Sunday, August 30, 2009

Naked Capitalism: Party Time! Wall Street Back to Its Old Highly Levered Ways

Party Time! Wall Street Back to Its Old Highly Levered Ways

Bloomberg reports that Wall Street is back to its free-wheeling, high-levered ways. This is a classic example of moral hazard in action. Why worry about blowing up the bank when you know the taxpayer will bail you out?

From Bloomberg (hat tip DoctoRx):

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

Yves here. That is a big increase in repo lending. Greenspan used to look at repos as a proxy for hedge fund leverage. And when repo lending contracts, as it did in the crisis, it tends to do so across a wide range of collateral as banks increase haircuts, leading to synchronized downturns.

And we get these tidbits:

The increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments....

Yields on top-ranked debt backed by auto loans and credit cards have fallen by as much as 2 percentage points relative to benchmark rates. The yield premium has shrunk to less than 1 percentage point since TALF began in March, according to Charlotte, North Carolina-based Bank of America Corp. data. The average interest rate on loans for new cars declined to 3.88 percent in June, from 8.23 percent in January, Fed data show.

Yves again. Note how auto lenders, who are mainly out to subsidize sales, are passing on the improvement in terms, while banks are instead using the fatter margins on credit cards to boost profits.

We clearly have not learned the lessons of the crisis, that leverage increases risk and fragility, period. We've thrown massive backstops against the financial system with no checks on risk-taking, and we are getting precisely the sort of behavior you'd expect. Worse, everyone assumes any problems would arise gradually, when shifts tend to be suddenly, more like phase changes. As an op-e, "This Economy Does Not Compute," by Mark Buchanan in the New York Times last year noted:

For example, an agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

Now this is admittedly just a model, but it seems far more descriptive of what we've just been through than anything the Fed appears to be using. And if it proves valid, relevering will proceed until we hit a trigger point again.

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