GREENSPAN’S RATE CUTS HELPED CREATE A CULTURE OF DEBT THAT IGNORED BORDERS AND WAS ULTIMATELY SHUNNED AS TOO RISKY
Barbara Shecter
North American debt markets are in an unprecedented state of turmoil, prompting some Bay Street professionals to quote the 1990s R.E.M. rock anthem: It’s the End of the World as We Know It.
The trouble began a couple of weeks ago with unexpectedly high defaults in the U.S. subprime-mortgage market. The events in the United States triggered a change in the perception of what constitutes risky debt, and the repercussions have spilled over the border into Canada, and into fixed-income products such as asset-backed securities and securitized loans that transfer risk from one set of investors to another.
“When one thinks about the financial climate, there was really only one direction to go and that was down — all that was needed was a catalyst,” Craig Alexander, vice-president and deputy chief economist at TD Bank Financial Group, wrote in a report that included the reference to the downbeat R.E.M. song .
The benchmark S&P/TSX composite index had a wild week, bouncing up and down in a range of 800 points. Some comfort was had when a coalition of banks and money managers converted short-term commercial debt to longer-term loans and Canada’s Big Five banks pledged to do their part to avoid a crippling credit crunch. And the U.S. Federal Reserve finally appears prepared to step in and ease interest rates after a year of musing about hikes to combat inflation.
Indeed, investors appear to have lost their appetite for debt of any kind. Several high-yield offerings have been cancelled and market observers are questioning whether large transactions relying on debt financing will be completed. At this point, it is not clear where the fallout will end or who will be on the hook for most of the losses.
LOW INTEREST RATES
It all started in 2001, when interest rates were lowered to bolster the economy and prevent a recession following the bust of the dot-com bubble.
Alan Greenspan, then chairman of the U.S. Federal Reserve, and the central bank’s policy arm, the Federal Open Market Committee, lowered interest rates from 6% to 1% by the end of 2003, creating an environment where it was suddenly easy to get financing for cars, homes and other big-ticket items.
Canada followed suit, and the Bank of Canada’s overnight rate fell from 5.75% at the end of 2000 to 2% in mid-2004.
“It did sow the seeds for some of the excesses we’ve seen in recent years,” says Doug Porter, deputy chief economist at BMO Capital Markets.
REAL ESTATE BOOM
As intended, low interest rates drove many renters into the home-buying market, with banks eager to lend money to first-time buyers with unproven track records who might one day entrust the banks to manage their growing wealth.
The U.S banks offered the riskiest home loans, with no down payments or insurance required, and interest-only loans where the buyer was not required to pay any of the principal in their regular payments. The belief was that home prices would continue to rise, protecting the lenders and giving the buyers equity in their homes.
But as interest rates began to rise again due to inflation concerns between mid-2004 and 2006, and the Fed indicated that further increases could be on the horizon, buyers dried up, putting a cap on house prices.
At the same time, many of those who owned homes found they could no longer afford to pay for them as they were forced to renew far more expensive mortgages. Defaults are on the rise, and house prices are down nearly 20% in some U.S. markets.The same trend has not occurred in Canada where house prices continue to rise. Still, Canadian lenders were also on the bandwagon of encouraging high levels of borrowing in the low-rate environment.
INVESTMENT FALLOUT
One of the consequences of declining rates was lower yields on U.S. Treasury bonds. Surprising even to Mr. Greenspan, the yields did not rise again with interest rates. As foreign banks in countries across Europe and Asia loaded up on U.S. Treasury bonds and other debt, the prices rose and yields diminished further. This led investors in search of higher returns to buy riskier and more complex loans.
At the same time, low borrowing costs and strong income growth combined, resulting in “tons of money? sloshing around looking for investment opportunities,” says TD’s Mr. Alexander.
The “global search for yield” pushed up prices on everything from real estate to fine art, and led investors to ignore risks, says BMO’s Mr. Porter. “People went into increasingly risky corners of the investment universe to get those yields.”As the hunger for returns grew, investors were willing to drop demands for guarantees on a company’s financial condition to protect their investments. “Covenant light” loans soon evolved into “covenant free” loans, which were often bundled with less volatile debt that further clouded the risk.The search for yield also pushed more investors into the stock market, and the increased demand for stocks pushed up prices.
HOW DID THIS DIFFER FROM THE PAST?
Before interest rates dropped to historic levels, many of today’s home buyers would not have gained access to the real estate market. And, if they did, they would have had to meet strict borrowing criteria, including proven collateral and income.
On the corporate side, risky loans were traditionally financed only if the lenders were guaranteed high enough returns to compensate them for the level of risk — returns that ran upwards of 10%.
The buyers were sophisticated money managers who were aware of the risks and demanded lengthy lists of covenants to protect their returns. Loans that were not considered to be investment grade, because they were extended to companies that already had a lot of debt or lacked a solid track record of being able to repay loans, were called junk bonds. “They were called that for good reason,” says a senior Canadian investment banker who works for a U.S. firm.
CHEAP DEBT
The cheap and plentiful debt that has flooded the markets over the past few years drove another trend: leveraged buyouts by private equity players. Private equity deals traditionally boost returns for equity holders by ramping up debt, something that became very easy to do.
A new pool of potential buyers increased demand and a host of companies became presumed takeover targets, another factor that contributed to high-flying stock prices.
Private equity funds have grown along with the abundance of cheap debt, with US$6-billion pools of capital raised by players such as Goldman Sachs Group Inc. and Blackstone Group LP ballooning to US$21-billion funds. This has exponentially increased the demand for cheap debt, which it appears can no longer be procured.
The pools of capital have already been raised, so further private equity investments seem inevitable. But because debt will be more costly, returns will be lower, a factor that will undoubtedly deflate demand for future investments. With the debt market convulsing, the days of raising multi-billion dollar private equity pools appear to be gone.
WHAT’S COMING NEXT?
If, as expected, foreign banks in Europe and Asia refuse to take on high-risk loans, there will be defaults and stock markets will continue to decline.
The U.S. central bank cut a symbolic lending rate yesterday, and indicated that the next move could be a cut in the meaningful overnight lending rate. But carnage in the stock market is unlikely to be avoided, says BMO’s Mr. Porter.
“I would say what we’re dealing with is much more than a garden-variety correction,” he said, adding that mergers and acquisitions that were priced into the market are now unlikely to occur. “The froth we saw earlier this year has been blown off–deservedly so.”
Stock in Canadian Pacific Railway Ltd. has drifted down to $70 after surging to nearly $90 last month on takeover speculation. And shares of Bell Canada Inc. (formerly BCE Inc.) are trading below $39 as investors continue to speculate that a $42.72 privatization bid will be re-priced lower to compensate for high financing costs.
Lower stock prices could ultimately rebalance the system and restart M&A activity, according to some investment professionals. If quality companies can be bought cheaply enough, there will be adequate returns for investors even if debt remains more costly.
