Friday, July 27, 2007

Swallowing The Hog Whole

Sometimes just one or two sentences are enough. Consider this paragraph, from a Bloomberg story.

The ``golden era'' for leveraged buyouts proclaimed by Henry Kravis two months ago is losing its luster.

Kravis, co-founder of New York-based Kohlberg Kravis Roberts & Co., said on May 29 that there was ``plenty of capital'' to finance acquisitions. Yesterday, Chrysler and Alliance Boots Plc failed to find buyers for $20 billion of loans to pay for their buyouts. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt. (bold added)

The last sentence, read in context, literally screams about how far we have come from traditional banking. Imagine... the banks "are stuck holding the loans"! As if banks are not supposed to make loans, in the first place.

It is obvious that in recent years major banks became so hubristically spoiled by making fat origination and securitization fees, that the very idea of loaning their "own" money shocks them. They had turned themselves into sausage factories: in came loans of the worst possible quality - "pigs" - and out came mouth-watering AAA link sausages to suit every taste: CLO's, CDO's, CPDO's, hybrid CDO's, CDO squared and cubed... the variety was captivating.

As any sausage maker knows, the trick is to take the cheapest possible meats, mix in a ton of extenders, flavorings, colorings, preservatives and water and turn them into "charcuterie" at ten times the price. Much better looking and smelling than the fat, dirty hog that originally came in. But, just like cheap bacon, all of the above bank products shrink to 1/3 their original size when things get too hot.

Well, the customers are finally realizing that bank sausages are not as healthy and nutritious as advertised and are passing on their latest offerings. The banks are now stuck with a roomful of smelly loans they don't know what to do with. Guess they'll have to swallow the hog whole - hairy ears and all...

With yesterday's drop in global stockmarkets came fresh upward pressure on credit spreads. The spreads for the CDX indexes calculated by Markit are rising very steeply, significantly including the one that follows investment grade bonds.

CDX Investment Grade Index

CDX High Yield Index

The importance of these moves is very high, given the leveraged nature of markets world-wide and the prevalence of debt-financed LBO's. In other words, first the takeover premiums are going to deflate to zero (no way to finance a deal right now) and then the leverage multiple is going to start working in reverse.


  1. Great post.

    I'm stunned by the speed of the turn out. It looks like the end of the party is near, possibly very near.

    It's a pity in a sense this great blog may become plain mainstream talk within a couple of weeks.

    The next question is: how dangerous is the situation going to be?

    Is the banking system robust enough to withstand a really tough financial crisis?

    Can technically "real banks" go bankrupt?

    I heard that they cannot since they have direct refinancing from central banks. How tested is that proposition?

  2. The reason for the blog's existence was/is to underscore the danger of the situation. The financial system is a web of interconnections based on one thing only: trust, also known as credit in banking.

    Prior to now we have had no hard numerical measure of trust. Now we do: Credit Default Swaps measure the "trust" or "creditworthiness" of just about every major borrower.

    In a twist of fate, the product that was supposed to lower risk (CDS) may actually create a meltdown episode as everyone now has the ability to clearly and measurably see risk go up and up (trust going lower and lower) and thus rush for the exits.