If any of the ingredients that make up a new and powerful financial crisis are missing from the current commercial bouillabaisse, it is awfully difficult to discern just what they might be.
The crux of the problem is not the obvious fact that the Dow Jones industrial average has been on a nearly uninterrupted five-year meteoric rise and is fast approaching 17,000. Or that the Standard & Poor’s 500-stock index is also at its all-time high. Or that we are again being treated to one absurd example after another of valuations gone wild in Silicon Valley: Uber at $18.2 billion anyone, up a mere $8 billion in weeks? WhatsApp at $19 billion? Snapchat worth more than $3 billion in Facebook’s cash?
“Short-term gain isn’t very interesting,” Evan Spiegel, Snapchat’s chief executive, told Forbes this year in explaining why he rejected the Facebook offer that would have paid him personally about $750 million for an app that lets users send photos that disappear after a few seconds.
No, the problem is that — just as in the year or so before September 2008 — the credit markets are once again badly mispricing risk. Thanks to the easy-money policies in ascendancy among central bankers around the world, which have pushed down interest rates to historically low levels, investors are desperate for yield, or higher returns on their money. The ensuing feeding frenzy is causing otherwise intelligent people to lose their minds about the risks they are taking with their own and other people’s money. It’s as if the debt markets can no longer conceive of a situation where things can go wrong, which is usually the precise moment when they do.
The evidence is everywhere. For instance, according to Barclays, the average yield on so-called junk bonds, or bonds issued by companies with less-than-stellar credit, was 4.99 percent last week, about half the historical yield for such bonds. The idea that investors would be so desperate for yield that they would bid up the prices of these bonds may make some sense on a relative basis — they are still yielding more than, say, the 10-year Treasury, which yields 2.6 percent — but on an absolute basis, it is a recipe for disaster. Lots of money will be lost when the tide inevitably turns.
But the “yield hunger games” show no signs of abating, as Matt Toms, the head of United States fixed income at Voya Investment Management, told The Financial Times. The issuing of “payment-in-kind” securities, which allow companies to pay investors for the use of their money in more risky paper rather than in cash, have soared so far in 2014, to $4.2 billion, the highest amount since the same period in 2007, when the issuance was $5.6 billion. In exchange for taking on the risk of not getting paid in cash, these “PIK” securities yield about 50 basis points, or 0.5 percentage point, more than those that pay cash. This is patently absurd, except in the land where, thanks to the Federal Reserve’s quantitative easing program, savers receive close to zero percent interest from the banks where they keep their money.
But wait, there’s more. Bonds backed by car-lease payments are on track for record issuance this year. Sales in the United States of high-yield collateralized debt obligations — packages of loans made to companies with shaky credit and sold as bonds — are also likely to achieve a record level of issuance this year. Securities backed by commercial real estate mortgages reached $102 billion in 2013, their highest point since 2007, when $231 billion worth was issued. Then there’s the increasing issuance of what are known as cov-lite loans, or bank loans made to companies with risky credit ratings that are devoid of the usual restrictive covenants that allow banks to monitor closely a company’s financial performance to determine whether it will pay back the money. So far in 2014, cov-lite loans have accounted for 55 percent of the new issuance in the market — or $131 billion — six times the level in the period a year earlier. Investors are further trying to goose the return on these investments by using leverage — or borrowing money at the low rates the central banks have devised instead of using more of their own equity.
In sum, in six short years we have rebuilt the proverbial house of cards that many thought could not happen again in our lifetimes, given what we collectively experienced in 2008. As usual, some people have been sounding the warning bells. They are known as the Credit Cassandras and, increasingly, no one wants to listen to them.
“A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to ‘reach for yield,’” the former Fed governor Jeremy C. Stein told a group of investors and bankers at the New York Athletic Club in February.
No less an investing guru than Seth Klarman, who manages the $27 billion Baupost Group hedge fund in Boston, warned his fortunate investors in his 2013 management letter that trouble was on the horizon. “A skeptic would have to be blind not to see bubbles inflating in junk bond issuance, credit quality and yields, not to mention the nosebleed stock market valuations of fashionable companies like Netflix and Tesla,” he wrote. “The overall picture is one of growing risk and inadequate potential return almost everywhere one looks.”
In March, David Stockman, the former Reagan budget director, started a blog dedicated to exposing the growing risks in the markets. In a recent interview, he predicted that “2014 is the year of the endgame. The party is over.”
At the SkyBridge Alternatives Conference in Las Vegas in May, David per, the hedge fund billionaire who made $3.5 billion in 2013 alone — tops among his peer group — warned a packed room that trouble was looming.
“I am nervous,” he said. “I think it’s nervous time.” He said he thought the markets were in a “mixed environment,” where caution should reign. “It’s a funny thing,” Mr. Tepper said. “When things are really horrible, we have this saying, ‘The worse things get, the better they get.’ When they’re really, really frickin’ horrible, they usually go up. But when they’ve been good, there is complacency. I just think you have a lot of frickin’ complacency out there. Listen, I’m not saying go short. I’m just saying don’t be too frickin’ long right now.”
The Dow dropped 167 points the day after Mr. Tepper voiced his concerns.
Part of Mr. Tepper’s prescription for reducing the risk of continued deflation in Europe — one of his many concerns — was to urge Mario Draghi, the head of the European Central Bank, to lower interest rates at its June meeting. Last week, Mr. Draghi did just that. He cut the E.C.B.’s main refinancing rate to 0.15 percent from 0.25 percent and its deposit rate to minus 0.1 percent from zero, making it the first main central bank to charge big banks to keep their money on deposit. Stock markets around the world soared.
It’s clear that with central banks intentionally engineering interest rates to be at historically low levels, thwarting the rules of supply and demand, the desperate hunt for yield will continue unabated and risk will continue to be mispriced. When the blowup comes — and that will be soon enough — at least this time no one can claim to be surprised.
William D. Cohan is a former senior mergers and acquisitions banker who has written three books about Wall Street. His latest book is “The Price of Silence: The Duke Lacrosse Scandal, the Power of the Elite, and the Corruption of Our Great Universities.”