Are the Good Times Coming to An End?

by: Michael Panzner

Increasingly, the mainstream media is coming around to the idea - as discussed in my book and here at the Financial Armageddon blog - that the good times are coming to an end.

Instead of promoting aggressive, high-risk strategies for getting rich quick, newspapers, magazines, and other media outlets are beginning to urge their audiences to adopt a more disciplined, cautious, and defensive approach - not only in regard to how they manage their investments, but with respect to their personal finances overall.

While there are still stories being pumped out about "investing to win" or "getting rich in America," there are a growing number of others, like "The Gathering Danger from Debt" from Kiplinger.com, that are geared towards helping people understand the harsh new reality.

Is the liberal use of debt fueling market gains and business growth of concern? Absolutely, says Knight Kiplinger, editor in chief of Kiplinger's Personal Finance magazine and business forecasts publications. It leaves the financial markets and the economy open to unpredictable but inevitable shocks. A disruption in oil supplies, a sharp hike in interest rates, the failure of a big merger - all could have much more serious consequences because the financial markets are so heavily leveraged.

Fully a third of mergers and acquisitions in 2007 will be financed through leveraged buyouts by private equity firms. In 2000, only 4% of M&A activities were leveraged buyouts. Companies acquired that way are loaded up with debt. In 2006, that debt totaled $317 billion, six times more than in 2002. That puts firms in a precarious position, with little cushion to fall back on if anything goes wrong. One of the primary movers in such transactions, hedge funds borrowed eight times more money in 2006 than they did four years earlier: $1.46 trillion. What's more, this year, collateralized debt obligations (CDOs) - bundled packages of subprime mortgages, junk bonds and other debt - will tally about $475 billion.

It's "an upside-down pyramid - a small amount of collateral holding up a large amount of debt," says Matthew Eagan, vice president and portfolio manager with Loomis Sayles & Co. "It's very difficult even for professionals to know where the risks lie."

Government regulators simply can't keep up. Credit instruments - from CDOs to options, futures and other products - have become so diverse and so complex that it's impossible to know exactly who owes what to whom. And the fact is that much of the activity falls betwixt and between federal authorities: the Securities and Exchange Commission oversees some of it, the Commodity Futures Trading Commission, other parts. The Federal Reserve and banking regulators play a role. But no agency really has responsibility for the totality. And federal regulators recognize that the same changes in the credit environment that are fueling the debt explosion are also delivering considerable economic benefits: more homeownership, greater business efficiency and increased trade. By dispersing the risk, the impact of a default is blunted.

What's more, while federal overseers fret about the excesses, they also fear doing more harm than good with a crackdown, spooking investors and triggering a rush to the exits. "That's why regulators are trying to emphasize voluntary supervision," Diane Swonk, senior managing director with Mesirow Financial, points out. So they'll continue to simply coax and coach, urging hedge funds and financial firms to have cash cushions large enough to absorb losses and to make sure risks are balanced and positions can withstand stress. But, Swonk adds, "a lot of CEOS, particularly at banks, are underestimating the risk."

Recently, the heavily leveraged system has begun to be tested with a series of subprime mortgage defaults and associated fund and company failures. We need to ask ourselves, says Richard Bookstaber, hedge fund manager and author of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, "Is this the canary in the coal mine? Is this only the first thing to come? What's next after that and after that?"

There are early signs of a market adjustment. Risk spreads are widening as investors demand that iffier credit prospects pay higher yields. And hedge fund returns are likely to flatten.

Of course, my outlook is far more negative. Still, baby steps are better than backward ones.