Felix Salmon

The duel of the newsweekly pundits continues! The battle

lines were drawn earlier this month, with Justin Fox of

Time saying

that the era of low interest rates is over, and Michael Mandel

of BusinessWeek saying

that in fact low interest rates are here

to stay.

Mandel responded

to Fox on Wednesday, pointing to low(ish) rates on the 10-year Treasury

bond, and saying that credit isn’t drying up across the board:

It is perfectly possible that we could have devastation in one part of the

credit market, while borrowing continued along merrily in other parts. In

fact, that’s what you would expect in an efficient credit market.

Fox then replied

to Mandel on Friday:

My article, being as how it was in Time and not Business Week, was almost

entirely about the rates being paid by U.S. consumers. And guess what: short-term

rates (ARMs, home equity loans, credit cards) are higher than or as high as

they’ve been in years… I’m not predicting some kind of future credit Armageddon,

just stating that, from the perspective of American consumers, the easy money

days are over.

Is this an attempt to kiss and make up? Fox seems to be capitulating, here,

despite the fact that he’s on stronger ground than Mandel is.

For the fact is that credit is drying up – and drying up pretty

much across the board. Unless you’re the US government, you will find it much

harder, or more expensive, to borrow money today than would have been the case

last month.

On the other hand, if you take a bigger-picture view, credit is still very

cheap by historical standards. Maybe that’s one reason why the credit markets

have dried up: the markets are willing to extend credit at vaguely sensible

spreads, but borrowers have become so accustomed to life in the credit bubble

that they’re not willing to borrow at those levels. Hence the stand-off, which

looks like a credit crunch but which in fact is probably just a discontinuous

repricing of credit.

I expect that M&A bankers are likely to take a bit of a breather for the

next month, and return in September with a fat pipe of deals. Which might not

be quite as rich as they would have been in June, but which will still generate

lots of fees all the same. The money’s still there: it’s just a little more

selective than it used to be, is all.

So I certainly don’t think that the current spread widening is reason

for the Fed to cut rates. A rate cut would encourage spreads to stay tighter

than they ought to be, which isn’t sustainable. And it would have more effect

on yields than it would on spreads in any event – and probably precious

little effect on yields, at that. The Fed should stick to worrying about inflation

first and unemployment second. The credit markets can look after themselves.

Alea has found

a tantalizing tidbit from Anthony Morris of UBS, as reported

by Reuters. Apparently CPDOs – structured products which pay high

interest rates on triple-A-rated securities – might have been put together

rather shoddily, at least in the early days:

"We think that early CPDOs, the ones that were introduced last summer

and fall, have a very fundamental problem with them," said Anthony Morris,

executive director in structured products research at UBS on a conference

call on Monday.

"Get out of early CPDO products, I wouldn’t touch them with a 10-foot

pole," Morris said. However, deals backed by higher rated credits have

a lot of value, he said…

If the assumption that "BBB"-rated credits mean revert were taken

out of the ratings models, the deals would be rated 10 notches lower, or an

"AA"-rated deal should be rated "B-plus," four levels

below investment grade, he said.

Morris’s argument is hard to understand from the Reuters precis – if

someone has more detail on its substance, I’d love to see it. But it certainly

fits in to the narrative we’ve been seeing a lot of, recently – the idea

that if you apply finanial voodoo to low-rated debt and end up with high-rated

debt, then those high ratings are not to be trusted. Indeed, Reuters goes on

to quote Morris as making this astonishing assertion:

Leveraging an "A"-rated index by 10 times would still be less volatile

than taking an unleveraged position to high yield credits, or to stocks, he

said.

Isn’t leveraging A-rated debt by 10 times exactly what the more highly levered

of the two Bear Stearns funds did, to disastrous effect? No one invested in

the stock market has seen their position wiped out. Meanwhile, the ABX-HE-A

07-1 index, which reflects the default risk on A-rated securities, has fallen

from 100 at the beginning of this year to 53.67 now. If you invested in that

at a leverage of 10 times, you would have lost 4.6 times your original investment

by this point.

As for the early CPDO products, I’m not convinced. Morris might be right that

some of the calculations assume that BBB-rated default risk mean-reverts. But

if it doesn’t mean revert, then all that’s going to happen is that spreads remain

tight, and losses in credit markets will be very small indeed. Remember that

in order to break a CPDO, you need the very weird combination of tight spreads

and high default rates. And so far, default rates remain at all-time

lows.

Bond investing is not some kind of morality play. As credit spreads widen out,

there’s a meme doing the rounds, that bond investors have it coming to them,

because they were trying to violate the rule of risk and return. Here’s Gretchen

Morgenson, in her column

on Sunday:

Investors bought into the myth of highly rated securities even though their

generous yields should have alerted them to risks.

And here’s Tim Reason, still trying to persuade us that securitization

is a bad thing:

I did a double-take when I read Salmon’s last

line. Securitization he says is "a way of lowering borrowing costs

for companies with bad credit. Which has got to be a good thing."

It can be a good thing. But if a company has bad credit, its borrowing costs

ought to reflect that risk. Sure, there are clever ways around that, but doesn’t

that sound a lot like the scenario that caused the whole subprime mess?

Note the normative language in both cases: "should have", "ought

to". This is much stronger than simply saying that there’s generally a

strong correlation between risk and return. Rather, Morgenson and Reason, and

people like Justin Lahart, who wrote a column along

similar lines a couple of weeks ago, seem to treat the correlation as though

it’s Holy Writ.

Underneath it all is a confusion about what drives yields in two very different

contexts. Some issuers try to minimize yields: if you’re a company or a country

or any other unsecured borrower, you raise debt at the lowest possible cost.

Other issuers, on the other hand, try to maximize yields: if you’re

a CDO or other structured product competing with lots of other CDOs for investors’

funds, then the best way to do that is by offering them more money.

Now it’s true that higher yields don’t always mean higher returns, except for

the corner solution where you have a buy-and-hold investor and default rates

are zero. But there’s also no ex ante reason to believe that higher

yields always mean lower returns, or even lower risk-adjusted returns. And there’s

certainly no reason to believe that a company with bad credit will

do better with high borrowing costs than it would with low borrowing costs.

Quite the opposite, in fact – as has been demonstrated compellingly by

the private equity industry in recent years.

Reason says that borrowing costs "ought to reflect" credit risk.

My response is that, most of the time they do. But that if and when they don’t,

no bolts of lightning will necessarily descend from the Market Gods. And that

in fact, if a company finds a way of borrowing money at a lower rate than its

credit risk might suggest, there’s a good chance it will be able to take advantage

of that fact to do very well for itself, generating a positive-sum outcome for

all concerned.

Tim Reason says

that Jonathan Weil is right

and I’m wrong

when it comes to securitization:

Securitization may have its economic benefits, but it is also a ridiculous

concept, a strained legal and accounting fiction invented by too-clever-by-half

investment bankers. It proves John Kenneth Galbraith’s contention that all

financial innovations are just various forms of leverage with a new name.

Reason is no rube, and he knows

the arguments why securitization is a good thing – I daresay he knows

them better than I do. But his arguments against securitization seem

weak. He’s particularly worried about what

happened at Aspen Technology, where a bunch of off-balance-sheet debt became

on-balance-sheet debt when some accounting rules got violated.

But if you take a step back, it’s really no big deal. If you’re a company,

you can raise money in two ways: you can sell debt, or you can sell equity.

At any time, with the help of your friendly neighborhood financier, you can

convert equity into debt, increasing your leverage, or you can convert debt

into equity, decreasing it. Securitization is just one way of converting equity

into debt – you lose cashflows which used to go straight to the top line,

and you gain a large up-front cash payment.

When Aspen moved a bunch of cashflows which it thought were off its balance

sheet back on to its balance sheet, the opposite thing happened. Its debt went

up, yes. But its income went up too.

Let’s say I own a money machine, which pours money down onto my head. The problem

is that I don’t have a suitable hat, which can catch the money so that I can

then deposit it in a bank account. I go to my bank and ask for a loan to buy

the hat, and they demand a very high rate of interest, because I’m a bad credit.

(After all, I don’t have any money – yet.) So raising debt to buy a hat

is expensive. But raising equity to buy a hat is even more expensive: my friend

Fred will pay for the hat, but only in return for a percentage of all the money

that flows into it in perpetuity. I don’t want to pay off Fred for ever, I just

want to get that hat.

The answer to my problems is securitization. I go to my friend Tom, and he

buys the hat. He doesn’t give me the hat immediately – he keeps possession

of it. And whenever money pours in, he takes that money until he’s paid off

the price of the hat, plus interest. But his interest rate is much lower than

the bank’s interest rate, because he has a guaranteed income from the hat –

which is a much better credit than my sorry self. And when he’s been paid back

for the hat, I get the hat: it’s all mine, and neither Tom nor Fred owns any

of it.

That’s why securitization is a good thing: it’s a way of lowering borrowing

costs for companies with bad credit. Which has got to be a good thing.