When rock stars buy…
David Rubinstein, managing director of Carlyle – the private-equity pioneer made famous by Michael Moore (though not in a way it likes) – said this to the assembled buyout superstars at Frankfurt’s “Super Return” conference this week:
“Now rock stars want to be private equity people. When rock stars are getting into our business, you know we’re at the top of the market.”
I’m not aware that anyone has rushed to defend Bono’s investing credentials. But actually you can apply Rubinstein’s remarks more broadly.
For years now, there’s been a torrent of cash pouring into hedge funds, private equity or any financial instrument apparently promising better returns than high-grade corporate or government debt. And the torrent has been turning to deluge.
So the volatility we’ve witnessed in global equity markets this week is simply the most conspicuous manifestation of widespread fears that we may be near the peak of this particular cycle.
In an era of relatively low inflation and low interest rates, the great markets trend of the past decade has been the so-called “search for yield”. That’s why private equity and hedge funds have boomed: they claim to offer super-normal returns.
It’s also precipitated a massive cross-border financial practice called the “carry trade”. This is the business of borrowing where interest rates are incredibly low – such as Japan, where the benchmark interest rate is half a per cent, less than a tenth of the British base rate – and investing the cash in instruments promising decent yields (in theory) such as emerging market bonds or corporate junk bonds.
The scale of the carry trade has been such that the price of genuinely toxic bonds – and potentially poisonous financial instruments issued by private equity to fund their purchases – have been driven up to levels where they don’t yield much more than really safe investments, such as US or UK government bonds.
Or to put it another way, substantial risk has been under-priced: investors have been behaving as though we live in a risk-free world.
That’s unsustainable. And when risk is under-priced, it only takes a smallish rise in expectations of risk for near-panic selling to ensue.
This is what happened this week, after a number of anxieties surfaced. First the sharp drop in the Shanghai index showed that financial assets in the fast-growing super-charged economies of China, India, Brazil and so on can go down as well as up.
Also – and probably more importantly – the value of the yen has been rising. So anyone who’s borrowed a load of yen and converted it into another currency suddenly found that the repayment cost has gone up.
Now in those circumstances, some yen borrowers will have tried to liquidate their portfolios of high yielding assets, such as junk bonds or emerging market debt or arcane products such as collateralised debt obligations. But the thing about these seductively high-yielding markets is that they often become horribly illiquid when everyone wants to sell. So investors are instead forced to sell the stuff that can be sold – which is why the price of blue chip UK and US stocks has been falling.
Finally, there have been worries for some time that the US housing-market bubble has been pricked and that there will be horrendous losses for sub-prime lenders or those who’ve lent to house purchasers who couldn’t raise conventional finance (such as our own HSBC, which has recently disclosed losses greater than had been expected and will doubtless disclose more about its US woes in its results on Monday).
The sub-prime market is enormous. But what the investment bankers I spoke to this week are really concerned about is the possible spread of losses from sub-prime to higher-quality home loans and a consequential collapse in consumer spending.
What was that about living in a risk-free world?
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There is a simple word to summarize that otherwise excellent analysis : greed. Investors, helped by MBA clad, maverick, market wise people are hoping for very large return on their investments. Raising the bar is never a bad idea but there is a limit to what financial instruments can yield. At the end od the day wealth as to be produced before it can distributed.
The rise of private equity is like removing all the bulkheads in a tanker-funds can slosh about freely in response to the latest wave of market conditions, with the result that the boat is less stable overall and may capsize in a storm. Volatility in oil prices has been shown to be a result of hedge fund activity, and retraction of prices has resulted in huge HF losses. The big risk is loss of confidence in the stability of financial systems, including US borrowing, and consequent run away monetary inflation of debt costs, with a downward spiral on housing and other activity. The central banks may want to nudge interest rates a quarter of a percent in either direction, but if they lose control of that toggle because of changes in the demand for debt in a particular currency, all hell can break loose.
In addition to all that, lenders are now making it harder to borrow money at the risky end of things. This will be another nail in the US housing market and will no doubt happen here as well.
This has the potential to be a 'perfect storm' with the by-to-let crowd over here heading for the exits quickly just as it looks like rates are going up, just as there's a general credit crunch.
Sell your house and buy some Yen!
So, in the light of this, whither the UK housing market? Are we about to see a crash?
Hopefully this is just a dip & brings some more realistic pricing of risk & some longer term stability.
What we need now is a similar dip & realism in another market that seems to think it's risk-free - the UK housing market.
RE Tallskipper's comments, with no offence, he is mistaken in his summary.
The effect of markets is not neccessarily to be productive but to be re-distributive. So inevitably there are winners and losers.
Skint.
Last week 60 billion dollars was wiped off the Dow. Where has this money gone and if it was at such risk are the people who placed it there utter idiots.
Hmmm... should be really interesting here then when the UK housing market gets pricked as well.
While David Rubinstein has plagiarised and paraphrased an aphorism attributable, I believe, to Joe Kennedy, father of JFK, that when his shoeshine boy started talking to him about his portfolio that he knew it was time to get out of the market, the writing has been on the wall for some time in a market driven by greed as Tallskipper has suggested and fuelled by ignorance on the part of investors.
J K Galbraith's book "The Great Crash 1929", published in 1954, examines the causes of the biggest economic collapse of the 20th Century. It should be compulsory reading and should be subtitled "caveat emptor". The boom and subsequent collapse in 1929 were accelerated by "margin trading", primarily by individuals; in principle, this is little different from hedge funds or private equity groups "leveraging" purchases to the hilt - great returns when things are on the up, but precipitous on the way down. There have been inadequate controls on the maximum leverage for a given amount of equity so there are going to be some private equity and hedge funds that must be feeling the pinch, particularly if interest rates rise further. But hedge fund managers will keep talking the market up for as long as they can - their bonuses depend on it.
Tallskipper is, however, wrong to tar all business school post-grads with the same brush - I am one (with a degree in Economics and Economic History and, subsequently, a professionally-qualified commercial property investment surveyor)who has been watching the commercial property markets with trepidation and wondering, during the past three years, where the value was going to come from and telling my clients the same. Personally, this approach has probably cost me a fortune in lost fees, but I can sleep at night, albeit not on a mattress stuffed with a City bonus.
One of the maxims I was taught at business school is that "there is no such thing as a free lunch". I have found this to be untrue. A great many 'advisers' have been enjoying a great many free lunches, at their clients' expense. Unfortunately for some of them, a number may now have to go hungry for a while, so I hope they have laid some of their exceptional returns and bonuses down to fat and that it will last them till the next boom when the same mistakes will be made by the next generation of chancers.
In the meantime, the really smart money, that is, the money that has been sitting this dance out, not dancing, waiting for the music to stop, will soon get onto the floor, when prices are realistic - or perhaps even lower than that - and then they will start their dance, buying low and waiting for prices to rise and selling again before the market peaks(after all, no one went bust taking a profit)- although how they will judge when the next boom is about to bust may vary: next time it probably won't be shoeshine boys or rock stars, but it will be their equivalents.
Total unregulated capitalism is destroying the very fundamentals of the delicate balance of the global economy. This is no more apparent than in USA, the epitome of "greed is good" mindset. With such a severe individualistic philosophy and a me me me culture, what else can happen but a total collaps in the economic system. The world works on a principle of inherent trust and when you are so individualistic that yuou cannot trust anyone else, the system cannot sustain itself. Unfortunately ever since the Republicans took over, this mentality has accelearated, with US tax payer money beibg siphoned off to the elite rich in the name of war. The sham Bush economy was only being held up by a overindlated housing market, where people were investing not to live in homes but to flip them and make short term gains. This midnset has pervaded to stock marketr as well, which has turned into a casino, where the insiders are just screwing smaller investors of their money. Its just turned into a massive free for all looting of the country.
Greed is the wrong word. Every investor (and I'm sure that will include you Tallskipper, if you have for example a pension being managed for you) prefers higher returns to lower returns for a certain amount of risk. A preference for more rather than less is not greed, it is rationality. And to label those who know the markets as mba clad mavericks is childish to say the least. If you are so much wiser then I'm sure you sold the world's stock markets at their highs before the recent sell off? Everyone has the ability to put their money where their mouth is. Have you?
If Bono is so bothered about world poverty, why doesn't he give his millions away to be used where it can do some good rather than investing to feather his own nest?
Excellent summary. Though, increasingly I am concerned at the assumptions we make in examining the system itself, I certainly agree with you on the state of the thing.
Further to my earlier note, the Smart Money will know the market has peaked next time when Ainsley Harriott becomes a stock market pundit and MasterChef becomes a competition about cooking the books.
So Is Bono not Sir Bono yet then?
He should not be knighted. He should tell the English to get out of Ireland