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A long article given by my FBR. After that kamar mailed me something about the potential future crisis too.

FYI. A piece written by Morgan Stanley former star economist Andy Xie.

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This piece was written two weeks ago and just printed in Caijing Magazine due to turnaround time. I am not trying to claim prescience. This is long time incoming. The credit bubble due to the false security from the derivatives is bursting. Many have argued that financial market has been creating liquidity. It is due to the derivatives bubble. As the US credit bubble bursts, it will bring down liquidity and affect financial markets everywhere and eventually the global economy.

Andy

The Next Crisis

As the Asian Financial Crisis approached its tenth anniversary, the world’s media descended upon Asia for clues to the next crisis. They were looking at the wrong place. The next crisis will most likely originate on the Wall Street. In particular, the derivatives bubble may burst. More than property, emerging market, or carry trade, the massive growth of debt derivative products is at the heart of today’s liquidity bubble. Its notional value is seven times the world’s GDP. It has artificially depressed debt cost and inflated debt demand, which is at the heart of today’s liquidity bubble. When this bubble bursts, it could dramatically increase debt capital cost and trigger a global recession.

As global inflation accelerates, it forces central banks to raise interest rates quicker. At some point, a tipping point is reached and insufficient liquidity triggers the bubble to burst. The bursting of the US Sub-prime mortgage bubble hints at what may be coming. 2008 may spell the end of the current global liquidity bubble, starting with the bursting sounds of the derivatives bubble on the Wall Street.

Liquidity has entered popular lexicon. Even your uncles and aunts are talking about it. Pundits use it as the excuse for buying risk assets like commodities, properties, or stocks. The popular understanding of the word refers to lots of money on the side waiting to pile into financial markets. For example, when people line up to buy properties or stocks, it suggests plentiful of liquidity. On Wall Street, it is measured as the money that financial institutions can put to use quickly.

For example, when financial institutions have lots of excess cash, IPOs are easy to sell. One often hears an IPO 20 or 30 times oversubscribed. Since commitments to IPO allocation require proof of funds available, it suggests plentiful of liquidity. The money available for investment at financial institutions depends on (1) inflow from final investors (mainly, households) and (2) credit condition (how easy it is to borrow).

The first factor refers to rising savings rate. The Fed Chairman Bernanke used the term ’savings glut’ to explain the low bond yield in the past few years. The US bond yield has been usually low and for a long time. If global savings rate has risen, the demand for financial assets relative to goods and services would also rise, which leads to higher valuation for financial assets like the US treasuries. The term for this phenomenon in the financial market is re-rating. But, the ’savings glut’ didn’t receive good endorsement, especially in the academic world. The IMF data seem to indicate that the global savings rate has barely changed in the past five years. Of course, global savings rate is very difficult to measure.

My hunch is that the reduction of investment cost has been more important than savings glut in the liquidity phenomenon. Multinational corporations have plenty of cash. The reason is that they are not investing as much as before for two reasons. First, they are building factories in low-cost countries like China . Each factory costs much less than before. Second, they are not investing fearing overcapacity due to rapid investment growth in low-cost countries like China . This migration of investment from high to low-cost countries decreases demand for capital. Instead of ’savings glut’, investment migration may partly explain the global liquidity phenomenon.

The credit condition may be more important than fluctuation in savings rate. In addition to low yields on government bonds, credit spreads have also been unusually low in the current economic cycle. Government bonds are the safest asset as governments have tax revenues to pay off debts and can tax anyone that they want. Bonds issued by any other entity are rated according to how high the risk of default the issuers face. Moody’s, S&P, and Fitch are the principal rating agencies in the world. The interest rate difference between certain grade bonds and government bonds is called credit spread. The highest rating for non-government bonds is AAA. The lowest investment grade is BBB. Anything below is called junk and is usually considered unsafe for non-specialists.

The spread between US treasury and AAA-rated corporate bonds according to the Moody’s averaged 145 bps in 1990s, peaked at 327 in October 2002, and dropped to 65 bps in January 2007. The spread narrowing is even more pronounced in lower grade bonds. The corporate bond spread has offset most of the increase of the Fed’s funds rate in this cycle. This is why private equity funds have been able to make so many deals despite the Fed raising interest rate so many times. The spread has backed up quickly in the past month as investors worry that the LBO-driven corporate bonds would have the same problem as the sub-prime mortgage market. This is why so many big deals, though announced, are facing financing problems.

The usually low credit spread in this cycle is mainly due to financial innovations-mainly, derivatives-that have spread credit risk among large number of investors and emboldened them to take on more risk. This should be a good thing. But, in many cases, if not most, the risk spreading is perception rather than reality. Also, illiquidity of many derivative products has led to their mis-pricing by financial institutions to deliberately mislead their investors, i.e., behind the low credit spread could be a giant financial fraud.

Risk premium is a fundamental concept in financial economics. Investors must ask for higher return for assets that carry more risk than government bonds. For example, if the average loss on BBB bonds due to defaults is 1% per annum, investors should ask for more than 1% higher return than government bonds. However, if an investor holds the bonds of 100 companies, if the default risks of these companies are uncorrelated, the law of large numbers suggests that he experiences about 1% loss due to defaults every year. Hence, he should just ask for 1% higher return on BBB bonds than government bonds, i.e., there is no risk premium. Diversification is probably the only free lunch in economics.

The derivatives boom has been mainly driven by this diversification need in financial market. For example, investors who hold corporate bonds can swap default risks of the underlying companies without actually trading the bonds. The credit default swaps have mushroomed into a gigantic market. Debt derivatives like credit default swaps have grown to nearly $400 trillion in notional value or 7 times the world’s GDP and three times as much as all the debts in the world, i.e., every bond has been swapped three times on average. The reduced risk, real or perceived, from using such derivatives have emboldened investors to demand more risk assets and, hence, brought down risk premium in general.

Two factors suggest that this derivatives boom is a bubble. First, the diversification is mostly unreal. Even though companies are distinct entities, their revenues are correlated even in different industries. This is due to economic cycle. When economic cycle turns down, all businesses are negatively affected. Complete diversification is just not possible for bond investors. Hence, risk premium should always be there.

Second, the derivatives could be mis-priced. The formula for options price is the Black-Scholes formula. Fisher Black and Myron Scholes published their seminal paper on option pricing in 1973 and received a Noble Price for it. It has spawned a huge financial market since. But, the growth of the options market has become massive in the past five years. It touched many new products like credit default swaps. Often, the new products are not so liquid. It violates the basic assumptions-market must be liquid, continuous, and stochastically constant-that make the Black-Scholes formula valid. Most corporate debts or asset-backed securities (’ABS’) are quite small. It is anybody’s guess how to price their options. Investment banks have aggressively pushed derivative products to investors. Sometimes, they create funds in house with other people’s money to buy such products. Investment banks are the visible hand in this derivatives bubble.

More importantly, financial fraud may be a fundamental factor in this bubble. Many buyers of such derivative products are small hedge funds. As such products are not liquid, their prices are largely self-determined. The hedge funds that own such products can just mark up the prices, send the ‘good news’ to their investors, and write a check to themselves as bonus for ‘good’ performance. Of course, such price inflation extends to other areas. Many hedge funds hold big chunks of small companies and essentially put their stock prices wherever they want, which is similar to ‘dealers’

(’¾±²È’) in China ’s stock market. Again, they can write a bonus check to themselves at the yearend for ‘good’ performance without liquidating their shares. Private equity funds also inflate the prices of the companies in their portfolio. As their companies are not listed, they can mark up the prices even more easily. The problem for them is that they cannot write a bonus check to themselves without liquidating their companies first.

The fraud has inflated demand for debt derivatives. It may be the factor that drives the derivatives bubble. The derivatives bubble, in turn, inflates credit demand and causes the global credit bubble. The fraud makes the credit market usually calm as nobody has the incentive to mark down price. But, it plants the seed for a financial crisis. When the funds that hold derivatives have liquidity problem, they go from ‘good performance to default in a nano second. The bursting of the sub-prime mortgage market could spread to other markets and bring down the house of cards in the credit market. Right now, most market mavens are trying to calm the market and talk in their expertly manner that the sub-prime problem is an isolated one in the credit market. I can assure you the opposite. The sub-prime bubble is one corner of the credit bubble. The bubble originates from the ability of financial institutions to sell hard-to-understand derivative products to investors at inflated prices.

A couple of years ago, I attended a conference that tried to bring hedge funds and their investors together. Some funds specialized in debt derivatives. The audience didn’t understand a word of the presentation by the fund managers. They left with the impression that it was a high-tech way to make easy money. The ignorance of the investors has made this bubble possible.

The derivatives boom is the key to low capital cost, which in turn drives credit demand. Central banks should determine liquidity. When they lower interest rate, market demand more money and vice versa. The derivatives boom decreases interest rate without central bank actions. Its effect is equivalent to central bank cutting interest rate. Indeed, the credit spreads suggest that this boom has kept interest rate 200 bps lower than otherwise. As the boom has continued to depress capital cost, central banks, in a way, have lost control over monetary policy. Unknowingly, the central banks have allowed a vast credit bubble to take hold in the global economy.

Bear Sterns, an imminent Wall Street investment bank, recently liquidated two hedge funds that were managed internally and raised money from its clients. The two funds were supposed to invest in high grade debt instruments in the sub-prime market. High-risk sub-prime mortgages can be pooled together to issue ABS. The income from the pool can be sliced into different segments. Some investors get paid first. Hence, if some mortgage borrowers default, it doesn’t affect the investors who have the highest priority to be paid. This artificial construct of different risk exposure turns out to be useless. The risk in the sub-prime market is mainly macro. When the macro condition turns, most sub-prime borrowers default together. Hence, the holders of the most senior segment like the two Bear Stern funds lose money just like everyone else. This is why these two funds suddenly went to zero value.

Following the bursting of the sub-prime mortgage market, the US corporate debt market is in trouble. You may have heard all those big deals made by those famous private equity funds. Such deals depend on their ability to issue bonds to finance the deals. Private equity funds play the leverage game. When they announce to pay $10 billion to buy a company, they mean that they will borrow $8 billion and use only $2 billion of the money in their funds. As long as debt cost is lower than the return on asset, this leverage game boosts the returns on $2 billion from their fund. Of course, the company must not default. Then, if the company defaults, they lose $2 billion-the money of their clients. The PE game is mainly about using other people’s money to take on more risk. If it works out, the PE managers get a big bonus. If it doesn’t, the PE managers find another job, and their investors lose everything.

The recent news in this market is not good. Many banks have already committed to issuing bonds for some announced deals. Sometimes, these are bought deals, i.e., the banks promise to buy the bonds themselves if the market wouldn’t. Unfortunately, the market wouldn’t now. Many banks are stuck with such bonds. If the bonds are really traded, they could lose 30% in value. The total amount of such bonds could be over $200 bn. This is why the Wall Street investment banks are trading under 9 times 2007 expected earnings. Their low stock prices indicate that the market is expecting a financial crisis.

Widening credit spread precedes every recession in the US . It may be the same this time. The bursting of the sub-prime mortgage bubble has spread to the private equity-driven LBO bonds. The effect of the spread-widening could be equal to 200 bps of rate increase by the Fed over the next twelve months. Could the Fed cut interest rate aggressively to offset this increase in the cost of capital? Unfortunately, it can’t. The US economy is facing significant inflation pressure. The year-on-year inflation rate is above 6%. The dollar weakness further adds to the inflationary pressure.

The Fed doesn’t have much flexibility. Further, what’s going on in the credit market is normalization. What was happening before was not normal. It doesn’t make sense for the Fed to stop this normalization process. But, one byproduct of this normalization could be a recession. If the US economy does experience a recession in 2008 due to rising capital cost, it would have big effects on the global economy and financial markets. For example, the commodity bubble would certainly burst if the US economy goes into recession. Even though China accounts for most of growth in commodity demand, the US still accounts for more in total amounts. The commodity bubble, in particular, the oil bubble, would burst with a US recession.

A US recession could cut the US trade deficit sharply. The large and growing US trade deficit has been fueling the liquidity bubble in emerging economies. The other side of the US deficit, the trade surplus of the emerging economies, has been fueling their monetary growth and asset price. A US recession could take that liquidity away. Stocks and properties in emerging economies could all adjust sharply in 2008.

2008 may not be a lucky year after all.

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