DANGER WARNING: WHEN BOND ISSUERS PLAY FOR TIME

The famous British economist A.C.Pigou, whose equilibrium theories became part of the neo-conservative view of monetarism, was a KGB agent-recruiter and passionate climber. He knew it can be as dangerous in deciding how to descend a difficult mountain as to climb it; the inclination is to use the same hand and foot holds coming down as were made going up. All holds that sap your strength or might give way under strain have to be correctly judged as merely temporary, not a fit subject for betting on the better purchase value of delaying decisions. When poor health meant he could no longer risk taking potential recruits climbing he entertained them instead to cream teas by the river as his suitability test. In both tests he who hesitated was lost.
A STITCH IN TIME SAVES NINE
Bank and Corporate bond issuers are repeating the mistakes of the credit crunch by hoping for lower spreads if they delay a few weeks or months! This is irresponsible and dangerous! How did such postponements trigger the credit crunch and recession?
One analogy comes from the question behind Obama's health care reform: if medicines cost money and are expensive, and instead of taking doses regularly as prescribed do you save money by waiting longer between dosages; do you risk a worse sickness?
It is inevitable that in business the main medicine is money, and the medicine cabinet is the bank.
Just as many medicines deal only with symptoms while buying time for the body to heal itself, so too does borrowing buy future time to pay for investments made now. As the world trade imbalance became extreme between credit-boom economies, that ballooned household debt backed by rising property wealth, and export-led economies, that suppressed household wealth and lent heavily to industrial companies, banks in both types of economy became over-lent, one to property, the other to production. We know how household and finance lending grew enormously in credit-boom economies, but so did it too in export-led economies e.g. Germany. Germany and China with the world's highest trade surpluses and described as awash with savings, do not have great financial resources internally. Their banks are also vulnerable from lending too much to business as UK and US banks lent too much to property. China has desperately tried to maintain its growth by expanding credit and now is rightly frightened about this, about how poorly Chinese manufacturers can service their debt and is cutting back. The credit crunch put a stop to the previous extreme imbalance in the pattern of world trade and its deficit financing. In credit-boom economies the banks went global, serving an international market (globalisation) that is only partly evidenced by banks' assets in ratio to home country GDP.BANKS POSTPONE DECISIONS AND FALL INTO WORSE LOSSES: examples
1. Economists saw the economic cycle peaking in 3Q 2005 and cyclically turning down a year later. To global macro-economists (of which there are precious few) the extreme imbalances in world trade were obviously unsustainable for much longer. Investment returns in property especially fell below bank deposit rates, and GDP growth in credit-boom economies slowed. Property markets peaked: sales dried up; prices falling patchily at first, then nationwide in the USA. Bankers smoothed the problem by upping issuance of securitised bonds to make mortgage lending self-financing short term and in credit derivatives leveraged up to chase paper-profits in unrealised asset gains as net disposable incomes and savings fell. Any banks who could borrow more by issuing bonds did so. They postponed the onset of 'Anglo-Saxon' credit recession by 1-2 years.
2. US and UK banks had $30 trillions of foreign balance sheets a ratio of 50% to world total output and 100% of world trade - that dominated the world's trade imbalances financing and international funding of banks round the world. They postponed withdrawing that liquidity until 2008-09 when it shrank by $3 trillions. The following graphic only shows the dominance of UK and US banks in private customer lending.3. After June 2007, when asset backed securities issued by banks were day after day downgraded following Moody's fixing its false ratings model. Moody's had graded half of all securitised asset-backed loans. Fixing its model and then regrading all of these sent the market values of the banks' bonds tumbling and directly triggered the credit crunch of interbank lending becoming too expensive to sustain banks' interest margins. Banks needed typically 1.5% lending margins. When margins fell to 0.5% (50bp), the banks sought 150bp from fees alone from lower quality tranches ABS. When the quality of bank bonds became exposed, bank shares weakened internationally and continued falling for 22 months. From August 2007 the interbank market for financing banks' funding gaps became expensive. 4. In Summer '07, Northern Rock with £110bn assets and the highest funding gap (between deposits and loans) based on growing aggressively several times faster than the growth of deposits, found, like many banks, that it could not book forward refinancing at rates to maintain its aggressively low interest rate margin and tried to postpone doing so in hope that funding rates would soften, but its board insisted on going to Bank of England for liquidity support - that became public thanks to the BBC. There was a run on the bank that became a worldwide news spectacle.
5. Q1'08 Bear Stearns collapsed when it failed to meet collateral margin calls. Other banks like Citicorp, HBoS, UBS, WaMu, M-L, and others face short-seller attack based on rumours they cannot economically refinance their borrowings at a price needed to maintain their lending margins, especially in corporate loans.6. Many banks bet that the fall in bank shares and in asset backed securities and credit derivatives would be temporary because underlying net cash flows remained strong e.g. Lehmans and RBS buying more stressed assets because they looked cheap, and Barclays trying to do so but luckily failing! UBS dumped loss-making assets into customers' 'profits-only' savings accounts! But they were wrong and had under-estimated the impact on their balance sheets and capital of write-downs and growing loan-loss provisions. Some banks had backed their contrarian wishful thinking by maximising their leverage to the extent of breaking the rules and limits on capital reserves and risk diversification, most especially Lehman Brothers. September '08, Merrils, AIG, Lehman Brothers, and HBoS, followed by RBS and Fortis, and others need emergency saving; they have hit absolute cash-flow insolvency. Lehman (with £0.8tn of claims against it) is allowed to collapse and $2.5 trillion of failed trades (were sellers had gone short) hit money markets. Central banks have to balloon their balance sheets (both sides) to save national and international banking system.
7. The inter-bank funding market spread, already expensive but slowly falling, in Q3 & Q4 '08 spiked and funding dried up almost totally - The Credit Crunch - requiring central banks to step in and replace private funders by taking banks' loanbooks (securitised or simply 'covered) as collateral for central bank counterparty assets.
At the time I said, and in hindsight it became clear, that had banks accepted the higher cost of funding refinancing as their notes became due, which would have proved temporary, their realised profit fall or losses (also temporary) and capital reserve loss, would have been a mere fraction of the losses they did incur.
The banks would have had to rapidly and radically adjust their business models. They resisted this or simply did not know how to or even lacked the management authority within their sprawling financial conglomerates to do so?
CORPORATE BOND ISSUERS
Denied bank loan growth and suffering balance sheet deteriorations, corporate borrowers found themselves having to offer junk bond rates at 9% typically, or double the spiked rates that the banks had refused to accept! Since April 2009 equities began recovering and bank funding rates softened, but in expectation that rates will significantly fall further, now many companies are deferring the renewal of committed revolving credit facilities.
Instead of simply accepting the price today, they are speculating, betting, living in hope that an improving market leads to better pricing, terms, and maturity. They have rapidly it seems failed to draw the lessons of, or forgotten, how at the peak of the credit crisis, revolving credit facilities - to fulfill their purpose as standby liquidity in the case of unforeseen events or to maintain the current balance of both sides of their balance sheets. As companies faced acute operating stress,drying of the bond, securitization and commercial paper markets, that meant changes in bank lending capacity and behaviour, revolving credit became the most critical factor in
corporate liquidity, just as it did for banks.
Draw-down of revolving credit commitments was historically considered a red flag viewed as a precursor to bankruptcy. As bank credit tightened and undrawn overdrafts were cut in the credit crisis, covenant violations, revolving credit maturities, or simply the capacity and willingness of banks to fund their commitments undermined the accepted practice of incorporating undrawn revolving credit capacity into an aggregate liquidity number.
As the uncertainties of the crisis grew, drawing down on revolving credit agreements became more commonplace and was often viewed as a prudent strategy as opposed to an unequivocal warning sign. At the depth of the crisis, revolving credit commitments extended by the banks became often limited to 364-day or two-year facilities as a result of bank capital ratio stress and negatively viewing corporate credit risk.
Corporates found that bank facilities only provided short-term liquidity protection and added to refinancing risks that in a prolonged period of high uncertainty (in trade, business and capital markets) undrawn credit facilities no longer offered long-term standby liquidity to weather the economic cycle and/or other credit risks.
BANKS RESTRUCTURING (SHRINKING) BALANCE SHEETS
Banks' balance sheets behave pro-cyclically, ballooning in cycle peak years, then suddenly shrinking in recession shcok and being slow to grow again in recovery years.
In the initial two years of the economic upswing after 2001 it was not loan demand, but reduction in bad loss provisioning that drove banks' earnings, followed by sharp rises rising on the warm air of the newsflow on corporate profits, plus aggressive cost-ratio cutting.
The rise then levelling out of loan demand and credit defaults falling to low default rates (dramatically lower default risk, easiest to achieve when new loans are easy or cheap), junk credit spreads fell from around 20% to below 8%. Unsurprisingly, bank share prices doubled in 2003 in six months, smartly outperforming the broader market.
Capital investment and bank lending to support this grew in the export-led countries. Utilisation rates in the US, Germany and Japan all moved higher along with profits for the corporate sector.
The UK and USA household credit cycle peaked in 2005. When recession was obvious by end of '07 and into '08, corporate debt expanded for a while even when the household sector's began to slow and residential property prices fell. Then, beginning with property developers, corporate debt looked very risky. But, the embarrassment of the corporate sector appears deeper but shorter lived than the household sector. UK and
US house prices appear now in Q1 '10 to be slowly on the rise. With greater backlog of orders, US firms are no longer cutting working hours, and unemployment rates are only edging higher after having moved up substantially in '09. In the UK, unemployment is a third less than normally be expected.
Some rise in consumer confidence is feeding through to the housing market, but based on a preponderance of buying properties at heavy discount and a lot of bank-owned properties being held off the market. Home sales are off their lows and, most importantly for banks, house prices appear to be forming a bottom. With a sharp reduction in loss provisioning, bank earnings ought to rise through 2010.
The steep yield curve is currently exceptionally helpful for the banks; about half of bank assets are lent at long- term rates, and 3-month LIBOR is c.50bp. As banks hold the line against growing loans (that fell 8% in 2009 by US and UK banks), banks can add to their Treasury holdings to further benefit from the yield curve. UK and USA Bank holdings of Treasuries have risen by $half a trillion over the past year and will increase substantially more to build up capital buffers.
In doing so, however, shrinking their loan books, the banks are not helping economic recovery. They are putting their narrow interests first and using new regulatory requirements to do so. Corporate bond issuers appear to be joining in the deleveraging, which means delaying capital investment, and now on top of this also delaying new net corporate bond issues?