January is the traditional time to banish bad habits. For a few weeks at least we all stick to our New Year’s resolutions. The inner Puritan, in exile during Bacchanalian December, returns to centre stage. Living it up gives way to lying low, cocktails to cocooning. Indeed, the only mixed drinks consumed combine whatever fruits make wheatgrass juice palatable to people who don’t knit their own organic yoghurt for the 11 other months of the year.
If only markets found the process of detoxing after a period of excess so easy. Unfortunately, as former Federal Reserve chairman Alan Greenspan noted in his valedictory address in the summer of 2005 to an audience of fellow central bankers at the annual Economics Symposium in Jackson Hole, Wyoming: “History has not dealt kindly with the aftermath of low risk premiums.” There are hangovers from 2006 that will thump long into 2007. Any one of them has the capacity to induce a nasty dose of nausea for investors.
1) The private equity debt binge. This is something of a bugbear already but there are no signs that excesses of private equity are being moderated. Take the Hertz IPO in November. Less than one year earlier a consortium of private equity firms, Clayton Dubilier & Rice, The Carlyle Group and Merrill Lynch, had paid $15 billion for the car rental company. Only $2.3 billion in cash was used, loading Hertz with more than $12 billion in debt to pay the balance.
In June the private equity firms paid themselves a $999.2 million special dividend, or 43% of the cash they used to finance the deal. They paid themselves another dividend of $400 million from the proceeds of the $1.3 billion IPO. They still own nearly three-quarters of Hertz. They were given a payment of “fees” of $25 million each when they took over Hertz and another $25 million at IPO. Hertz’s reward for its brush with private equity was a 90% increase in annual interest expense to $672 million.
At Berkshire Hathaway’s annual general meeting, Charlie Munger asked his boss, Warren Buffett: “How will private equity firms make money by just flipping and flipping and flipping?” The Sage of Omaha replied: “They’ll make it on fees, fees, fees.” The cupidity of private equity firms would make even hedge fund managers blush. Nemesis awaits. But it is not only the private equity firms that will suffer...
2) The structured credit alphabet soup. One of the reasons investment banks are happy to fund this binge (other than fat fees and old-fashioned complicity) is that they have become highly effective at repackaging debt and shifting it off their balance sheets. The result has been CDOs, CLOs, leveraged loans and the pullulating rash of structured credit investments.
Yield-hungry investors, often leveraged themselves, have been buying this paper with alacrity. Latest twists include CPDOs (constant proportion debt obligations). First issued by ABN Amro in a structure called Surf in August, there have already been multi-billions of dollars of copycat CPDOs. By leveraging up to 15 times, these notes offer a 200 basis point spread pick-up over the iTraxx or CDX investment-grade CDS indices. However, to hedge their books, banks issuing CPDOs have bought the underlying CDS, compressing already tight spreads.
Surf and products like it are riding a wave of global liquidity. Waves always break. The current spate of innovation in credit markets is reminiscent of the early 1990s when inverse floaters, range floaters, principal-only strips and other derivatives were all the rage in the US mortgage market. Early in 1994 David Askin boasted to Institutional Investor magazine that he was buying a lot of “weird stuff”. Then the Fed raised rates, blowing a $600 million hole in Askin’s Granite Fund.
Lest we forget, Askin had been head of research at Drexel Burnham Lambert, the firm that funded much of the first LBO bubble. The current wave of private equity deals and hunger for yield is spawning plenty more weird stuff. It is interesting to note that the issuers of all this exotica are bolstering their distressed debt units. Are the investment banks placing their chips on red and black? You bet they are. Investors would do well to take heed.
3) Funding the $850 billion US deficit. The two consensus trades in markets are that the dollar will continue to fall and that the Fed will start cutting interest rates in March. Dollar weakness should be benign. The exorbitant privilege the US enjoys means that when the dollar falls against other currencies so does the value of America’s external liabilities. The US current account should stabilize and then fall in line with the dollar. This is what happened, with a lag, in the mid-1980s.
However, what is different this time is that the US depends on the kindness of strangers to fund its deficit. US treasuries have offered an attractive yield pick-up over yen- and euro-denominated debt. That yield differential has fallen and if US rates are cut it will narrow yet further. If US treasuries no longer attract a bid from Asian central banks, the dollar’s fall could become a rout, dragging other asset prices lower. It might also constrain Fed chairman Ben Bernanke’s ability to cut rates sharply even if the economy slows further.
Happy New Year? Let’s hope so. In the meantime, it might be worth stocking up on your favourite hangover cure, even if you are enduring a dry January.
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