Are
We at The Peak of a Minsky Credit Cycle ? Are
We at The Peak of a Minsky Credit Cycle ?
Nouriel Roubini.
It is always risky to call an equity market peak and the beginning of a
bear market in equities; so I will not try to do that. But leaving aside
equity valuations, it increasingly looks like we are at the peak of acredit/debt
cycle, in the US and globally.
Specifically, the crucial macro question that we should ask ourselves today
is whether we are at the peak of a Minsky Credit Cycle. Or as the UBS economist
George Magnus – an
expert of financial instability - put it: “Have we reached a Minsky moment?”
Hyman Minsky was an American economist who died in 1996. His main contribution
to economics was a model of asset bubbles driven by credit cycles. In his view
periods of economic and financial stability lead to a lowering of investors’ risk
aversion and a process of releveraging. Investors start to borrow excessively
and push up asset prices excessively high. In this process of releveraging
there are three types of investors/borrowers. First, sound or “hedge
borrowers” who
can meet both interest and principal payments out of their own cash flows.
Second, “speculative
borrowers” who
can only service interest payments out of their cash flows. These speculative
borrowers need liquid capital markets that allow them to refinance and roll
over their debts as they would not otherwise be able to service the principal
of their debts. Finally, there are “Ponzi borrowers” cannot
service neither interest or principal payments. They are called “Ponzi
borrowers” as they need persistently
increasing prices of the assets they invested in to keep on refinancing their
debt obligations.
The other important aspect of the Minsky Credit Cycle model is the loosening
of credit standards both among supervisors and regulators and among the financial
institutions/lenders who, during the credit boom/bubble, find ways to avoid
prudential regulations and supervisions.
Minsky’s ideas and model fit nicely the last two US credit booms and
asset bubbles that ended up in a recession: the S&L-based real estate boom
and 
bust in the late 1980s; and the tech bubble and bust in the late 1990s.
But the experiences of the last few years suggest another Minsky Credit Cycle
that has probably now reached its peak. First, it was the US households (and
households in some other countries) that releveraged excessively: rising consumption,
falling and negative savings, increased in debt burdens and overborrowing,
especially in housing but also in other categories of consumer credit, an increase
in leverage that was supported by rising asset prices (housing and, more recently,
equity). We know now that many sub-prime borrowers, near-prime borrowers and
many condo-flippers were exactly the Minsky “Ponzi borrowers”:
think of all the “negative
amortization mortgages” and no down-payment and no verification of income
and assets and interest rate only loans and teaser rates. About 50% of all
mortgage originations in 2005-2006 had such characteristics. Also, many other
households (near prime and subprime borrowers) were Minsky “speculative
borrowers” who expected to be able to refinance their mortgages and debts
rather than paying a significant part of their principal.
The Minsky idea of loosening of credit/lending standards among mortgage lenders – and
the phenomenon of supervisors/regulators falling asleep at the wheel while
the reckless credit bubble occurs – is also now evident in the recent
mortgage credit cycle. A supervisory ideology that tried to minimize any prudential
supervision and regulation and totally reckless lending practices by mortgage
lenders led to a massive housing and mortgage bubble that has now gone bust.
The toxic waste aftermath of this bust includes more than fifty subprime lenders
gone out of business this years, soaring rates of delinquency, default and
foreclosure on subprime, near prime and non-conventional mortgages, and the
biggest housing recession in the last few decades with now home prices falling
forthe first time – year over year – since
the Great Depression of the 1930s.
While the process of releveraging started in the household sector – that
is the most financially stretched sector of the US economy – the releveraging
more recently spread to the corporate and financial system: in the financial
system the rise of hedge funds, private equity and speculative prop desks led
to a sharp rise in the financial system leverage. In the corporate sector given
the cheapness - until recently - of credit we observed a massive process of
switch from equity to debt that took the form of leveraged buyouts, share buybacks
and privatization of formerly public companies. This releveraging fed that
equity/asset bubble: as expectations of more LBOs occurred equity valuation
of many firms went higher and higher. The excesses took recently the form of
premia of 40-50% or higher on the stock price of firms that were a leveraged
takeover target. Specifically, CLO demand for corporate debt helped fuel the
private equity sponsored LBO wave over the past few years, and thus contributed
to the recent bull market in equities. Notice also that the amount of issuance
of low grade corporate bonds (below investment grade “junk bonds”)
had been rapidly rising in the last few years. While pure “Ponzi” borrowers
were not as common in the corporate system, there is wide evidence of “speculative
borrowers” who relied and still rely on continued refinancing
of their debts. Ed Altman, a colleague of mine at Stern, is recognized as the
leading world academic expert on corporate defaults and distress. He has argued
that we have observed in the last few years record low default rates for corporations
in the U.S. and other advanced economies (1.4% for the G7 countries this year).
The historical average default rate for US corporations is 3% per year; and
given current economic and corporate fundamentals the default rate should be – in
his view - 2.5%. But last year such corporate default rates were only 0.6%,
one fifth of what they should be given fundamentals. He also noted that recovery
rates - given default - have been high relative to historical standards.
These low default rates are driven in part by solid corporate profitability
and improved balance sheets. In Altman’s view, however, they have also
been crucially driven - among other factors - by the unprecedented growth in
liquidity from non traditional lenders, such as hedge fund and private equity.
Until recently, their demand for corporate bonds kept risk spreads low, reduced
the cost of debt financing for corporations and reduced the rate of defaults.
Earlier this year Altman argued that this year "hot money" from non
traditional lenders could move to other uses for a number of reasons, including
a repricing of risk. If that were to occur, he argued that the historical patterns
of default rates - based on firms’ fundamentals - would reassert itself.
I.e. we are not in a new brave world of permanently low default rates. He said: "If
we observe disappointing returns to highly leveraged and rescue financing packages,
some of the hedge funds may find it difficult to cover their own loan requirements
as well as the likely fund withdrawals. And broker-dealers who are not only
providing the leverage to the hedge funds but whom are also investing in similar
strategy deals will recede from these activities." The same
could be said of the consequences of the unraveling of some leveraged buyouts.
Altman suggested that triggers of the repricing of credit risk could also be "disappointing
returns to highly leveraged and rescue financing packages". So he argued
that the unraveling of the low spreads in the corporate bond market could occur
even in the absence of changes in US and/or global liquidity conditions.
Thus, until recently the Minsky “speculative borrowers” in the
corporate sectors included corporations that could service their debt only
by refinancing such debt payments at very low interest rates and financially
favorable conditions. While “Ponzi borrowers” were
those firms that, under normal liquidity conditions, would have been forced
into distress and debt default (either of the Chapter 7 liquidation form or
Chapter 11 debt restructuring form) but were instead able to obtain out-of-court
rescue and refinancing packages because of the most easy credit and liquidity
conditions in bubbly markets. The Minsky phenomenon of loosening credit and
lending standards during a credit bubble included both the corporate borrowers
and financial institutions. First, there are clear parallels between the mortgage
market and the leveraged loan markets. These include corporate borrowers’ high
leverage ratios, declining credit standards (“cov-lite” loans instead
of subprime), PIK (or payment-in-kind) deals (variants of negative amortization),
insufficient monitoring by lenders due to the “originate and distribute” model
(loans repackaged into CLOs instead of CDOs), banks’ retained
exposure (bridge loans as opposed to CDO equity tranche). In the financial
system, margin requirement for hedge funds and other leveraged speculators
became lower and lower as the competition for prime brokerage
services for hedge funds among lenders became fierce.
Housing bubble, mortgage bubble, credit bubble, debt bubble and asset prices (equities, housing, prices of corporate debt and other risky loans) rising well below what could be justified by the economic and credit fundamentals. It certainly looked like a typical Minsky Credit Cycle. The first crack in this cycle was the bust of housing and of subprime mortgages in the US. The second crack was the spread of the subprime carnage to near prime and prime mortgages and to subprime credit cards and auto loans. The third crack is the most recent repricing of risk in a variety of credit markets and the beginning of a credit crunch in the LBO and corporate credit markets.
We are clearly now observing a significant worsening in US financial conditions
and a peaking of the Minsky Credit Cycle in a variety of markets:
- a housing recession that is getting worse by the day and home prices now
falling (for the first time since the Great Depression) as the housing asset
bubble has now burst.
- a credit crunch in subprime that is now spreading to near prime (Alt-A) and
prime mortgages (see the Countrywide financial results) and to subprime
credit cards and subprime auto loans;
- massive losses - at least $100b in subprime alone and most likely to end
up higher – in the mortgage markets;
- a significant recent increase in corporate yield spreads (by 100 to 150 bps);
- the beginning of a liquidity crunch in capital markets that starts to look
like the one experienced during the LTCM crisis (10 year swap spreads are
- at 70bps - at their highest levels since 2002 and close to the levels that
triggered the 1998 LTCM crisis);
- the effective shut down of the CDO and CLO markets as investors risk aversion
towards complex derivative instruments - whose official ratings
are clearly bogus given the subprime ratings debacle - is sharply up;
- up to 40 LBO deals now in serious trouble (restructured, postponed or cancelled)
as the credit crunch is spreading to the leveraged loans and LBO
market;
- the overall increasing stresses in a variety of credit markets ("a constipated
owl" where" absolutely nothing is moving" is how Bill Gross
of Pimco described the effective recent shutdown of the CDO
market);
- credit default swap spreads being sharply up;
- the ABX, TABX, LDCX, CMBX, CDX, iTraxx indices all showing rising risk aversion
of investors, sharply rising credit default spreads and significant
concerns about credit risk in a variety of credit markets (US, Europe and Japan
corporate, high yield corporate, commercial real estate, leveraged
loans), not just in subprime or in mortgage markets.
Note also that, as Minsky - as well as more recently the BIS – have warned the deflation of such credit-driven asset bubbles is historically painful and associated with economic downturns and recessions. So “Have we reached a Minsky moment?” It certainly looks like it. Let me now explain why…
Repeated episodes of financial turmoil did occur - but remained contained and
temporary - in 2003 (following the Enron collapse), 2005 (following the GM/Ford
downgrade), spring of 2006 (following the bout of turmoil in emerging market
and advanced economies during an inflation scare), February of 2007 (following
a growth scare and a subprime scare). Optimists will point out to these past
episodes to suggest that the current turmoil in financial markets will be
another brief and temporary phenomenon. But there reasons to be more pessimistic:
the US housing recession is getting worse; the saving-less and debt-burdened
US consumers is now buffeted by the housing bust, the mortgage credit crunch
and rising oil prices; private consumption, capex investment and housing
are weakening in H2 of 2007; the bubble in equities markets that was fed
by the LBO mania is now fizzling; the problems of the releveraging corporate
sectors are now emerging as there is a sharp repricing of risk; and the credit
house of cards of credit derivatives, leveraged buyouts and loans, and massive
releveraging of speculative players (hedge funds, private equity, prop desks)
is now coming under serious strain. In the next few weeks and months equity
and credit markets may – at times – recover
partially and temporarily following positive macro news. But the sense that
we are close to the peak of the debt and financial excesses of the last few
years is becoming clearer by the day. And the risks of a disorderly adjustment
of financial markets and the real economy is increasing as well. Minsky’s
credit-driven asset bubbles usually end up in painful asset busts, credit deleveraging
and serious economic downturn. So this is not a good time to be complacent.
Written on 30 July 2007.
Copyright © 2008 Roubini Global Economics, LLC. All rights reserved
More: link 1
More: links. 1 2 3 The forthcoming Monetary cisis: 1 The list of those to blame 1
