One of the most alarming things about the recent investment market is the apparent disappearance of risk premiums. One is supposed to pay a premium for safer investments but these days safe and risky are priced the same.
One of the biggest contributing factors to the housing bubble is the willingness of banks to lend money to anyone with a pulse. This article on bonds shows that its not just the housing market that is being impacted by current thinking and the same cause - the people who make the loans dont hold them and the people who buy the loans dont know who pays them.
Will it take another great depression to wake people up? I sure hope not.
Din of Roaring Corporate-Debt Market Drowns Out Growing Talk of a Bubble
March 3, 2006
Despite a long-held anxiety that companies soon will find borrowing money tougher, conditions in the corporate-debt market are as friendly as ever.
Long-term interest rates remain cheap and credit defaults are rare. Low-quality corporate bonds are trading like they are almost risk-free with very low yields, and investors are loaning money to companies with few constraints.
But these blissful conditions are prompting rising concern among some veteran analysts about a possible bubble, fueled by a still-easy monetary policy, despite 14 consecutive short-term interest-rate increases by the Federal Reserve since June 2004. "The Fed hasn't done much," says William Dudley, an advisory economist for Goldman Sachs Group. "Overall financial conditions are much easier than in 2002."
The corporate-debt market reflects the same desperate search for yield that has sent investors looking for deals in everything from timber to Tajikistan shares. "Risk and return are all out of whack," says Dan Toscano, head of loan syndication at Deutsche Bank. "People are taking the riskiest pieces of the corporate capital structure even though they are not being paid to do so."
The friendly environment has given rise to more borrowing. Private-equity firms, which invest in businesses with the hope of ultimately selling them or taking them public at a healthy profit, are increasingly active, piling up debt, or leverage, on their portfolio companies.
In the past, banks strongly encouraged conservative capital structures. But that is no longer the case. "Banks used to want to see you be more conservative," says Daniel O'Connell, chief executive of Vestar Capital Partners, a major private-equity firm. "Now they encourage us" to borrow more.
The banks are more aggressive because they rarely keep the loans they make. Instead, they sell them to others, who then repackage, or securitize, the loans and sell them to investors in exotic-sounding vehicles, such as CLOs, or collateralized-loan obligations. Every week brings announcements of billions of dollars in new CLOs, created by traditional money-management and hedge funds, which then sell them to other investors. In many cases, they may keep some slices of these complicated securities.
The main concern, though, comes from the fact that the CLO funds buy loans that the banks arrange largely with borrowed money. For example, to create a $500 million CLO, a fund will take no more than $50 million of its own money. The remaining $450 million is borrowed. All is well as long as the companies whose debt is in the structure pay off their obligations.
Another sign of the times is deficits. Growing deficits are supposed to be a sign of danger - and risk premiums... Once upon a time.
As Deficits Rise Bond Investors Turn a Blind Eye
February 9, 2006
More than a decade ago, bond investors were widely considered the watchdogs of government finances. Not today.
Back in the 1990s, as deficits and government borrowing rose, Washington worried that bond investors would rebel against rising deficits. The fear: Investors would demand lower prices for an increasing supply of government debt, which would drive up yields and borrowing costs across the economy.
Contrast that with today, as the government brings back the 30-year bond amid a new bout of deficit spending. Bond vigilantes -- investors who rebelled against deficits in the recent past -- are nowhere to be seen, and that's rekindling an old economic debate about the complex interplay among deficits, financial markets and interest rates.Economists disagree about the impact that deficits have on interest rates. President Bush said Monday that the budget deficit will reach $423 billion this year, or about 3.2% of gross domestic product, compared with a 40 year average of 2.3%. Economic theory says that should matter. To finance the deficit, the Treasury expects to issue a record $188 billion in new debt this quarter alone.
Theoretically, the more bonds the government issues to finance its deficits, the less investors should be willing to pay for them, all else being equal. That, in turn, should push up Treasury yields, punishing the government by increasing its cost of borrowing. The higher interest rates would also hurt economic growth by making corporate borrowing less attractive -- an effect that economists call "crowding out."
