Having predicted both the end of the debt binge and the unravelling of the toxic structured credit products it spawned, only one thing surprised me about the financial crisis of 2007 – how long the money-for-nothing junkies remained in denial. As the storm clouds gathered in July we were told it would be a one-quarter event. That soon became two quarters. We were then reassured that the problems were contained in such obscure backwaters as sub-prime, CDOs and SIVs.
But as the poison spread, it paralysed the entire banking system, precipitated an unparalleled loss of trust, $119 billion and counting of write-downs, tarnished reputations, tattered balance sheets, and multiple rescue rights issues that dare not speak their name. So much for the past. What does the future hold?
There is still a surprising ostrich-like mentality at large. The "one-quarter snafu" true believers of last summer now expect the Federal Reserve to steer the US away from a recession and the rest of world to decouple from that slowdown and continue to post above-trend growth rates. They have still failed to grasp the magnitude of the crisis. Stock markets, for example, have barely begun to play catch-up.
The US will have a recession, if it is not already in one. Even if faith is restored in securitization there will inevitably be a dramatic contraction in the availability of credit – even to normally creditworthy businesses and individuals – as banks rebuild their capital ratios. That will mean a simultaneous drop in individual consumption and business investment.
Other economies will suffer too, starting with those that have drunk mostly deeply from the well of cheap credit, such as the UK, Spain and Ireland. But nor will the rest of the world be immune. It is economically illiterate to think that a US consumer-led recession will not have an impact on the textile manufacturers of emerging Asia that fill the racks of Gap and Victoria’s Secret. Putting off the purchase of that latest digital camera or HD DVD does not just damage RadioShack but also manufacturers in Japan and their suppliers in Korea, Taiwan and beyond.
In the financial world, those that suffer most will also be those most reliant on cheap credit. The obvious victims (please shed a tear) are the private equity barons. In many cases, recent transactions have been built on limitless cash, on any terms at deal time and still more when it came to refinancing. That model is broken.
Not only will big LBOs be few and far between in 2008, deals done in 2006 and 2007 are likely to be under pressure. Refinancing will be tough. Previously light covenant standards might help but the assumptions that many of the deals were predicated on have gone out of the window. Businesses that aped the private equity firms will find themselves under similar strain. M&A bankers reliant on financial sponsors will have a lean time.
The collateral damage will be widespread (according to one report the US has already lost 161,000 jobs in the financial sector). Bond syndicate and loan desks will do less business. However, distressed debt specialists will enjoy a vulture’s feast. The smarter investment banks were also quietly beefing up their distressed debt divisions while still enjoying last orders at the credit party. Lawyers, no slouches when it comes to pursuing passing ambulances, will also be dusting off their running shoes.
There will also be many parts of finance where it will be business as usual. Old-fashioned bankers with real corporate clients will be fashionable again. FX will continue its rise as an asset class, with volumes to match, as other investment opportunities look less appealing. Customer facilitation businesses, such as broking, will still be needed and they are used to relatively thin spreads. Mainstream asset managers might have to cope with lower ad valorem fees if markets fall, but they have enjoyed bumper profits of late, so the well-managed ones will continue to thrive.
Credit hedge funds that relied on the excessive leverage of market beta are probably already out of business. The rest of the sector will have to bear the costs of more expensive financing and demands for better collateral and bigger haircuts. That will knock returns and profits. The hedge fund world has always been Darwinian. The fittest will emerge in 2008.
The same 2007 column that predicted the end of the debt binge and implosion of structured credit also made one investment call. In truth, it was a no-brainer, although it turned out to be a profitable one. It said volatility would spike. An investor buying the US VIX index then would have booked more than a 100% profit. In the present environment there is no easy money. The best bet for 2008 might be to buy and hold the iBoxx Inflation Linked Bond Index.
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