Wednesday, November 12, 2008
A few notes on the economy
Oil is around $58 the barrel this morning. Yes, that is the consequence of the abrupt decline in most industrial economies, but it is also an automatic stabilizer that will put billions into the hands of average people all over the world. They will either spend that extra money or use it to pay down debt, which will free up lending capacity. And -- bonus! -- it means less money and more economic hardship for the bad guys. All good. Now, let's not screw it up by reverting to our wasteful ways. Extend your new gasoline-saving habits, and you will have even more money to pay down debt and spend on other things.
After spiking through the roof during the dark days of October, three-month LIBOR has fallen to its lowest level since 2004. If you are lucky enough to be borrowing at that rate or at a spread over it, your borrowing costs are much lower today. That means you are making more money, or losing less. That will help you pay down debt more quickly.
The so-called TED spread, the gap between U.S. Treasury securities and "eurodollar" borrowings of similar duration, is closing in on normal levels. The risk is coming out of short-term borrowings because the government has spread around enough implicit or explicit guarantees that money can flow between banks.
As I discussed on my weekend "episode" of "TigerHawk TV," in the last couple of weeks we have moved from the end of interbank lending -- a terrifying new place nobody alive had seen before -- to the gloomy but familiar terrain of deep recession. We know where we are, now, even if we do not like it.
That explains, I think, why politicians are now suddenly talking about using the TARP to bail out the auto industry. We have moved from panic over the collapse of the international financial system to the usual concern that we stimulate the economy and protect the interests of our favorite, well, interest groups. Bailing out the UAW and the clowns who run General Motors is pretty normal corporate socialism, even if we have not seen much of it since the 1970s.
The return to "normalcy," albeit hideous normalcy, also explains why politicians are now pressuring banks to make loans where there is apparently no independent profit motive to do so. We have seen where that policy leads, too. If memory serves, a political desire to stimulate lending to borrowers who would not qualify for loans under traditional metrics pushed us into the subprime mortgage debacle in the first place.
This exposes the inherent tension between the "stabilization" objective of the TARP and the stimulus objective. Pushing banks to make unprofitable loans in order to stimulate the economy is not going to make people who might lend to or invest in banks more willing to do so. Credit will flow to worthy borrowers when banks can be certain that their loans will generate an actual profit. So the question is, why is that not happening now?
Well, the main reason that even healthy banks are not making new loans is that they can go buy perfectly sound corporate credits at substantial discounts to "par." As long as you can earn a high return doing that, why would a bank go to all the trouble and expense of making a new loan at a lower rate?
So the next question is, why are perfectly good corporate credits selling at a discount? Because there is still, TARP and its foreign counterparts notwithstanding, less lending capacity in the world than outstanding debt. Too much capital has been destroyed too quickly. Banks need time to rebuild their equity capital, which is a proxy for lending capacity. Some of that will come from new investors, but since all the recent purchasers of bank equity have been run over, flattened, destroyed, the first and best source of new equity is retained earnings. Therefore, the faster that banks make money, the faster they will build their capacity to make new loans, and the sooner it will become profitable to make new loans to genuinely creditworthy borrowers.
14 Comments:
By 
Charlottesvillain, at
Wed Nov 12, 11:17:00 AM:
A couple of supplemental points regarding the discount on corporate debt, as I see them. During the peak of the credit bubble, a couple of things happened that have left a lasting impact on the market today. One, the percentage of corporate debt funded in the institutional market reached an all time high. This means that it was not banks doing the lending, but structured vehicles, CDOs, CLOs, etc. that allowed institutional investors to in effect fund corporate debt. This market is pretty much dead, eliminating more than 50% of the funding for the leveraged side of the maket. It is unclear at this point when or if this funding source will return, but it does not appear likely in the short term.
Second, the terms of underlying loans became quite lax. Not only did credit spreads become compressed and fail to appropriately price long term credit risk, deals got done at higher levels of leverage and there was a proliferation of less secured second lien loans as well as of "covenant lite" loans that included fewer protections for lenders. This combination of changes in the market practically guarantee that, under even mildly adverse conditions, loans will trade at a discount. (I will say that most of this pertains to the leveraged portion of the market, no the highest credit quality sector which also trades at a discount).
One other point about covenant lite credits: debt covenants allow lenders to force stressed borrowers to the bargaining table, and put into place measures that conserve capital (usually to the detriment of equity holders and subordinated debt). In extreme cases, covenant breaches constitute defaults. Cov lite deals don't give lenders the same options, and may encourage managements to take more risks to "dig out of the hole." Default rates may not actually reflect credit deterioration that is going on. But expect ultimate recoveries for these deals to be far lower if they do ultimately go into default.
A final point: anyone following the corporate debt makets has sween borrowers with untapped revolving credit facilities tapping their lines, in many cases with a full draw. We are also seeing a big increase in borrowers electing to pay in kind (PIK) which means they have stopped paying interest and are adding it to the notional value of the debt. These are troubling signs, and contribute to the fear that the next big shoe to drop will be corporate credit.
Sorry for the long comment. It could not be contained.
By TigerHawk, at
Wed Nov 12, 11:40:00 AM:
All good comments. My one tweak would be on the last point -- I do not think that most of the tapping of credit lines is because borrowers have in fact weakened. For non-financial borrowers, at least, I think a lot of it has to do with equity investors "moonlighting as credit analysts." More than one company just wants to show a lot of cash on its balance sheet to deflect paranoia among its equity investors, even at the cost of negative carry. Until the equity investors get less paranoid about liquidity and go back to focusing on EPS, these lines will remain tapped.
By Charlottesvillain, at
Wed Nov 12, 12:01:00 PM:
That's probably right. Also, borrowers have become concerned that their banks might withdraw the line or otherwise be unable to honor the commitment later.
Here in Charlottesville, the paper reports that the construction of a new downtown highrise hotel has halted because the lender has failed to advance the next tranche of funding and the contractors have not been paid. I can see why, if you had the option, you might just draw down the balance of your loan and sit on it.
By Charlottesvillain, at
Wed Nov 12, 12:17:00 PM:
I just received an alert that a company is going to its lenders to receive permission to buy back its own debt in the secondary market. If allowed, this would be a great option for companies with cash, and one way to add liquidity to the market.
I have to say, the financial crisis is fascinating to watch unfold on a day by day basis.
By Escort81, at
Wed Nov 12, 12:49:00 PM:
Gentlemen: What is your feeling about the audible at the line of scrimmage that Sec. Paulson has just called, and its impact on the debt and equity markets (from AP):
"Treasury Secretary Henry Paulson said Wednesday the $700 billion government rescue program will not be used to purchase troubled assets as originally planned.
Paulson said the administration will continue to use $250 billion of the program to purchase stock in banks as a way to bolster their balance sheets and encourage them to resume more normal lending.
He announced a new goal for the program to support financial markets, which supply consumer credit in such areas as credit card debt, auto loans and student loans.
Paulson said that 40 percent of U.S. consumer credit is provided through selling securities that are backed by pools of auto loans and other such debt. He said these markets need support.
"This market, which is vital for lending and growth, has for all practical purposes ground to a halt," Paulson said.
The administration decided that using billions of dollars to buy troubled assets of financial institutions at the current time was "not the most effective way" to use the $700 billion bailout package, he said.
The announcement marked a major shift for the administration which had talked only about purchasing troubled assets as it lobbied Congress to pass the massive bailout bill.
Paulson said the administration is exploring other options, including injecting more capital into banks on a matching basis, in which government funds would be supplied to banks that were able to raise capital on their own."
Audibles can be good or bad; it depends on how good the QB is at reading the defense as he comes to the line of scrimmage. I am philosophically uncomfortable with Uncle Sam taking long term equity interests in banks, buy if this is a trading buy that doubles as a backstop for banks' balance sheets and restores confidence, then I am willing to be open-minded. What was it, though, that made Treasury decide that direct purchase of troubled assets was not working well?
The Dow is down about 230 as I write this, shortly after Paulson's announcement.
I am seeing anecdotal data that the consumer has had the crap scared out of it and people are cutting back on discretionary spending, even if they can otherwise afford it. I would expect -- duh -- that the Christmas retail season will be horrible. I have not stopped buying dry aged New York strip steak at my local Whole Foods, however.
Who is raising private equity money right now for turnaround fund that will buy private companies at distressed prices? Putting money to work sometime in the second half of next year might work out.
By SR, at
Wed Nov 12, 01:11:00 PM:
What was the role of oil price spikes in the mortgage meltdown in general? My simple-minded view was that oil prices drove the budgets of homeowners askew from almost every direction. Everything a homeowner paid for became more expensive. Thus there could be a significant squeeze on the ability to make mortgage payments.
By Charlottesvillain, at
Wed Nov 12, 01:49:00 PM:
Escort,
The Treasury and the Fed have been seat of the pants for the past year. They don't know what will work, and will keep trying new things until something does or until they cannot raise any more money. I don't think its any more complicated than that.
I agree with your concerns about government taking equity positions. I strongly suspect it will not result in large capital gains for the tax payer. I do believe that Congress will begin to see this as a lever to force institutions into doing things that they think will get them votes, are not likely to be good uses of capital. I find the whole thing very disconceting, especially since I remain unconvinced that this monumental shift in economic policy won't actually make things much worse in the long term.
By Escort81, at
Wed Nov 12, 03:05:00 PM:
So Treasury/Fed is pretty much like Indiana Jones' line from the original Raiders movie: "I'm just making this up as I go along"?
That's reassuring -- at least Indy didn't end up with his face melted off like that German soldier at the end, once the Ark was opened.
By Escort81, at
Wed Nov 12, 03:13:00 PM:
Oh, and I thought it is worth noting with regards to your oil price bet to be paid off in a few weeks at the family Thanksgiving table -- dated Brent spot oil is just over $51/bbl right now. While TH may have lost the bet, as a consolation, he should at least have first dibs on white meat / dark meat / stuffing.
Anyone want to call the bottom on NYMEX Crude Future prices (close in, currently $56.22/bbl, using the same link at the top of TH's post)? Are sustained forties that far away?
By 
, at
Wed Nov 12, 06:35:00 PM:
My answer to the GM problem
Use some of the TARP fund to buy all the outstanding shares (should take less than $2 billion)
Turn the shares over to the UAW.
Let them figure out how to save their own jobs.
By , at
Wed Nov 12, 07:38:00 PM:
Escort81 ... more appropriate Indy reference is "we have top men working on it" ... these guys are freaking clowns. Honestly, every thing the feds have done has failed to 'stabilize' things. Let these corporations take their lumbs, and I say that even though it'll cost me, and just start over.
Throw the handful of 'top men' responsible for this mess into the can, and just get it over with.
By Purple Avenger, at
Thu Nov 13, 12:56:00 AM:
Are sustained forties that far away?
Close in I won't speculate on, too many noisy unknowns. 15-20 years out, I think it'll be in $20/bbl range.
Middle out, if the Canadians and US flogged the shale/tar thing hard and had any excess capacity, that would essentially peg the the low point at the production cost of those methods.
By , at
Thu Nov 13, 05:57:00 PM:
http://mises.org/story/3132
http://mises.org/story/3142
http://mises.org/story/3154
http://mises.org/story/3161
http://mises.org/story/3169
http://mises.org/story/3202
http://mises.org/story/3085
http://mises.org/story/2257
http://mises.org/story/1611
By , at
Thu Nov 13, 05:58:00 PM:
that last anonymous post was me ADN...
