“Up and down the City Road,/In and out of the Eagle,/ That’s the way the money goes,/Pop goes the weasel.” News last month that UK pawnbrokers are doing 20% more business in 2006, and that one-in-25 mortgage holders had missed a payment in the previous 12 months, should probably come as no surprise. As the popular 19th-century song reveals, the great British public has always been thoroughly dissolute.
These days the Brits are far from unique. Over the past 50 years the average US household savings rate was 7.4%. In mid-2004 it switched into negative territory, largely as a result of booming house prices and record mortgage refinancing. It has stayed there. Perhaps Mom and Pop are taking their cue from the Federal government, which is running a record $800 billion current account deficit.
Debt in its myriad forms is repackaged and sold via the financial markets. As the world was purged of inflation from the 1980s onward, investors loaded up on bonds. Both in terms of its duration and magnitude the great bond bull market, bar the odd blip such as 1994, has easily eclipsed anything seen in equities. Maximum bullishness has spawned innovation and ugly acronyms, from CLOs (collateralized loan obligations), CDOs (collateralized debt obligations), CDS (credit default swaps), to PIK (payment-in-kind) bonds.
The buyers of these frequently leveraged debt instruments are often leveraged themselves. US research firm Greenwich Associates estimates that hedge funds account for 58% of the annual trading volume in CDS, 47% of distressed debt, 45% of emerging markets and 32% of leveraged loans. If it’s levered, illiquid, or both, hedge funds are likely to own it in spades.
Take PIK bonds (don gauntlets and safety goggles first). According to a report in the Financial Times last month citing Credit Suisse, hedge funds bought €3 billion in PIK bonds in Europe in the second quarter. For European investors this instrument was only of passing historical interest as little as two years ago. $5 billion of PIK bonds help to finance the $25 billion LBO of RJR Nabisco in 1989 at the height of the first junk bond boom.
By October 1990, in a very different market, Barron’s was predicting a slow, quiet death for PIK bonds. PIK bonds don’t pay a coupon. Instead, the bondholder gets more bonds (a payment in kind). It’s the apogee of financial wizardry: company financing without any need to worry about such old-fashioned niceties as generating sufficient earnings to service the debt.
By far the biggest issuers of PIK bonds are companies owned by private equity houses. These companies are often issuing bonds not to reinvest in the business but to pay their owners a dividend. LBO firms leverage up to buy companies, those companies then ratchet up that debt to keep their new owners in the style to which they have become accustomed. The buyers of these slim PIK-ings are, in turn, often leveraged. Debt cubed.
No one likes doomsayers, flat-earthers or sentimentalists. Financial innovation is a good thing. But 1989 is best remembered for the fall of the Berlin Wall. PIK bonds were not a highlight. Those that do not learn from history are doomed to repeat its mistakes.
Central banks are now worried about inflation, not deflation. If inflation breaks out, rates will go up sharply and debt will become an ever heavier burden. Rates will only be cut if growth slows dramatically. If that happens corporate profits will fall away even faster and paying bondholders will be more difficult.
Knowing Euromoney readers to be a cosmopolitan and polyglot bunch, it should be explained that the Eagle was a public house and music hall of dubious repute on City Road in London. After over-celebrating the good Queen’s diamond jubilee in 1897, or the relief of Mafeking in 1900, our Victorian forebears would “pop” (pawn) their weasel (weasel and stoat is rhyming slang for coat).
It might be best to steer clear of pubs in the months ahead. When the debt money-go-round stops turning, we will all be in need of a sturdy weasel to help us shelter from the storm. But if you want to find a bolthole on the City Road, you could do worse than the latter-day Eagle (the original was demolished). It is a rather good gastropub. Now that’s real progress.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.
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