One of the sure signs that problems are a pretty likely outcome is when risk is priced at levels which are unlikely to pay enough to adequately reward investors over time. When the world gets a bit too complacent, conditions seem perfect and volatility is low, we tend to project that into the future. Thus, as Hyman Minsky (scroll down to A Minsky Review) pointed out, stability leads to instability. If a car seems safer, we tend to drive faster. If risk in financial markets doesn’t present itself for a while, we pile it on until it causes the stability to become unstable. This is true in a number of areas outside of finance as well, but it is asserting itself with a vengeance in finance right now.
So I am over at Angry Bear and notice this from PGL:
Could I ask one favor from James Pethokoukis – stop emailing me stupid stuff like this:
For a more upbeat take, here is another of my favorite guys, Don Luskin of TrendMacrolytics:
The price of risk in credit markets has returned to normal levels, but for those who gorged for years on a zero price of risk, it feels like whiplash.
It’s bad enough that you cite the Stupid Man Alive on any economic issue. When Luskin says “the price of risk” is zero, what is he babbling about?
Now, I tend to disagree on the likely fate of financial markets with Don, but frankly I have to agree with him here. PGL justifies his incredulity with this little graphic:
So what is a normal level for something like a credit spread and has this spread been zero recently? Well, let’s look at the difference between interest rates on BBB rated corporate bonds and the ten-year Federal bond rate as a proxy for this idea (if Luskin has a better measure, it’s a shame he failed to mention it). It would seem that this credit spread has not been zero for the past several years. In fact, it was higher in 2002 and 2003 than it is today. So when Donald Luskin
claims people have “gorged for years on a zero price of risk” – he has no idea what he is talking about.
Frankly, I have no idea why PGL is going on about this at all, other than he despises Don Luskin, because that isn’t how you look at it. Plenty of people have noted exactly what Luskin is saying. Luckily I don’t have to go find an explanation that sounds coherent, because Don found one for me, from Bill Gross (essential reading by the way, most successful bond manager in the world and a decent writer to boot.)
…high yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. 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. At LIBOR + 250 in other words, high yield lenders were giving away money! [emphasis in orginal]
For those who don’t want to do the math, about 50 basis points. Of course, unlike Don, I view the risk premium as pretty much non-existent throughout most of the market and across most asset and sub asset classes, but if you can’t give credit to those you disagree with when they are agreeing with you, well, when can you? PGL knows better, he knows spreads have been too low. He doesn’t have a fundamental issue with Luskin even if he thought Luskin was using a bit of hyperbole and wasn’t referring to expected loss compared to the spread, but just felt they were too low. To put it another way, if the same comment had come from, well, Angry Bear, or Bill Gross, he wouldn’t have raised a peep. Politics has fried just about everybody’s brain.
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I think it many cases this was literally true. Most banks that I know were falling all over themselves to get money out the door even as recently as a year ago. My guess is that many institutions got caught a little flat-footed by private equity and hedge funds lending money to traditional bank customers. The private lenders demanded a bit higher of a premium, but a lot less control and paperwork, and they actually facilitate getting projects up and running, whereas banks tend to bog everything down with secured status, and total asset control.
So the fact that financial institutions were willing to suck up 50 basis points to get money out of the vault and into working capital actually makes sense. It’s the age old result of competition in the market place — in this case, the lending market.
I certainly can accept that as an explanation of why, however it obviously makes little economic sense when the expected return for treasuries is actually higher. My only explanation is they didn’t believe the risk was as high as it has been historically. It is different this time, or so they thought.
The same with some hedge funds and private equity. They could use leverage to turn small spreads into large gains because credit was stable and understandable in its relationships, so they think. If everything works out 10 to 1 or even much higher leverage can turn that 200 basis point spread into a whole lot of money. Borrow against the yen and its even better as long as the yen behaves and the credits work out. If they don’t, blammo. That goes for banks too (10 to 1 leverage being their secret as well.) Too much money chasing the same opportunities forced them to decide to sit it out and wait for a better opportunity, or deceive themselves. Nothing new there, bubbles and manias are a stock feature, but when bankers do it it is the worst.