Dog with a Bone

Like the Captain of the Titanic, I cannot bring myself to the life boats just yet. Yes, I am back to my old favorite: global liquidity. Now, Nouriel Roubini is adding his booming voice to the likes of Edward Altman. We are apparently experiencing a true crisis in the credit markets these days. Not just a liquidity issue, but a fundamental insolvency problem. Reciting the melting subprime mortgage industry, the hurting US consumer/homeowner, and contracting credit availability emanating from there, Nouriel is persuaded we are at the beginning of something big and terrible.

I still wonder. Not because I disagree about the loony levels of corporate (and sovereign) debt that have been slapped on the books in recent years. I am not under under the impression that these unprecedented debt levels are magically sustainable by business or government operations when they have never been sustainable before in human history. I agree that credit issuances are badly matched against the fundamental businesses of the issuers. And so I also agree that a crunch must be coming, and that the longer it takes to get here, the worse it will be.

Where I disagree - or more likely, fail to understand - is in the timing. Nobody that I have read makes a well-crafted connection between the weaknesses that Nouriel describes on the one hand and the huge sums of capital that remain in the global system on the other hand. It seems clear to me that the recent build-up of over-indebtedness is a direct result of massive global liquidity. (Does it perhaps matter whether such liquidity is due to central banks' addition of money to the system, whether the liquidity is merely credit, or credit derivatives-related, or something else, or some combination?) Every problem that an issuer could encounter of late has been resolvable by the introduction of more liquidity - more money at cheaper prices, and with fewer restrictions.

Assuming that is a fair way to see things, what the heck has changed? From what I can tell, massive amounts of money are still on the side-lines, much of it sitting in sovereign wealth funds, whose aggregate size dwarfs the size the global hedge fund industry. Not so, I am told, when one considers the leverage that hedge funds bring to bear - with that leverage, hedge funds are a much heavier influence on the globe. But, I wonder, what happens when the sovereigns begin to deploy such leverage on a similar scale? And where are the fleeing investors going anyway - are not sovereign obligations, like T-Bills, more appealing to investors these days? Does that begin to sound like sovereigns expanding their ability to lever their investments?

OK, I'll slow down. But is it not the case that there is at least the strong possibility of further rescue financing or further opportunistic asset purchasing by these sovereigns? And if not, where will all that money go? Has anybody worked this stuff through? Because I am lost. But I cannot see the logical path to concluding that today is the beginning of the insolvency crisis.

Contrarian Optimism

Mostly because it's fun, I am going to stick by my liquidity guns for a while longer. This has been a scary week for those who follow the credit markets. Many of my friends who run fixed-income portfolios are not even returning phone calls, they are so busy managing their affairs, presumably looking for exit ramps and downside protection. We have seen stories cascading out of the US sub-prime mortgage lending debacle: LBO financing arrangements are stalling en masse, credit default protection for large investment bank debt is getting much more expensive, US Treasury bill prices are sky-rocketing, emerging market spreads are widening drastically. Everybody is fleeing to quality, we are told.

Other developments are making the media and investors even breathier. Stock markets are plunging. US housing sales are way off. Government officials and market gurus are telling us that these developments may be the beginning of a serious market correction. People reading about these developments are getting even more scared, which must be causing even more selling and even more price declines.

I cannot deny that these developments are large and important. I doubt that my limited window into the credit markets makes me smarter than the experts and the investing herd. Still, being a contrarian type, and seeing nothing that has changed my earlier-posted liquidity analysis, I am going to remain of the view that these developments are not (yet) the beginning of a major correction. I am not sure where all the sovereign wealth funds are going to deploy their vast sums in the next months and years. But I have to imagine that the relatively recent trend of these sovereigns pursuing greater investment diversification will continue. I imagine that diversification may slow somewhat, as sovereigns may find that greater sums need to be invested - say in US treasuries, even at the newly inflated prices - in order to pursue policy goals, such as currency pegs.

But all that money, not to mention the amount of private capital that is also on the side-lines at the moment, has to go somewhere. And the recent market dips must have some appeal as buying opportunities. If not, I have a large mattress at home that I might be able to roadshow successfully in Beijing, Singapore, and Dubai.

How Liquid Is That?

This post is just to note another piece of evidence in support of my earlier post on the likelihood that the global liquidity glut may last a while longer yet. Usual caveat: nobody can predict cataclysmic change, and I have to confess that the huge and growing notional amount of the credit derivatives market has been troubling me a good deal of late. Check out this post on the Seeking Alpha page for a chilling report on that subject.

But I could not suppress a smile when I read this story on Bloomberg yesterday. It seems that the same week as the ratings companies are finally realizing the US sub-prime mortgage market disruption means related mortgage-backed paper should be down-graded, US HUD Secretary Jackson is in Beijing urging the Chinese Government to invest more heavily in US mortgage-backed securities.

I am sure I am wrong, but it sounds like somebody is asking the Chinese to provide liquidity to help revive a deflating market in the US. The story didn't say what the Chinese reaction was, although I imagine if Secretary Jackson had been laughed out of the room, Bloomberg would have mentioned it.

Let's get this bubble started

China is investing $3 billion in Blackstone's IPO. What do we make of that? Well, the US media is intrigued by what the deal signals about the power of Blackstone's game plan. And, of course, tremendous amounts of ink have been dedicated to whether the development means China plans to take over the US, just as the US feared about Japan in the 1980s. I wonder, though, whether the US media ought to get out of its usual, parochial rut, and consider whether the development signals something much more important (and less paranoid).

Something about global liquidity. Global financial players have been commenting on global liquidity excesses and potential asset bubbles for the past several years. I have yet to hear any rational, defensible explanation for all this liquidity. Where is it coming from, and why? Is it connected to a glut of savings from the about-to-retire baby boomers? Is it connected to huge hard currency reserves in oil producing nations and elsewhere? Is it connected to China's protection against a precipitous rise in its currency's value? This novice couldn't begin to explain the liquidity excess, but nobody has been arguing that it isn't there and growing.

Among the recited ramifications of all the liquidity have been (a) increases in housing prices, (b) inflated share markets, (c) booming corporate debt issuances, (d) red-hot private equity / M&A markets, and (e) extremely low corporate default rates. In the markets that the Western financial media follows, the past years have been a wide-spread asset boom that would have been hard to imagine beforehand. Investors have been chasing yield in an increasingly crowded and competitive marketplace. (Never mind that huge swaths of the earth's population continue to live in abject - and often worsening - poverty. And never mind that the liquidity glut will almost certainly not be used to address their plight in any meaningful way. That subject will have to be another post's.)

A debate my friends and colleagues often engage in these days is what might burst this liquidity bubble, and, of course, when. People who well understand finance and global markets argue forcefully from experience that what goes up must come down. These people recite the irrationally high P/E ratios on which shares trade and the incredible EBITDA multiples that companies can finance these days. The argument is that these levels are not sustainable, and a melt down is nigh. Since mid-2003, in my experience, this meltdown has constantly been stated to be six-nine months away.

Perhaps. The arguments certainly are sensible, and they are rooted in historical trends that surely teach us much. But is the China/Blackstone deal perhaps meaningful in this discussion as well? I think it is, and it is huge. For months, the Chinese have been quietly (and occasionally openly) considering how to deploy their $1.2 trillion in hard currency reserves in assets that are higher-yielding than the US T-bills which they buy in bulk.

Imagine the effect on today's asset bubbles of the addition of that much money to the yield-chasing investor pool. While nothing is certain, and unpredictable events can cause markets to tumble precipitously, it seems to me likely that China's investment diversification will only expand and extend current trends. Mark my words, the Blackstone deal is only the tip of the iceberg. Don't be surprised to see China and Singapore team up as investors, to see India and oil producing countries' more openly and frequently investing hard currency reserves into private markets, to see Chavez' Bank of the South take off and become a player, and to see other non-US pools of funds collaborating in the same spaces. And don't be surprised if the six-nine month window extends to several more years. Plan and hedge accordingly.

Connect the China Dots

The Economist ran a special report on China last week. A couple articles buried separately toward the back of the issue were as helpful as the report itself. These articles alone would tell a very useful story were somebody to connect them. The first article asks whether multinational corporations are really investing as much in China as one would expect given all the hype about China's increasing commercial importance. The article states that multinationals' revenues and especially business growth potential in China far outstrip their infrastructure and human resources in China.

The second article points out how corporate borrowers globally these days command ever more leverage in negotiating debt terms with their lenders. The article describes the evolution of the world's commercial lender base from multinational banks to multinational funds of various stripes, and it points out that fewer lenders seem to be bothered with loan terms that regulate borrowers' business activities in any way at all.

Spot the connection? Neither did The Economist. A very real and important story here, though, is how much money is flowing into China (and elsewhere) on the kinds of terms that have proven so dangerous in the past - institutionally and anonymously, without regard for investor-investee (eg, lender-borrower) relationships or commercial leverage points. Post-Asian currency crisis, it should be clear that the first kind of investor to be forgotten in a time of stress is the anonymous investor who has nothing further to offer a struggling business - and no ability to hurt it. On the other hand, that business' critical and ongoing commercial/trading relationships are treated better longer. But these relationships require resources "on the ground".

Multinationals are over-weighting the known-to-be dangerous kinds of investment in China and under-weighting the more secure. And they likely haven't done enough homework even to notice. But Chinese business owners must be delighted.