Credit Velocity in the Driver's Seat

Includes: GRE, TLT
by: Erwan Mahe

We have been concentrating on this issue for over six years now, going us back to the days when CDOs and later CPDOs, characterized by us at the time as an absolute disaster, accelerated this velocity and then pulled it sharply downward in the wake of their collapse.

Do you recall the launch of the Constant Proportion Debt Obligations in the week of November 7, 2006, which led to a contraction of the iTraxx premium to its historic low of 22 bps, thus, triggering panic at the short credit hedge funds?

Or that this narrowing of the credit spread pushed issuers of these same CPDOs to increase their leverage up to 15 to maintain a "decent" yield?

Or the enormous trades of dividend purchases, which crushed all the 2007 index forwards, while implied 2-year EuroStoxx option volatility was at 12.50%?

Once the Bear Stearns hedge funds were decimated, it dawned on us that the death of securitization would lead to a reversal of the arithmetic sign of V in the equation, MV=PQ. And this became the spearhead of our macro analysis.

Even the extraordinary hike in M, engendered last year by the major central banks, was not enough to convince people of the sustainability of the economic recovery, given high worldwide debt leverage and a still lifeless securitization market, while the debt deflation process has yet to come to an end.

This explains our bias in favor of fixed interest rates on government debt and against risky assets since June 2007, aside from our short tactical entry on this market, which explains why we are still unwilling to change our conservative bets. It is also the reason why we have always opposed hyper-inflation alarmists.

I have decided today to quote from the very instructive speech pronounced in Sidney yesterday evening by New York Fed Governor Dudley, in order to illustrate the concrete nature of this problem, and how the debt deflation process works on a day to day basis in G3 economies. He has certainly had some of the richest experience in dealing with the phenomenon: The US Financial System: Where We Have Been, Where We Are and Where We Need to Go.

You will see that he takes up many of our recurring themes, while proposing a more realistic view of the road ahead.

(The titles and underlined text are mine.)

Debt leverage -- death of securitization – debt deflation process

At the heart of the crisis was a tremendous build-up in leverage which our regulatory framework failed to prevent. Large amounts of opaque, illiquid, long-term assets were financed by short-term liabilities, and much of this financing occurred in the shadow banking system.

The disruption of the securitization markets caused by the poor performance of highly rated debt securities led to significant problems for major financial institutions. These banks had to take assets back on their books, backstop lines of credit were triggered, and banks could no longer securitize loans, thus increasing the pressure on their balance sheets.

This reduced credit availability, which increased the downward pressure on economic activity, which caused asset values to decline further, and in turn, increased the degree of stress in the financial system.

Still some road to hoe

Turning to where we are now, the financial system is in much better shape today than it was a year ago. The capital markets are generally open for business—with the important exception of some securitization marketsU.S.

However, many smaller and medium-sized banks remain under significant pressure.

Such institutions hold assets that are carried mainly on the books on an accrual basis. Compared with mark-to-market assets, such assets adjust much more slowly to changes in market conditions and the economic environment. Second, many of these banks have a much more concentrated exposure to commercial real estate, a sector that remains under considerable pressure.

U.S. commercial real estate prices down by about 40 percent to 50 percent from the peak reached in 2006.

This in turn means that credit availability to households and small businesses will still be curtailed.

A solution: debt to equity swaps

It would also be very desirable to develop a mechanism in order to bolster the amount of common equity available to absorb losses in adverse economic environments.

This might be done most efficiently by allowing the issuance of debt instruments that would automatically convert to common equity in stress environments, under certain pre-specified conditions.

Such "contingent capital" instruments might have proven very helpful had they been in place before and during this crisis.

Given this clear analysis of the reasons of the current turmoil, from our current stage in the process to solutions, I am more than a little surprised to read the comments by St Louis Fed Governor Bullard who, despite his credentials as a hawk appears to be looking for an "exit" a bit early .

In addition to asserting that the Fed could begin selling assets in the second half of the year, even before it starts hiking interest rates, he said that he expects the programmes to reboot securitisation, the ABS and Legacy CMBS TALF, will not be prolonged after March 2010.

The discussion at the Fed board meeting promises to be interesting.


As for as our investment biases, some clients have been kind enough to comment that the advised option positions, below, do not really go in the same direction as our bias against risky assets, since they are very delta positive on the EuroStoxx.

As I pointed out last week, due to the steep decline in indices since the beginning of the year (14%), we are now betting on a very short-term stock market rebound amounting to a few percentage points and a narrowing of eurozone peripheral nation debt spreads and thus stagnation on the Bund Bobl and Schatz.

This is a temporary tactical bias, and any marked upturn will lead us to again recommend bearish structural positions on interest rates in indices.

As I said to a client who asked me about my long-term interest rate targets, so much the better if everyone profits, even if this earns me a few slings from the believers of a resurgence in hyperinflation: 2.5% on 10-year German bonds.

Disclosure: Author long 20 years OAT 0% Coupons, EDF Corp 5 Years 4.5%