David Leonhardt is somewhat sanguine about the state of the financial system given its apparent steadiness after the Dubai World default. Perhaps too sanguine.
First, it’s always impossible to predict what will do the old record scratch to stop the music when the party’s on. Remember all the warning signs in 2007, from the blowing out of subprime spreads in February to New Century’s bankruptcy in April to the Bear Stearns funds’ collapse in June and finally to August when BNP Paribas suspended withdrawals, signaling the crisis was on. Lenders kept making ever-worse loans during that time and equity investors kept on playing; the Dow didn’t peak for another two months.
Does anyone doubt that we’re in a secondary bubble right now?
If you do, read this very important Henny Sender story in the Financial Times today:
Some of the most controversial financing practices of the credit-bubble years – from cov lite loans to Pik toggle notes and dividend recap exercises – have returned to Wall Street, stoking fears that debt markets are growing overheated.
I mean, yikes. These are some of the worst signs of the wretched excess of the High Bubble Era—instruments you’d think wouldn’t poke their heads out for a decade or more.
It’s excellent reporting by the FT and good work synthesizing several activities on Wall Street to raise larger questions. And it makes it easy for just about any somewhat-savvy reader to tell why these practices are problematic.
Covenant-light loans are just that: Loans with few covenants, or conditions on the borrower. It makes the lending terms much easier.
Payment-in-kind (PIK) toggle deals let you repay your loan with more debt (!). How could that go wrong?
And dividend recapitalizations allow a company to borrow a bunch of money to pay its owners a big one-time dividend. In other words, they load up a company with a sometimes-choking level of debt to minimize their investment or even make an immediate gain.
Each of these—usually private-equity tactics—is a red flag of a lending bubble. It means power has shifted back to at least some borrowers, which means there is an oversupply of money looking to be lent.
As Sender reports:
The reappearance of such instruments in recent weeks has stirred concerns that government efforts to stimulate lending are having unintended consequences, encouraging lenders to take positions based on “best-of-all-possible-worlds” assumptions.
“We have had a huge rally in debt,” said Dino Kos, a former New York Federal Reserve Bank official and now a managing director of Portales Partners, a research boutique. “Everything needs to be just right for that rally to be validated.”
That’s scary in a system that is still extremely fragile.
So back to Leonhardt, who writes this on the Dubai shakeout:
Fortunately, the last week has suggested that the world economy might now be able to handle any one of these problems. Dubai was a stress test, and the financial system passed.
Which is all the more reason that policy makers, here and abroad, should continue to shift their focus now. The financial crisis itself was yesterday’s main problem. The fallout from the crisis — starting with unemployment — is today’s.
He’s right that the main indicators of debt nervousness aren’t blinking red, but that could also be a bug, not a feature. And it’s wrong to say the crisis was yesterday’s anything. There’s still a lot of debt out there being carried on the books at God knows what levels. Commercial real estate has yet to really hit. And the housing crisis is far from over. Leonhardt points all this out, I just question his (somewhat-hedged) conclusion.
It’s no time for complacency. We need much more reporting on the new red flags. Here’s to the FT for doing so.