Inefficient Market

Credit derivatives may win praise from U.S. banks and Alan Greenspan, but they encourage analytical methods that contribute to the reckless expansion of credit and financial volatility, says Edward Chancellor.

This has been a year of record corporate defaults. Yet thanks to the advent of credit derivatives, U.S. banks have managed largely to avoid the debacle. Some people argue that credit derivatives have produced a better distribution of risk throughout the financial system, thus increasing the growth potential of the global economy. Alan Greenspan has even claimed that credit derivatives are improving the measurement of risks.

On closer examination, however, we find that these derivatives contributed greatly to the reckless expansion of credit in the late 1990s. Far from improving risk measurement, they have encouraged the adoption of technical credit analysis methods, which are contributing to unprecedented financial volatility.

According to the British Bankers’ Association, the notional market value of credit derivatives has grown from $180 billion to over $2,000 billion over the last five years. Banks (mostly of U.S. origin), securities, houses and hedge funds have been large buyers of credit default swaps. Insurance companies and re-insurers (mostly European) have been net sellers. The banks have done very well from this. According to Avinash Persaud, head of research at State Street Bank, despite this year’s corporate defaults of a face value close to $200 billion, the loan losses of U.S. commercial banks are running at around 10% of equity (compared with nearly 35% in the early 1990s).

What is good for the banks is also good for the economy, argues Charles Gave of Gavekal, a research boutique. In the past, at the end of every economic cycle, the banks would find themselves with bad loans, which caused their balance sheets to shrink. The multiplier effect would lead to the rapid contraction of credit. Under such circumstances, even sound companies were denied access to finance. Businesses were, therefore, forced to cut spending and lay off workers. Gave suggests that all this belongs to the past. With credit derivatives and the securitization of debt, banks no longer exacerbate the economic cycle. However, he admits that his rosy scenario only holds as long as the ‘shock absorbers’ in the financial system continue to operate.

There are several reasons why insurance companies are unlikely to continue playing the shock-absorbing role. First, they have been paid too little for the risk they ended up carrying. As the head of a large European re- insurer said recently, the industry has provided "naïve capital" for the banks. Banks were never perfect at assessing credit risk, but at least their loan officers realized their jobs were at risk if the loans didn’t pay off.

Once credit insurance appeared, the banks lost interest in estimating the quality of a loan over its whole life. All they had to do was originate, sell it on and collect on the insurance if it blew up. Without an incentive to prudence, it was inevitable that loan quality would deteriorate. Banks began playing a greater-fool game of credit creation.

Another reason why insurers will be reluctant to provide credit insurance is that they no longer have the resources to do so. Insurers got into this business when their balance sheets were bolstered by the soaring equity market. At the time, many insurers increased the percentage of equities in their portfolios from the traditional 10% to around 50%. Thus, their increasingly important role in the credit process was linked to the level of the stock market.

As students of Japanese banking will know, this process makes for both wonderful booms and terrible busts. During the bear market, the insurers have seen their capital adequacy ratios decline and have become forced sellers of equities. Many are now getting out of the credit insurance business. For instance, Scor, the troubled French insurer, is set to wind down its $2.7 billion of credit derivatives exposure over the next couple of years. Many others will follow.

In the past, banks have been responsible for their share of folly. As suppliers of credit, however, they had certain advantages. They knew their customers well and loans came with a long-term banking relationship. Furthermore, a multiplicity of banks produced a variety of opinions.

It is this variety of opinion, according to Persaud, which is essential for the efficient operation of markets. With credit derivatives, the assessment of default risk has been taken away from the banks and placed into the hands of the insurance companies. Having no relationship with the debtors, the insurers have adopted uniform methods of credit risk analysis. Risk is now measured using technical methods, derived from the bond and equity markets. This creates the potential for a feedback loop.

During the bull market, a company’s rising market capitalization was sufficient justification for lenders to supply it with credit. On these grounds, telecom companies attracted over $1 trillion of loans between 1998 and the end of last year. The same process works in reverse: falling equity prices lead to the presumption of declining creditworthiness and an increase in funding costs.

Thus a company that is out of favor in the stock market may find that the insurance company is hedging its own credit default risk by shorting the firm’s bonds or even its shares. Such activities could send a company into a death spiral.

The potential for credit derivatives to reduce economic cyclicality is wonderful. Perhaps their recent troubles are mere teething problems. However, if they are to play an important part in the future, credit derivatives need to be properly priced. The suppliers of credit default insurance will also need to apply a variety of measures of credit risk and adopt a more long-term view than they do at the moment.

They will need to be better capitalized. And above all, they will need to improve their position relative to the bankers who originate the loans. Unless the balance of power changes, you can bet your last dollar who will end up with the wooden nickel.


Edward Chancellor,
for The Daily Reckoning
November 25, 2002

Editor’s note: Edward Chancellor has been a freelance contributor to a number of publications, including the Economist, the Financial Times and the New York Times. He is the author of Devil Take the Hindmost: A History of Financial Speculation, published in 1999 in New York and London. It has subsequently been translated into eleven languages. A version of this essay was published by:

Apogee Research

Oops. I guess we were wrong.

Deflation is No Problem, after all. How do we know? Well, we read it in the paper.

"Unlikely," said Michael Moskow, president of the Chicago Fed. The risk of deflation is "extremely small," added Fed governor Ben Bernanke. "Extraordinarily remote," agreed the Fed’s chairman, Alan Greenspan.

Fed officials seem to be of one mind: deflation is nothing to worry about. Why then did the Fed cut rates by an unexpectedly large 50 basis points a couple weeks ago?

Oh that…well…it was just insurance against a "soft spot" in the economy, explained Bernanke in his speech.

The Fed governors all seemed to be reading the same script. Just a day or two before, Alan Greenspan had referred to the economy hitting a "soft spot", too.

Meanwhile, a Fed survey of 35 prominent economists showed falling expectations for economic growth. The economists were once looking for 2.6% growth in the 4th quarter; when the question was last posed, they cut that estimate in half. For next year, they expect only 2.6% growth.

They could be wrong in either direction, of course, but now that deflation has been thrice denied by Fed officials, it seems almost inevitable. The Japanization of the U.S. economy, worries Stephen Roach, implies growth rates dangerously close to ‘stall speed.’

The financial press has finally picked up on the Japan example. Fed officials are now routinely asked: "Well, how come the Japanese have been unable to avoid deflation? And how will the Fed do better than the Japanese Central Bank?"

Bernanke didn’t wait for the question. The Japanese could have avoided its bouts with deflation if it had targeted higher inflation rates, he maintains.

Don’t worry about that here. Even if we get down to zero rates [real rates are already below zero], said the Fed governor, there are plenty of other things the central bank can do. Print money, for example. "Sufficient injections of money will always reverse deflation," said Bernanke.

In the 1930s, he continues, Roosevelt ended deflation by devaluing the dollar 40% against gold. He might have added that deflation ended after the worst depression in America’s history had forced 10,000 banks to go bust and left one out of every three workers jobless.

Is it comforting to know that the Fed can beat inflation by destroying the dollar and the economy?



Eric Fry in New York…

– Wal-Mart and Home Depot may be having trouble attracting eager shoppers these days, but the New York Stock Exchange is having no trouble at all. Investors are loading up their shopping carts with stocks of all sorts, especially those pricey, glitzy tech stocks…Goodness, is there a tech-stock shortage?

– For the week, the tech-laced Nasdaq jumped 4%, while the Dow chalked up its seventh straight winning week by gaining 225 points to 8,804.

– "The dissipation of fear and the embrace of risk are unmistakable characteristics of the market right now," Barron’s observes. "High-grade and junk-level corporate bonds have both been surging in value versus Treasuries." Then again, almost everything is surging in value versus Treasuries. The same economic-recovery delusion that is enticing buyers into the stock market is also spooking panicked sellers out of the bond market. Government bonds tumbled lower all week, as the yield on the benchmark 10- Treasury note jumped from 4.03% to 4.18%.

– But even though both the stock and bond markets "see" a recovery coming, hard evidence of said recovery is scant. Earnings estimates, for example, are falling even faster than share prices are rising. "Expected earnings growth of Standard & Poor’s 500 tech companies for the fourth quarter have been nearly halved, to 17% from 32% just since October 1," Barron’s reports. "Based on next year’s expected earnings, the tech contingent is due to produce about 5% of total earnings generated by all S&P 500 companies, yet the sector now accounts for 15% of the index’s value." Given the uninspiring earnings outlook for tech stocks, Barron’s concludes that investors are "looking through the wrong end of the telescope when eyeing a fundamental recovery in the group."

– Last week’s stock-market gains mean that the S&P 500 has jumped more than 20% since October 9th. The jubilant bulls proclaim that it’s a new bull market, while the bears gripe that it’s just another classic – albeit spectacular – bear-market rally.

– As the bearish Comstock Partners points out, "The S&P 500 is now up 22% from the bottom compared to a similar 22% for the spring rally of 2001 and 24% for the rally from late 2001 into early 2002." Both of the earlier rallies withered up and died as the bear market continued to grind lower.

– "Is the current rally in the stock market any different from the two that preceded it?" wonders Morgan Stanley’s Stephen Roach. "Or is it just another bear trap – a rally that fails in the face of unrelenting dip-prone tendencies of America’s post-bubble business cycle?"

– We favor the latter point of view…And, if this isn’t a bear-market rally, it OUGHT to be. Stocks are still expensive and they are still as popular as ever. In other words, there’s more than enough irrational exuberance to go around.

– Consider the frothy SOX Semiconductor Index. "Despite its recent 38% pop, the SOX is 75% below its top of March, 2000," the Financial Post reports. "But in absolute fundamental terms, the semiconductor sector is far from cheap. The SOX sports a forward price/earnings multiple of 535 and there is no trailing P/E because the average company in the group has been unprofitable over the past year." That’s 535 ESTIMATED earnings! Are these the valuations that typically launch a new bull market?

– The stubbornly high price for a seat on the New York Stock Exchange is another straw in the wind suggesting that stocks haven’t yet hit bear market bedrock. "The cost of membership on the New York Stock Exchange, measured by the price of a seat on the Big Board, has failed to collapse in the manner typical of every previous bear market," writes Barron’s Michael Santoli.

– "The last sale of a seat took place at a price of $2.5 million earlier this year. That isn’t even 6% below the peak price of $2.65 million, reached in 1999, despite the fact that the Dow has fallen 25% and the broader S&P 500 is down nearly 40%.

– "John Roque, strategist at Arnhold and S. Bleichroeder, points out that in the 1929-32 collapse, seat prices were flattened, to the tune of 97%. The comparable decline in 1968-69 was 93%, and the brief period of distress following the crash of 1987 pulled seat prices lower by 38%…It isn’t clear what should be inferred from the way seat prices have stayed firm this time."

– Maybe so, but it seems pretty clear to us what should NOT be inferred: "The bottom is in."


Back in Paris…

*** Stocks seem to be going up. But should you buy them? If you enjoy gambling, sure…why not. Maybe the rally will continue long enough to make a buck.

But here at the Daily Reckoning, we take a different view towards investing. We buy low so that we might sell high later. Few stocks are low now, so there aren’t many of them that we would buy.

We may miss a great opportunity to make money – just as we did in the great bubble of ’98 to ’99. But at least we’re able to enjoy the show without worrying about how it turns out.

*** There is a severe shortage of priests in rural France. Every now and then, none can be found for our little church in the country. So, we make do with a prayer service conducted by gray-haired ladies.

"As you do unto the least of them, so do you unto me," Jesus had said in Sunday’s gospel lesson.

"Be nice to each other," was the spin applied by one of the gray heads, limping through a sermonette on the subject.

*** "Why did you have to be so critical of West Virginia," asked a very gray head, rhetorically, at dinner. "It just wasn’t very nice."

Even in his own home, your editor finds no shelter. Over vegetable soup, his mother joined in defense of the Mountain State.

But he was ready for her: "When you go into a restaurant," he replied, "do you do the chef any service by not noticing that his soup tastes like dishwater?"

"If Jules goofs off and doesn’t do his homework," he continued, mounting a horse so high he almost needed a stepladder, "does it help him when you don’t say anything?"

"If an Enron lies about its earnings…if strategists make a self-serving call in order to get more IPO business…or if Alan Greenspan comes up with some lame justification for driving consumers further into debt…what possible good could it do to sit silent, like a groundhog watching a bank robbery?"

"You mean, you think you’re providing constructive criticism," came the hopeful response.

"Well…at least we’re providing the criticism… After all, the Daily Reckoning is free. If people want the constructive part, they can pay for it."

*** Out in the country, we raise our own turkeys. We don’t know why, but they seemed unusually suspicious and nervous this past weekend…

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