(Editor’s Note: this is the “Buttonwood” column from this week’s issue of The Economist.) Hollywood may love to churn out sequels but markets do not think much of them. Almost four months after the rescue of Bear Stearns, investors are again grappling with worries about the health of the banking industry. The spreads, or excess interest rates, on the riskiest corporate bonds are almost back to the levels last seen in March.
Each day brings new sources of alarm. On July 7th shares in Freddie Mac and Fannie Mae, the American housing-finance giants, were pummelled on account of a Lehman Brothers report which suggested, if accounting rules were strictly applied, that the government-backed firms would have to raise $75 billion between them. Although Lehman thought the rules would not actually be applied to Fannie and Freddie, that was brushed aside by sellers determined to assume the worst. Meanwhile, an American mortgage lender, IndyMac Bancorp, was told by regulators that it had insufficient capital. It is now slashing its loan book.
Although this week’s commitment by Ben Bernanke, chairman of the Federal Reserve, to extend the Fed’s lending window to investment banks into 2009 may offer some reassurance, investors still worry that medium-sized American banks may be allowed to go bust; after all, they are neither too big nor too complex to fail. And in Britain the share price of Bradford & Bingley, a mortgage bank, sank even further, dropping a long way below the rights-issue price and reopening debate about its future.
For credit markets, these banking problems are doubly ominous. They will cause the industry to cast about for more capital, but there is no reliable source of supply. If Bradford & Bingley is any indication, investment banks will have grown more cautious about underwriting rights issues. Hedge funds, another potential source of capital, are funded by the banks themselves. Fund-management groups, according to a recent Merrill Lynch poll, mean to be underweight bank shares.
That leaves the sovereign-wealth funds as the only investors with cash to spare. But such funds are still licking their wounds, having provided capital to banks last year at share prices well above today’s.
The banks’ problems feed back into the credit markets. For if the banks cannot raise as much capital as they need, they may feel they have to sell assets. And that may mean off-loading corporate and asset-backed bonds, even if the banks must accept fire-sale prices. The ABX index of asset-backed bonds is below the level that it sank to in March.
Analysts tend to agree that spreads are much higher than are needed to compensate investors for the likely default rate. According to Moody’s, a ratings agency, the default rate over the past 12 months on global speculative, or junk, bonds was just 2%; the only company outside America to walk away from its debt was a Bulgarian steelmaker. Jim Reid, a credit strategist at Deutsche Bank, quips that, if the spreads on investment-grade debt accurately reflect default rates, everyone will end up living in caves.
But spreads often fail to reflect the likelihood of defaults. This was true during the credit boom, when they fell to historically low levels, as investors chased anything with a yield higher than government bonds. And it is true now because, although an investor could make money by buying corporate bonds and holding them for five years, few are able to follow such a strategy. The big risk investors face is buying too soon. Traditional bond managers fear losing their clients if they have another poor quarter. Hedge-fund managers may find that the prime brokers who lend them money will cut off their funding if their positions deteriorate.
Just like last summer, the risk is of a downward spiral, in which nervous investors sell bonds, driving prices down, only increasing the general nervousness. The system is still deleveraging, at least according to the latest figures from America—which show bank loans contracting at an annualised rate of 8% over the 13 weeks to June 25th.
To make matters worse, the fundamentals for the corporate-bond market have worsened since last August. Expectations for corporate profits are being revised down, as margins come under pressure from slower growth and higher commodity prices. Headline inflation is well above target, so central banks are unlikely to ride to the rescue with interest-rate cuts; indeed, many are preferring to tighten monetary policy. This is one sequel where the scriptwriters are going to have to work extra hard to come up with a happy ending.