DEBT. DEBT. EVERYWHERE DEBT! May 4, 2007.
Several weeks ago I predicted that the next bubble to burst will be the credit bubble. Nothing I have learned since has changed my mind.
We’re all aware that consumer debt is at an all-time record, and unfortunately at a time when unusually high food, gasoline, and housing costs are taking additional money out of pockets.
We’re aware that stock market investors have run margin debt (used to buy stocks with 50% down-payments), to a record high, higher in total dollars even than at the market peak in 2000.
We’re aware of how dramatically the government has been spending more than it takes in, creating record budget deficits where once there were budget surpluses. I am not ignoring the unusual events that brought them about, but merely pointing out that the record debt is there, regardless of the reason. The budget deficit for 2006 was $248 billion, raising the total U.S. national debt to $8.8 trillion at the end of 2006.
Several other areas of unusually high debt levels are contributing to the bubble.
For instance, let’s take a look at hedge funds. They have sprung up over recent years like dandelions on a rainy day, until there are now roughly 10,000 in existence. They manage total assets of approximately $1.4 trillion.
Hedge funds borrow heavily on their assets and then use the borrowed money to make massive leveraged bets in financial and currency markets, operating chiefly in derivatives markets, where the derivatives themselves are often leveraged. How much debt hedge funds owe to financial institutions is a big question mark since there is virtually no reporting required by hedge funds.
However enough is known that on Wednesday of this week the New York Federal Reserve issued what it termed its most serious warning regarding the risk to the financial system posed by hedge funds since the 1998 collapse of hedge fund Long-Term Capital Management.
To refresh your memory of that event, HTCM had investor assets of $4.7 billion at the beginning of 1998, after making annual gains of 40% for its investors in its first couple of years of operation. How much leverage did it employ to produce those gains, and at how much risk? We know from the HTCM bankruptcy hearings that with only $4.7 billion in equity, HTCM was able to borrow $124.5 billion from major banks, and then used those borrowings to take leveraged derivative positions amounting to $1.2 trillion. To make a complicated story short, its positions collapsed, its losses were huge, the banks and brokerage firms it had borrowed from faced losses that threatened the entire U.S. financial system. So the Federal Reserve stepped in and organized a consortium of international financial institutions, pressuring them to provide a $3.6 billion bailout of the lenders.
As noted there are now 10,000 hedge funds, with somewhere around $1.4 trillion in assets, most borrowing heavily and then using the proceeds to take leveraged positions in derivatives. No one believes many of them are as foolishly in debt and leveraged as HTCM. Surely the banks and other lenders learned something from the HTCM experience. But concern regarding their highly leveraged debt has been growing. And now the New York Fed has issued a warning saying that “Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998.”
By high correlations among hedge fund returns they mean that many hedge funds appear to now be making the same high debt bets in the same markets. So if a problem arises it will not be just the leveraged losses created by one fund like HTCM with $4.7 billion in assets, but the risk of quite a number of much larger funds having similar problems at the same time.
More signs of a credit bubble?
How about the craze for leveraged buyouts that has dominated the financial news and markets of late? Some of the largest, publicly traded, multi-billion dollar, corporations in the world have been targeted over the last year by the relatively new phenomenon of ‘private equity funds’. It seems a major leveraged acquisition is announced almost daily. Where does the money come from?
Private equity funds issue bonds (debt), and take out loans and other financing to leverage what cash they put in, to pay for their acquisitions. According to Jim Jubak in an article on Money Central, even much of that borrowed money has first been borrowed by the lender, piling debt on top of debt. Jubak reports that Wall Street’s four largest securities companies financed $3.3 trillion in assets last year on which there was just $130 billion of shareholder equity.
Is it high risk debt? Well, 37% of the bonds sold for leveraged buyouts in 2007 were rated CCC by Standard & Poor’s. S&P’s definition of a triple-C rating? “In poor standing. Such issues may be in default or present elements of danger with respect to principal or interest.”
Then there are the debt problems related to the real estate industry, in the sub-prime mortgage market, mortgage-backed bonds, mortgage-backed securities, and the like.
There could hardly be more evidence that a credit bubble has formed across broad sections of the economy.
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