Thursday, July 7, 2011

Super 8: Debt Boogeyman Overdone?

Had dinner with a buddy last night and then we hooked up with another friend to watch Steven Spielberg's Super 8. Hadn't been to the movies in a long time and didn't know what to expect. It started off slow, but when the action scenes hit the screen, I started getting into it. Won't give away the plot, but the theme of the movie plays perfectly into my latest topic, the debt boogeyman.

Tim Kiladze of the Globe and Mail reports, Greece weighs on Canada’s debt market:

Europe’s debt crisis is thousands of kilometres away, but it’s helped to bring Canada’s market for fixed-income financings grinding to a halt.

Even though borrowing costs fell sharply in June, the volume of new debt offerings by Canadian companies slid to its lowest level this year, as investors’ anxiety about the possible implications of a Greek default rose to new heights.

Typically, companies like taking advantage of low rates, but they haven’t been able to this time around because investors are too nervous to put money into new corporate bonds, fearing that any negative news could send the value of their new purchase plummeting. Should this hesitation continue, issuers could be in trouble because many must borrow to fund their growth strategies.

For the moment, the fears have been kept in check. Greece’s parliament approved an austerity package last week, and hopes that the European crisis is moving closer to a resolution have helped to push down the spreads on Canadian provincial and corporate bonds. Spreads are the extra yield that issuers must pay above safer government bonds to compensate for added risk.

But any sign that the European crisis isn’t contained could trigger a new avalanche of worry. New financings were virtually non-existent in Canada last week, with only one deal coming to market, and no new offers have popped up since the long weekend. Plus, rating agency Moody’s cut Portugal’s debt rating to junk status on Tuesday, which could further hamper the fixed-income markets.

“People are very, very cautious,” said fixed-income analyst Jean-François Godin at Desjardins Securities. “You don’t need much of a story to make investors shy or request higher spreads.”

Many investors seem content to park themselves on the sidelines and watch.

“Look how fast the sovereign crisis spread [between] Ireland, Greece, Spain,” Mr. Godin said. “People know that if you buy at the wrong time, all of the spreads can blow up in your face” – meaning yields would move higher. Higher yields on bonds mean lower prices.

At Alberta Investment Management Corp., which oversees $70-billion in pension and other funds, chief executive officer Leo de Bever has even started pressing to reduce the province’s exposure to bonds. Citing problems like those in Greece, Mr. de Bever worries that systemic changes could be under way, such as investors beginning to view corporate bonds as a less risky product relative to sovereign bonds. With such unpredictable outcomes, AIMCo would rather be less exposed to the asset class.

Because investors are so skittish, they are now demanding that corporations pay bigger spreads for new issues, Mr. Godin said. While Greece’s troubles are far away, the capital markets are so interconnected that European fears quickly spread to Canada and investors have adopted a risk-averse mentality. Even though yields are lower, corporate issuers have balked at paying those higher spreads because they believe their risk hasn’t increased, and that has contributed to the dearth of new issues.

However, Greece isn’t the only culprit. A slew of companies financed from January to March because they expected the Bank of Canada to hike interest rates. Those firms have already raised their funding requirements.

Plus, Canadian banks typically dominate new issues and they were particularly active during the first quarter, as many home-buyers looked to borrow in advance of new, tighter rules on mortgages. To fund the mortgages, the banks had to finance in the public markets.

Following those two trends, the market has only gotten shakier. “I think it’s wrong to attribute the decline in yields to the worry about Greece alone,” said fixed-income strategist Mark Chandler at RBC Dominion Securities. “Equally there was concern about the weakness in some of the economic statistics” that started coming out in April, he said.

In response, investors started heading to the sidelines. Corporate issuance of new bonds fell in April to $8.9-billion and has plummeted to $4-billion in June. For the quarter, $20-billion was raised, versus $32-billion in the first quarter.

But that doesn’t mean all is lost, said Mr. Godin. “We had a very, very strong first three months and obviously we could not support that kind of pace.”

The trend also isn’t exclusive to Canada. South of the border, corporate bond issues totalled $58.5-billion (U.S.) in June, the lowest total in over a year, according to Bloomberg.

While there are some signs of a turnaround, there are also fears that the market for new issues will stay tight during the summer, when fixed-income issuance is typically slower. That means companies may have a hard time borrowing all the way until Labour Day.

Still, corporate issuers appear ready to strike as soon as confidence shores up. “I think there are a couple of deals, at least on the corporate side, that are waiting to be brought back to the market once the crisis fades,” Mr. Godin said.

This entire "debt crisis" is starting to get on my nerves. Turn on the television and all you hear is about how another country got downgraded to junk status by those corrupt ratings agencies, the latest being Portugal. The timing of these announcements is extremely fishy. How corrupt are ratings agencies? Enough for Europe to issue a full-throated assault on credit ratings agencies on Wednesday, saying there were signs of bias against the European Union after Moody's downgraded Portugal's debt to "junk" status.

Moreover, according to Bloomberg, European lawmakers called for restrictions on traders' use of credit-default swaps to profit from defaults on sovereign debt they don't own:

The European Union Parliament in Strasbourg, France, also voted in favor of a ban on short selling of government bonds in the EU unless traders have at least “located and reserved” in advance the securities they intend to sell.

“Today we are sending a very strong political message,” Pascal Canfin, a French lawmaker who is responsible the legislation in Parliament, said after the vote. Negotiations on the measures with governments in the 27-nation region will continue next week, he said.

Politicians including German Chancellor Angela Merkel and French President Nicolas Sarkozy have claimed that naked short- selling and credit-default swaps worsened the euro area's sovereign-debt crisis, and have called for EU curbs. Michel Barnier, the EU's financial-services chief, said last year such trades may lead to “disorderly markets and systemic risks.”

The Parliament is seeking tougher curbs on short selling and sovereign CDS than those supported by most EU governments.

The assembly called for a ban on the buying and selling of credit-default swaps on European Union nations' debt, unless the buyer either owns the underlying security or another asset whose market price moves in close tandem with it. That would allow investors to take out insurance if they know that a default would harm their non-sovereign holdings such as shares in companies in the defaulting nation.

Greek Crisis

Greece's fiscal crisis shows “how urgent and necessary legislation in this field is,” Canfin said in an e-mailed statement. “Traders dealing in Greek CDS are throwing oil on the fire, with their only goal being that of making money.”

The Alternative Investment Management Association, which represents hedge funds, has warned that a naked CDS ban could “push up government borrowing costs.”

Finance ministers from the 27-nation region agreed in May that traders should be allowed to short sell government bonds and stocks if they have a “reasonable expectation” that they can obtain the underlying securities. They also rejected calls from Germany for a ban on sovereign CDS.

Here are my thoughts on this. Normally, I would agree that these regulations will only drive up interest rates and thus government borrowing costs, but the reality is that large hedge funds and bank prop desks have profited enormously from speculative activity via naked CDS. In other words, they're talking up their books, which is why they loathe regulation in this area. (While they're at it, regulators should also enforce the law and ban naked short selling in the stock market!).

All this to say that the Europeans are finally waking up to the corrupt nature of ratings agencies and their hedge fund masters. They work together to make enormous profits. This whole debt crisis has been blown way out of hand so that the financial oligarchs can engorge themselves as they collect 2 & 20, claiming they're delivering true alpha. Remember the story of the bankers going to Louis the XIV to tell him that France was insolvent. I have a feeling my buddy is right, today's bankers and hedge fund "royalties" are pushing the limits and they will suffer the same fate.

That's why I'm not overly concerned with the debt boogeyman and remain long risk assets, realizing that while train wrecks make great movie scenes (see below), in the real world, there isn't going to be a massive debt derailment unless you give speculators and ratings agencies free reign. It's high time regulators cut off the heads of ratings agencies and greedy speculators who are wreaking havoc on global credit markets and causing irreparable damage to the real economy.

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