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Will Third Avenue pop the post-crisis asset bubble?

Is this the long-dreaded popper?As every student of recent economic history will know, the first rumble of thunder in the global financial crisis came with the collapse in the summer of 2007 of two large Bear Stearns hedge funds. Investors demanded their money back, but managers were unable to liquidate their positions fast enough to deliver. These early signs of panic were to snowball into an all-embracing run on the global banking system, forcing central banks to flood the market with cheap liquidity to prevent mass liquidation and economic collapse.
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Are we about to see history repeat itself? That’s been the question on everyone’s lips since the closure last week – or “shuttering” to use the technical term – of the Third Avenue Focused Credit Fund, one of a number of funds set up to chase yield in a world of poor to non-existent rates of return. Two other smaller US funds have also since taken action to prevent investors removing their money.

It’s all eerily reminiscent of the events leading up to the credit crunch of seven years ago. Did we learn nothing from the greatest financial crisis in history and, by treating its symptoms with vast quantities of central bank money printing, did we not merely set ourselves up for the next one?

By promoting “search for yield”, the low interest rate environment has sucked investors into all manner of high risk assets, including a plethora of funds specialising in high-yield corporate debt. These funds have been hoovering up the stuff as fast as the investment bankers could manufacture it. A major beneficiary was the American shale boom, whose estimated $US350 billion plus of investment over the past six years was substantially financed in these markets.

With the collapse in oil prices has come a reckoning. At least 18 of the newcomers have filed for bankruptcy so far this year, and many others are now struggling with debt servicing costs. Barclays predicts that the default rate for speculative-grade companies – increasingly made up of oil and gas firms – will double over the next year.

Standard & Poor’s ratings service recently warned that an astonishing 50 per cent of US energy junk bonds are at risk of default, or $US180 billion ($249 billion) in total. If we extrapolate this out to the $US2 trillion of debt sold globally by energy and mining companies since 2010, the numbers begin to look strikingly similar to the sub-prime mortgage lending which front ran the financial crisis. Of the $US2 trillion of mortgage lending that became distressed, $US800 billion was sub-prime and $US1.2 trillion of the supposedly less risky Alt-A. ‘Keg of dynamite’

High-yield debt markets have also helped fund the explosive growth of mergers and acquisitions in recent years, particularly in pharmaceuticals and telecoms. Some of this too shows signs of distress.

So is Third Avenue the long dreaded popper that will finally puncture the post-crisis asset bubble, all puffed up by years of ultra-low interest rates and relentless central bank money printing?

The standard view is no, this is not it, if only because Third Avenue is a bit of a one-off, having loaded up not just on junk, but on the junkiest and most high-risk form of it. The whole portfolio is filled with distress debt, some of which seems so close to default that it commands no market price at all, and is therefore essentially worthless. For the moment, it can’t be sold for love or money, forcing the fund to close its doors on the stampede of angry investors demanding their money back. If something looks too good to be true, then it almost certainly is, goes the old investment saying. Oddly, this never seems to deter income-hungry investors. The Third Avenue Focused Credit Fund is very much a case in point.

Reassuringly perhaps, few other high-yield funds seem to have pursued an investment strategy quite as reckless as this one.

All the same, there is good reason to worry. As Carl Icahn, the US activist investor, has repeatedly pointed out, the parallels with 2007 are uncanny. Just as with mortgage-backed securities, there is virtually no liquidity left in corporate distress debt markets, which he likens to a “keg of dynamite that sooner or later will blow up”.

To close observers of credit markets, warning signs of a high-yield bust to come have been evident for a long time now. All the old tricks have been present: companies funding special dividends to private equity owners by issuing debt; others issuing more debt just to pay for existing debt service payments; and commission-hungry investment bankers cynically selling the stuff to hapless investors while simultaneously shorting it themselves in anticipation of trouble to come. Many companies that don’t deserve to exist have found it easy to get finance in the one time scramble for yield. Debt deluge

But with the US Federal Reserve gearing up for an interest rate rise, it has been over for a while now. Over the past two years, according to analysis by Driehaus Capital Management, high-yield spreads have widened 275 basis points. For riskier, CCC-rated paper, it was a eye-popping 750 basis points, 200 of them in the last month alone. It is not as if no one saw this coming.

In any case, there are a number of factors that seem to make the current outburst of jitters somewhat different from the financial crisis. The first is financial leverage, which although still relatively high, has been significantly reduced since the crisis, making the system more robust against losses.

We must also assume that regulators have been more vigilant this time around, and prevented the banking system from loading up with junk in quite the same way as it did ahead of the crisis. Tougher capital and liquidity requirements have decimated proprietary trading desks, which is perhaps one reason why there is such limited liquidity in these markets now that everyone wants to sell. This should at least prevent the rout from becoming systemic. Many investors will suffer a nasty haircut, but unless regulators have again been asleep at the job, it shouldn’t pull down the entire banking system.

The latest bust should none the less serve as the loudest possible of wake-up calls. Swamping the system with cheap money may have saved the world economy from a depression, but by pumping up asset prices afresh to unsustainable levels, it has also made the system more vulnerable to financial crisis, not less so. The world economy has never been more awash with debt. In this sense, the high-yield squall may well be a harbinger of much worse to come.

The Telegraph London

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