Nouriel Roubini | Jul 30, 2007
It is always risky to call an equity market peak and the beginning of a bear market in equities; so I will not try to do that. But leaving aside equity valuations, it increasingly looks like we are at the peak of a credit/debt cycle, in the US and globally.
Specifically, the crucial macro question that we should ask ourselves today is whether we are at the peak of a Minsky Credit Cycle. Or as the UBS economist George Magnus – an expert of financial instability - put it: “Have we reached a Minsky moment?”
Hyman Minsky was an American economist who died in 1996. His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.
The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions.
Minsky’s ideas and model fit nicely the last two US credit booms and asset bubbles that ended up in a recession: the S&L-based real estate boom and bust in the late 1980s; and the tech bubble and bust in the late 1990s. But the experiences of the last few years suggest another Minsky Credit Cycle that has probably now reached its peak. First, it was the US households (and households in some other countries) that releveraged excessively: rising consumption, falling and negative savings, increased in debt burdens and overborrowing, especially in housing but also in other categories of consumer credit, an increase in leverage that was supported by rising asset prices (housing and, more recently, equity). We know now that many sub-prime borrowers, near-prime borrowers and many condo-flippers were exactly the Minsky “Ponzi borrowers”: think of all the “negative amortization mortgages” and no down-payment and no verification of income and assets and interest rate only loans and teaser rates. About 50% of all mortgage originations in 2005-2006 had such characteristics. Also, many other households (near prime and subprime borrowers) were Minsky “speculative borrowers” who expected to be able to refinance their mortgages and debts rather than paying a significant part of their principal.
The Minsky idea of loosening of credit/lending standards among mortgage lenders – and the phenomenon of supervisors/regulators falling asleep at the wheel while the reckless credit bubble occurs – is also now evident in the recent mortgage credit cycle. A supervisory ideology that tried to minimize any prudential supervision and regulation and totally reckless lending practices by mortgage lenders led to a massive housing and mortgage bubble that has now gone bust. The toxic waste aftermath of this bust includes more than fifty subprime lenders gone out of business this years, soaring rates of delinquency, default and foreclosure on subprime, near prime and non-conventional mortgages, and the biggest housing recession in the last few decades with now home prices falling for the first time – year over year – since the Great Depression of the 1930s.
While the process of releveraging started in the household sector – that is the most financially stretched sector of the US economy – the releveraging more recently spread to the corporate and financial system: in the financial system the rise of hedge funds, private equity and speculative prop desks led to a sharp rise in the financial system leverage. In the corporate sector given the cheapness - until recently - of credit we observed a massive process of switch from equity to debt that took the form of leveraged buyouts, share buybacks and privatization of formerly public companies. This releveraging fed that equity/asset bubble: as expectations of more LBOs occurred equity valuation of many firms went higher and higher. The excesses took recently the form of premia of 40-50% or higher on the stock price of firms that were a leveraged takeover target. Specifically, CLO demand for corporate debt helped fuel the private equity sponsored LBO wave over the past few years, and thus contributed to the recent bull market in equities. Notice also that the amount of issuance of low grade corporate bonds (below investment grade “junk bonds”) had been rapidly rising in the last few years.
While pure “Ponzi” borrowers were not as common in the corporate system, there is wide evidence of “speculative borrowers” who relied and still rely on continued refinancing of their debts. Ed Altman, a colleague of mine at Stern, is recognized as the leading world academic expert on corporate defaults and distress. He has argued that we have observed in the last few years record low default rates for corporations in the U.S. and other advanced economies (1.4% for the G7 countries this year). The historical average default rate for US corporations is 3% per year; and given current economic and corporate fundamentals the default rate should be – in his view - 2.5%. But last year such corporate default rates were only 0.6%, one fifth of what they should be given fundamentals. He also noted that recovery rates - given default - have been high relative to historical standards.
These low default rates are driven in part by solid corporate profitability and improved balance sheets. In Altman’s view, however, they have also been crucially driven - among other factors - by the unprecedented growth in liquidity from non traditional lenders, such as hedge fund and private equity. Until recently, their demand for corporate bonds kept risk spreads low, reduced the cost of debt financing for corporations and reduced the rate of defaults. Earlier this year Altman argued that this year "hot money" from non traditional lenders could move to other uses for a number of reasons, including a repricing of risk. If that were to occur, he argued that the historical patterns of default rates - based on firms’ fundamentals - would reassert itself. I.e. we are not in a new brave world of permanently low default rates. He said: "If we observe disappointing returns to highly leveraged and rescue financing packages, some of the hedge funds may find it difficult to cover their own loan requirements as well as the likely fund withdrawals. And broker-dealers who are not only providing the leverage to the hedge funds but whom are also investing in similar strategy deals will recede from these activities." The same could be said of the consequences of the unraveling of some leveraged buyouts. Altman suggested that triggers of the repricing of credit risk could also be "disappointing returns to highly leveraged and rescue financing packages". So he argued that the unraveling of the low spreads in the corporate bond market could occur even in the absence of changes in US and/or global liquidity conditions.
Thus, until recently the Minsky “speculative borrowers” in the corporate sectors included corporations that could service their debt only by refinancing such debt payments at very low interest rates and financially favorable conditions. While “Ponzi borrowers” were those firms that, under normal liquidity conditions, would have been forced into distress and debt default (either of the Chapter 7 liquidation form or Chapter 11 debt restructuring form) but were instead able to obtain out-of-court rescue and refinancing packages because of the most easy credit and liquidity conditions in bubbly markets.
The Minsky phenomenon of loosening credit and lending standards during a credit bubble included both the corporate borrowers and financial institutions. First, there are clear parallels between the mortgage market and the leveraged loan markets. These include corporate borrowers’ high leverage ratios, declining credit standards (“cov-lite” loans instead of subprime), PIK (or payment-in-kind) deals (variants of negative amortization), insufficient monitoring by lenders due to the “originate and distribute” model (loans repackaged into CLOs instead of CDOs), banks’ retained exposure (bridge loans as opposed to CDO equity tranche). In the financial system, margin requirement for hedge funds and other leveraged speculators became lower and lower as the competition for prime brokerage services for hedge funds among lenders became fierce.
Housing bubble, mortgage bubble, credit bubble, debt bubble and asset prices (equities, housing, prices of corporate debt and other risky loans) rising well below what could be justified by the economic and credit fundamentals. It certainly looked like a typical Minsky Credit Cycle. The first crack in this cycle was the bust of housing and of subprime mortgages in the US. The second crack was the spread of the subprime carnage to near prime and prime mortgages and to subprime credit cards and auto loans. The third crack is the most recent repricing of risk in a variety of credit markets and the beginning of a credit crunch in the LBO and corporate credit markets.
We are clearly now observing a significant worsening in US financial conditions and a peaking of the Minsky Credit Cycle in a variety of markets:
- a housing recession that is getting worse by the day and home prices now falling (for the first time since the Great Depression) as the housing asset bubble has now burst.
- a credit crunch in subprime that is now spreading to near prime (Alt-A) and prime mortgages (see the Countrywide financial results) and to subprime credit cards and subprime auto loans;
- massive losses - at least $100b in subprime alone and most likely to end up higher – in the mortgage markets;
- a significant recent increase in corporate yield spreads (by 100 to 150 bps);
- the beginning of a liquidity crunch in capital markets that starts to look like the one experienced during the LTCM crisis (10 year swap spreads are - at 70bps - at their highest levels since 2002 and close to the levels that triggered the 1998 LTCM crisis);
- the effective shut down of the CDO and CLO markets as investors risk aversion towards complex derivative instruments - whose official ratings are clearly bogus given the subprime ratings debacle - is sharply up;
- the overall increasing stresses in a variety of credit markets ("a constipated owl" where "absolutely nothing is moving" is how Bill Gross of Pimco described the effective recent shutdown of the CDO market);
- credit default swap spreads being sharply up;
- the ABX, TABX, LDCX, CMBX, CDX, iTraxx indices all showing rising risk aversion of investors, sharply rising credit default spreads and significant concerns about credit risk in a variety of credit markets (US, Europe and Japan corporate, high yield corporate, commercial real estate, leveraged loans), not just in subprime or in mortgage markets.
Note also that, as Minsky - as well as more recently the BIS – have warned the deflation of such credit-driven asset bubbles is historically painful and associated with economic downturns and recessions. So “Have we reached a Minsky moment?” It certainly looks like it. Let me now explain why…