Tuesday, July 24, 2007

Hmmm... Gross

There are some amusingly unpleasant conditions in debt markets at present, and these have much more potential to create economic shocks than the dollar's decline. Not that I'm not interested in the dollar's plunge - a few weeks back I transfered money over from the UK, back in the halcyon days when it was $2.025 to the pound. Sweet! Oh wait, it's now $2.06.

Still, if you read one dense piece of writing about the workings of financial markets today, make it this month's letter from famous bond investor Bill Gross.

I'm slightly happy at the fact that corporate debt is going to start getting more expensive, because it means less work for Mrs. Cutesome, who facilitates such things, and is perennially overworked, and slightly more for the maudlin group of European bankers that constitutes my beat.

But Mr. Gross sounds positively egalitarian, a man worth $1.2 billion urging his fellow plutocrats, much as Warren Buffett has, to pay more tax. He even gets this nice little zinger in:

What pretense to assert, as did Kenneth Griffin, recipient last year of more than $1 billion in compensation as manager of the Citadel Investment Group, that "the (current) income distribution has to stand. If the tax became too high, as a matter of principle I would not be working this hard." Right. In the same breath he tells Louis Uchitelle of The New York Times that the get-rich crowd "soon discover that wealth is not a particularly satisfying outcome." The team at Citadel, he claims, "loves the problems they work on and the challenges inherent to their business." Oh what a delicate/tangled web we weave sir.

He goes on to look at the effects of the collapse in house prices, increase in mortgage defaults, difficulties with the performance of securities backed by mortgages, and the difficulties at some funds that invest in these. He thinks, as most commentators have by now decided, that it will soon become much more expensive for corporations, whether public, private or private equity, to borrow money.

He also thinks, and offers up some figures, to support the idea that it is presently too cheap for them to do so. Here are his figures:

Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans.

He then compares this 3% expected loss, based on historical default levels, with the current margins available to these borrowers of 2% to 2.5%. Which does indeed suggest that the return to lenders on such loans is lower than the amount they might use, and my elderly investment banking grandmother once told me that risk and reward should always be prudently balanced.

The hole here, if you can see it, is that we still don't know if corporate defaults will follow their historic pattern, let alone the pattern of mortgage borrowers. Default rates were low in May, although Moody's, yes that discredited rating agency, says that they will increase.

For the moment, indicators of corporate health (profits, cash on hand, job creation) are good. Corporate borrowers will probably not struggle to service their existing cheap debt. But they will find it very hard to refinance their debt at similarly cheap rates next time it comes due. And new deals will be harder to do, as Gross suggests.

But I'm still sceptical about the "loss of principal in bankruptcy", or loss given default, number he cites. My suspicion, as I have suggested in the past, is that while loans have presently been structured in such a way that lenders do not have as much access to the cashflows of a borrower as they have in the past, they do have much greater levels of security over a borrower's assets.

A 50% loss given default brings expected loss levels much closer to 2.5%, or what borrowers were charging for high-yield debt until recently. Still Mr. Gross has probably had more bond positions go sour than I've been to uninspiring indie rock gigs, so I'll defer to his assumption that loss levels will revert to the historic mean.

But go read it. He may be a seasoned, and successful, investor in one of the less exciting forms of financial instruments, but he really does seem to be cheerful at the mess we all think is going to go down. Oh that's right, he's a bond investor. He loves it when borrowing is expensive. Caveat lector.


Post a Comment

<< Home