Editor's letter: Chill wind after joy of spring


Clive Horwood
Published on:

After the bleakest of winters, springtime in the debt capital markets was an especially joyous affair. In April and May there were record new-issue volumes in the US and a revival of the European market. That is good news for large financial institutions and the big underwriters.

The importance of a functioning new-issue market cannot be understated. It is primary issuance that creates transparency and pricing, helping secondary market trading. Regardless of whether the new issues are cheap, expensive or priced fairly, the key is that – at that moment, for that issuer – there is a clear price in the market for a very large transaction. From that follows the relative pricing of different issuers and structures.

The return of some liquidity is also good news for credit valuations. Much of the credit market is not actually impaired but trading at distressed levels mostly because of widespread nervousness and the absence of once price-making leveraged investors, who now have no access to funding.

The debt capital markets thawed when fears that systemic problems would overcome the global financial system faded. But they are not in the clear. The air of relief was tempered as credit spreads started widening again in late May. The catalyst was the release of the minutes of the Federal Open Market Committee meeting in April when rates were cut. It is clear the Fed has inflation in its sights and that further rates cuts are unlikely.

Although the market liquidity and banking system capital crises appear to have been dealt with, the macro picture is ugly. Banks might not be going down but they aren’t in good enough shape to do much lending, and that will become a big problem for consumers and corporates. It would be a miracle if the biggest financial crisis in a generation happens without a massive negative impact on economies across the globe.

Put simply: when the cost of credit goes up, the value of everything else goes down. This financial truism is already working its way through housing markets. In time, other sectors will feel the cold wind of the credit crunch. US consumers are retrenching and will continue to do so amid negative wealth effects from house price falls and stagnant equity valuations. In the UK, mortgage rates are going up, even as policy rates decline.

No one can accurately gauge the impact of tighter lending conditions. The gap between the largest banks’ write-downs and credit losses (just shy of $400 billion) and their capital raisings is approximately $120 billion. That’s a lot of missing equity and a huge amount of missing lending capacity. The typical leverage applied to most banks’ balance sheets is within a 12x to 15x range. That could mean something like $1.5 trillion of credit creation does not occur.

A further cloud is regulators pushing hard for less leverage on banks’ balance sheets in return for implicit and explicit taxpayer support. At the same time, the SEC is pressing US accountants to change the rules on securitization vehicles, which could force more unwanted assets back on to balance sheets already swollen by the rescue of collapsed vehicles and drawdowns on revolving credits. And that does not account for the pro-cyclical effects of the new Basle II regime.

Of course, credit managers are increasingly risk averse anyway.

Banks will struggle to generate revenues in these conditions. Their margins are being crushed by the rising cost of their own debt financing. The closure of structured finance markets – there are simply no buyers – will dramatically reduce the ability to churn assets and slash fees for the arranging banks, in addition to reducing a needed funding avenue for all financial institutions.

As their funding costs rise, many banks have credit spreads that are locked on the asset side, through medium-term credit commitments already extended during the good times. They will find it hard to quickly jack up the cost of funds to long-standing corporate relationships even if their own spreads in the wholesale markets have doubled. The crunch means that there is a whole swathe of corporate activity, especially middle market, that doesn’t interest many banks. When financials raise money at a higher cost than corporates, it becomes a money-losing proposition for many banks to lend money to their corporate clients.

One potential side effect of all this is further disintermediation of the banks. Real-money investors have lots of cash. The good news is that this should mean that the flow of new capital market issues from corporates continues to rise. The danger is that the banks are still sufficiently important to mean that corporates eventually default as credit is restricted and, especially in cyclical businesses, earnings collapse.

The only surprise is that stock markets continue to ignore much of this. Yes, financial stocks are lower, but analysts still estimate double-digit earnings growth for the S&P500 in the last half.

One can only hope that they know something that fixed-income markets do not.