Opinion

Crash, bang, wallop

Finance | 1 Sep 2007

Avinash Persaud analyses recent turmoil on financial markets.

Concerted central bank intervention on Friday 10 August 2007, to inject liquidity into the global financial system, did not mark the begin ning of the end of recent financial market turmoil. It merely marked the end of the beginning. Liquidity injections will not deliver lengthy respite. When it arrives, the next phase of market volatility will be more vicious than before.

Although rating downgrades will be a consequence of existing anxieties about credit quality, downgrades will have knock-on effects. Substantial parts of the credit markets are not routinely traded, but are priced off these ratings. Incidentally, this presents rating agencies with serious conflicts of interest that will become centre-stage when hurt investors start looking for a scapegoat. Rating downgrades will convert risks into losses. Loss-making credit funds will suffer redemptions, forcing fund managers to dump the well-performing parts of their portfolios as well. Loan covenants will require rated entities to inject liquidity on a downgrade. We will be pushed to a point of intense liquidity preference. Where central banks are pushed to ease liquidity conditions more aggressively than their inflation objectives might suggest, currencies will weaken. The Japanese yen will rebound.

Those who are older than the trading-floor average will have seen this before. But what makes this credit cycle more complicated, and perhaps more hazardous, is the very thing that Sir Alan Greenspan and others argued had made financial systems safer: the securitisation of credit. Securitisation brings benefits. But in these circumstances it will make the down cycle more severe and will trans mit systemic risks along untraditional paths that may prove less sensitive to interest rate cuts than in the past.

Before securitisation, whenever the credit cycle turned down, a bank’s loan officer could conclude, through his long relationship with the credit or a portfolio of credits, that the market was under-pricing the credit and could use the bank’s balance sheet to hold on to out-of-favour credits until the market stabilised. Banks have since earned fees for securitising credits and selling them on to credit funds and pension funds. This has enabled banks to originate more loans than their balance sheets would have previously allowed.

Now when the down-cycle arrives and credit prices fall the fund manager with only passing knowledge of the underlying credit and without a large balance sheet, cannot hold on to the credit. Credit risks have moved from knowledgeable, long-term hands, to fast hands.

Can lower interest rates temper investor losses? Yes, if the problem is caused by a temporary lack of liquidity; no, if the problem is caused by a de-rating of asset quality as is occurring today.

Higher credit costs will hurt those equity sectors dependent on leverage. Much focus has been on the removal of the debt-financed private-equity bid for companies. Last year this bid was worth $0.7trn in the US alone. But the effects of higher credit costs run deeper. Some old private equity transactions will be forced to issue equity and share buyback programmes will be halted. Buy-backs were as powerful a bid on equities as private equity last year. It is tempting to think that emerging equity markets can continue to show high and uncorrelated returns. But, it is important to recognise that while many private equity funds are based in the US and northern Europe, they have been big buyers of Asian equities.

The crash of 2007–08 could have been avoided. It was the result of poor investment decisions supported by the monetary and regulatory policy background. Investors will need to ensure that their fund managers are agile enough for fast markets. It is too late for policy-makers to do much other than to protect the most vulnerable consumers and ensure that misgivings over credit quality are not compounded by a genuine shortage of liquidity. Indeed, as policy-makers respond to the current screams and anguish they should be careful to ensure that they are not merely laying the foundations for the next crash.

Professor Avinash Persaud is chairman of Intelligence Capital and Emeritus Professor of Gresham College.
A version of this article first appeared in the Financial Times. 

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