Abandon ship

田归农

Investors sail into a credit storm amid worries about the debt markets

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THE symbolism is almost too perfect. According to TheStreet.com, a financial website, John Devaney, a hedge-fund manager, has put his 142-foot yacht Positive Carry up for sale, along with his 16-bedroom mansion in Aspen, Colorado. Funds run by Mr Devaney's group, United Capital, have had to halt payouts to investors after making heavy losses on mortgage-backed bonds.

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Ironically, Mr Devaney's early life pointed to the excesses that were to come. He used his student credit card to buy a house, on which he took out a second mortgage. But Mr Devaney's recklessness was not unusual in the recent global debt bonanza, where rash lending became commonplace. Bank executives will be haunted by memories of Ninja loans (to people with No Income, No Job or Assets) and Pik toggles (agreements that gave firms the right to pay interest in the form of further IOUs rather than cold, hard cash).

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Hedge-fund managers, such as Mr Devaney, were happy to borrow money to buy those loans because they made the “positive carry” that he boasted about; ie, the return on their holdings was greater than the cost of financing them. What they forgot was that relying on positive carry alone comes with a risk: that the debtor will not repay the loan.

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Now, at last, investors and lenders have woken up. Credit spreads, the premium that riskier borrowers must pay over government debt, have surged since June. That is a problem for companies and banks in the middle of doing deals. Financing packages for the takeovers of Alliance Boots, a British health-care chain, and Chrysler, America's third-biggest car giant, have been postponed. Merrill Lynch says some 35 bond or loan deals have been cancelled or restructured in the past five weeks. And it is not just the riskiest borrowers that have been affected. Globally, only $98 billion of investment-grade bonds (to the most creditworthy borrowers) were issued in July, the lowest since August 2004.

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The stockmarket has reacted with alarm to this credit squeeze, partly because it was counting on a continuous stream of debt-financed takeovers to push share prices higher. That confidence has now gone, and with it the market's swagger.

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The change in mood was swift. On July 19th, the Dow Jones industrial average closed above 14,000 for the first time. By July 27th investors were as risk averse as at any time since September 2001, according to UBS's risk index. But for all the nervousness, there has not (yet) been a calamitous decline in share prices. In percentage terms, the 311-point fall in the Dow Jones Industrial Average on July 26th was only the 698th largest in history. The Dow has yet to fall 10%, the level that qualifies as a correction in market lore.

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As for credit markets, the remarkable thing is the low level of spreads before the sell-off, rather than where they are now (see chart). Spreads would have to double to get back to the levels of the early 1990s and almost triple to be where they were after Enron and WorldCom collapsed in 2002. And thanks to lower yields on government bonds (as investors sought out safer assets), the price of debt for companies with a Baa rating from Moody's is little changed from mid-July, according to the Federal Reserve.

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Many companies have no need to borrow. Corporate profits are still rising, although at a slower pace than in recent years. Jan Hatzius of Goldman Sachs points out that American companies overall have enough cashflow to cover their capital expenditure.

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Nor are firms having problems paying back their existing debts. According to Jim Reid of Deutsche Bank, the global default rate is 1.38%, near the bottom of its historical range. Standard & Poor's, a ratings agency, had 621 bonds on standby for a downgrade in mid-July; that was slightly below the 12-month average.