Credit Crunch – “The After Burn!”

By City Fund Management Chairman - Christopher Lee (January 2008)

The credit crunch is not over yet as we have yet to experience the “after burn”! The markets have settled down a bit and there are comments emerging suggesting the “worst is over”. That may well be the case, but it also may not be as the central banks and regulators have yet to put their new rules on the table. One word encapsulates the reason for this financial crisis which started last June, “leverage”.

The whole banking industry is based on leverage through lending a multiple of their capital. If their client is a hedge fund seeking leverage to achieve larger returns (and potentially larger losses) then you suddenly have double leverage. If the hedge fund then uses margin based products to create even more leverage then you have triple leverage! And so it goes on.

The only way this can be controlled is to reduce the leverage at source, and the way this is done is for central banks and regulators to insist that banks hold more capital against the same amount of lending, thus de-leveraging at source. Of course the banks will wish to make the same returns so they will charge more for the credit they are providing so what was a 1% margin on lending generated from £100.00 of allocated capital will now become 2% if they are forced to allocate £200.00 of capital to the same amount of gross lending.

Of course the banks can raise more capital to bring their lending capacity up to their previous levels but the flip side here is a reduction in return on capital, unless they increase their margins. So either way borrowing costs rise. Add to the mix a bit of spice, such as a weak equity market, the drag of the existing loan book where suddenly twice as much capital is required to support the “old loans”, along with the associated lower profitability on these assets, and suddenly a quick emergence from intensive care seems less likely.

Mergers and acquisitions may ease the pain but not necessarily cure the disease which has become widespread throughout the financial system over many years. The reality is that the central banks and regulators can only control the markets through the central banking systems and they face a balancing act over the coming months. The patient may not be strong enough to recover from a serious operation, but could respond to remedial care; however this would of course take longer. In short the “after burn” could be more painful than many are predicting as there are clearly some significant adjustments to be made in order to re-create long term stability and confidence.

In recent years there has been much speculation that the big hedge funds are the new banks as they ventured into the traditional banking markets by providing credit in various forms to a variety of borrowers. As this happened and banks lost these assets from their balance sheets they simply replaced them with lending to the hedge funds. Back to the double leverage described above, as the only way hedge funds could generate sufficient returns to cover their additional fees was through leverage or increased levels of risk. It is reasonable to assume that the regulators will take the opportunity to reverse the trend of recent years by encouraging base lending back into the banking sector where they can monitor it and control it.

“What about the investors?” I hear you cry. Well, they have had a torrid time over the last twelve months or so as traditional equity markets have bombed and property markets have dived. Where can one earn an easy buck these days? The reality is there never was an easy buck. High returns mean high risk. Investments offering 20% to 30% returns, after fees, have inherent risk and investors need to know what this is. Transparency is key in being able to assess the risk in any investment and any manager who is not prepared to reveal to his investor what he is doing with his money should not be surprised if the investor goes elsewhere. Amazingly however, investors are still blinded by headline returns. Shown returns of 20% and 10% most investors will go for the 20% return. Strip out the fees and the risk factors such as leverage, liquidity etc. and compare the returns with risk free returns such as Treasury Bills and in many cases the better quality return will be the lower headline figure, in this case 10%.

In simple terms, if the risk free return is 6% p.a. and the fund return is 10% p.a. then there is clearly in excess of 4% risk return in the product. It is this factor that the investor should look at and make his judgment accordingly. Higher returns can be delivered year after year for many years but it does not change the risk profile. The investor, who identifies good quality risk returns over time and withdraws his individual investments over time so that the residual investment simply becomes his “profit”, is the smart guy. Add diversification into a wider range of products and you have the smart portfolio manager.

The irony for many hedge funds is that yields will fall as the “cost” of leveraging rises, or alternatively because credit is no longer available to them so they are unable to increase leverage through borrowing.

Since the end of June 2007 we have had dysfunctional markets. To put this into context 9/11 arguably only resulted in dysfunctional markets of about ten days. Some commentators suggest we are in the worst banking crisis for over 100 years and it is difficult to argue with this assessment. In short, we have not reached the end game yet and when we do it is reasonable to assume we will be operating in a very different market in terms of the capital base and structural conditions being applied. This cleansing of the soul is no bad thing as excesses have to be washed out of the system so that markets can operate freely again. Many sections of the market are being blamed for the breakdown of the credit market, the banks, hedge funds, investment banks, rating agencies, risk managers, compliance officers, central banks, regulators and so on. Reality is that this situation is not the fault of any single entity, but the result of greed and a benign attitude to risk across all sectors of the market.

Neither of these is new, and both cause market disruption on a regular basis, it just so happens that in this instance they combined on a massive scale across global markets resulting in a kind of market meltdown. The result of the turmoil of the last few months will be a re-structuring of the market either by take over (such as Bear Stearns), merger for capital strengthening purposes, re-capitalisation, portfolio re-balancing, or a combination of a number of these. Whatever it turns out to be it will not be quick but will evolve over a number of months.