Commentary - Floating on the Crest of Cheap Credit

In his must read comment in Wednesday's New York Times, author Martin Mayer reminds us all why foreign central banks keep their surplus dollar holdings free of charge with the Federal Reserve Bank of New York. For many market participants, reading about the US dropping the gold standard in the late 1960s or the danger to the economy and the dollar of foreign holdings of US Treasury paper may be a new experience.

But the thing which caught our eye in Mayer's astute opinion piece was the last line, where he warned that a rise in foreign holdings of US Treasury debt could presage "a hard landing for a world economy still floating on the crest of cheap credit." Indeed, is it not remarkable that years into the start of the latest Fed tightening cycle, liquidity remains abundant and credit market behavior continues to deteriorate?

Last week, we heard yet the latest confirmations from two New York area banks that their effective cost of credit is zero -- or even negative. One regional banker, taking issue with how we calculate Loss Given Default for our Basel II metrics in the IRA Bank Monitor, complained that "we have not lost money on a real estate foreclosure in years" and pointed to the still buoyant real estate market in the Northeast as the reason.

Fear not, we're going to stick to our methodology of comparing current period defaults with current period recoveries. We made this decision not after talking to the regional banker, but when a contact in DC confirmed that the FDIC is disbanding many of its bank closure teams due to a lack of bank failures.  It has been seven years since there was a regulatory bank closure in the US.  Call that a trailing indicator.

We also heard from a big bank risk architect, who like his colleague at the regional bank confessed that many lending segments report a zero cost of credit. He noted that when modeling forward LGD, his organization had to go back two economic cycles to make up for the low default rates seen in recent years.

"We don't even update our internal loan default studies because we don't have enough events to make it worth while," the risk architect reports. "LGD is about collateral, not probability of default, thus so long as asset prices remain high, extending credit is going to be a low or zero risk proposition."

The veteran risk practitioner, who like the IRA has enough gray hair to have heard of Martin Mayer, reports that his bank has actually been releasing reserves during some recent periods because loan losses have been so low. Though he uses the 35% long term average LGD as a baseline, the credit officer worries about how high LGDs will go "when the credit cycle worsens" given how long default rates have been below the long term average.

"If we benchmark Basel II at this point in the economic/credit cycle," the big banker concludes, "then we are clearly not going to have sufficient capital in the industry to deal with what lies immediately ahead" in terms of credit events.  This means we'll be adjusting Basel II again in a couple of years."

After that conversation, one of our buy side contacts forwarded a report from Morgan Stanley touting the attractiveness of "equity zeros." The pitch included the now ubiquitous OFHEO/BLS chart showing the sharp rise in real home prices in the US over the past decade, something we highlighted in our last comment.

"Will Real Estate Be the Next Bubble" the pitch asked innocently, but then reassured that "risk tolerance is still high despite shakeup" -- doubtless a reference to the slide in global markets over the past couple of weeks. "Despite the recent aversion," the report went on, "the Global Risk Demand Index (GRDI) says risk reduction has a long way to go."

The report then describes the benefits of taking a position in a zero-coupon tranche of what looks like some type of CDO structure. Says the report: "An 80 bp rise in Treasury rates is worth 3 to five points in a zero."

The buy sider ranted bitterly about the MS report:  "I am so upset I didn't think of this structure!" he yowled. "Think about it, locked in to the first loss in the debt/capital structure till maturity.  You could call it a poor-man's first-to-default single-name CDS. Supposedly these things are red-hot right now with, you guessed it, hedge funds. Why, because of the 'diversity' they provide. Smacks me of getting diversity by playing Russian Roulette with multiple guns."

As any commercial fisherman will confirm, when you are sitting atop the crest of a wave, sometimes it is difficult to judge the depth of the trough which lies just ahead.