankers) “pegs” short-term interest rates, promises advanced warning of any rate increases, and basically guarantees that markets will remain liquid. Too many guarantees and promises are to blame for securitization and derivatives markets thoroughly perverting global risk markets.
How anyone really could have expected such a system to effectively regulate Credit, price risk, and allocate resources is beyond me. Subprime CDOs – yes, the tip of the iceberg. And today’s surging oil prices, widening Credit spreads and weak dollar wouldn’t appear to portend bullishness. It’s official, we’re now on Second-Half Liquidity Problem Watch.
June 29 – Reuters (Natalie Harrison) – “The credit market has had a strong run so far this year, with global corporate bond issuance, for both high-yield and investment grade, up around 30% in the first half from the same period a year ago. Overall, global debt capital market deals are up 11% in the first half of 2007, compared with the first six months of last year, totalling $3.7 trillion, according to…Dealogic… Of the $1.26 trillion global investment-grade deals done since January, $626 billion were in the European, Middle East and Africa (EMEA) region, and $502 billion in the Americas. The latter was a 36% increase on the period from January to end-June 2006. In terms of size, Asia Pacific and Japan trailed behind, but still saw a 26% and 42% respective jump in deals. The Americas accounted for the vast majority of high-yield deals too, with a 40% jump in the value of issuance to $109 billion, followed by EMEA, where deal values rose to $48 billion… Global asset and mortgage-backed securities were also dominated by the Americas, which generated $1 trillion of them, though that was down 4% from the first half of 2006. EMEA saw the strongest pick-up, with a 39% rise in issuance to almost $311 billion.”
June 29 – Financial Times (Anuj Gangahar and Joanna Chung): “Riskier types of debt accounted for a higher portion of global corporate fundraising in the first half of this year than last, underlining investors’ robust appetite for low-quality paper. Leveraged loans, highly leveraged loans and high-yield bonds made up 29% of the total global corporate fundraising, up from 22% during the same period last year, according to Dealogic. The amount of cash raised through the debt capital markets as a whole - including bonds of both investment grade and lower-quality junk-rated paper - reached $1,450bn, the highest volume on record, and up 32% over the same period last year.”
June 29 – Financial Times (Lina Saigol): “The volume of merger and acquisition activity worldwide surged 50% to reach $2,780bn during the first six months of the year, despite growing concerns among companies about a turn in the credit markets and fears that the cycle has reached its peak. Since 2003, chief executives and private equity investors have been fuelling the M&A boom by taking advantage of cheap debt and strong cash flows to bid for companies… Buy-outs by private equity groups reached a record high of $568.7bn, a rise of 23% on the previous high of $459.2bn in the second half of 2006… Private equity represented 20% of total announced M&A this year, according to Dealogic… Europe, the Middle East and Africa accounted for 44% of global volume during the first six months of the year to reach $1,230bn. In the US, the volume of deals increased by 37% over the same period, while the pace of activity in the Asia-Pacific region reached $353.4bn. In emerging markets, volume rose 17% to $356bn, with Russia the most targeted nation, followed by China and India.”
June 29 – Reuters (Jessica Hall): “Merger activity in the United States hit a new record in the first half of the year, fueled by deep-pocketed private equity firms and low borrowing costs, even as the pace of deals began to slow in June… The U.S. broke through the $1 trillion level for total mergers, marking the first time that mergers have hit that level in the first six months of any year, according to…Dealogic. So far this year, U.S. merger volume totaled $1.005 trillion, up 36% from the same period a year ago. The number of deals, however, dropped 12%... April was the busiest month of the year in the U.S., with $210.5 billion in deals, while June was the slowest month with $124.2 billion in deals, Dealogic said.”
June 29 – The Wall Street Journal (Ellen Sheng): “Chinese and Indian companies raised the most money from the stock market during the first half, according to a ranking of Asian countries excluding Japan, Australia and New Zealand, from…Dealogic… Fueled by the booming economy, the number of Chinese initial public offerings nearly doubled in the January-June period from a year ago and helped push the number of stock deals in Asia, excluding Japan, up 55% from year-earlier levels. In all of Asia, there were 838 deals raising $99.5 billion in the first half, compared with 723 deals, which raised $64.1 billion, last year. Chinese companies launched 85 IPOs, raising $21.5 billion in total, up from 46 IPOs raising $15.6 billion a year ago. Including secondary offerings and convertible deals, mainland Chinese companies did 177 deals and raised $47.1 billion in the year to date, up from 100 deals and $25 billion a year ago.”
June 29 – Reuters (Brian Kelleher): “Asia Pacific mergers and acquisitions excluding Japan surged 50% in the first half to a record $253 billion, with Australian buyout deals and an overseas push by Indian firms expected to keep activity at high levels. Australia accounted for $76 billion worth of deals in the half, followed by China ($55 billion) and India ($39 billion), according to…Dealogic.”
June 29 – Reuters (Brian Kelleher) - Privately owned Chinese companies helped drive a 42% increase in Asia Pacific stock issuance in the first half, and a recent wave of Indian activity will keep bankers busy through the rest of 2007. Asia Pacific equity capital markets volume, excluding Japan, was $105.1 billion in the first half, according to…Dealogic, and bankers expect the strong activity to continue through the second half.”
June 29 – Reuters (Daisy Ku): “More listings from Russia and the Middle East are expected to keep markets buoyant after Europe set the global pace for IPOs in the first half with a 51% gain and topped the United States in total issuance. Equity capital markets activity reached $445 billion over the first six months of 2007 on 3,000 deals, the highest dollar volume since the record set in 2000, according to…Dealogic. It was a 19% gain from $375 billion in the first half of 2006.”