Now it Begins to Unravel
The Credit Bubble Peak was Marked by “Totally Crazy Lending.”
Debt is good. More debt is better. Funding consumer spending with debt is even better – that’s what economists have been preaching – because the consumed goods and services are gone after having been added to GDP, while the debt, which GDP ignores, remains until it is paid off with future earnings, or until it blows up.
Corporations too have gone on a borrowing binge. Unlike consumers, they have no intention of paying off their debts. They issue new debt and use the proceeds to pay off maturing debts. Funding share-buybacks and dividends with debt is ideal. It’s called “unlocking value.”
Debt must always grow. For that purpose, the Fed has manipulated interest rates to rock bottom. Actually paying off and reducing debt has the dreadful moniker, bandied about during the Financial Crisis, “deleveraging.” It’s synonymous with “The End of the World.”
At the institutional level, “debt” is replaced with more politically correct “leverage.” More leverage is better. Particularly if you can borrow short-term at near zero cost and bet the proceeds on risky illiquid long-term assets, such as real estate, or on securities that become illiquid without notice.
Derivatives are part of this institutional equation. The notional value of derivatives in the US banking system is $190 trillion, according to the Office of the Comptroller of the Currency. Four banks hold over 90% of them: JP Morgan ($53 trillion), Citibank ($52 trillion), Goldman ($44 trillion), and Bank of America ($26 trillion).
Over 75% of those derivative contracts are interest rate products, such as swaps. With them, heavily leveraged institutional investors that borrow short-term to invest in illiquid long-term assets hedge against interest rate movements. But Treasury yields and mortgage rates have moved violently in recent weeks, and someone is out some big money.
These credit bubbles always unravel to the greatest surprise of those institutions and their economists. When they unravel, the above “End-of-the-World” scenario of orderly deleveraging turns into forced deleveraging, which can get messy. Assets that had previously been taken for granted are either repriced or just evaporate. But they’d been pledged as collateral. Suddenly, the collateral no longer exists….
On the way up, lots of money can be made on this debt, in myriad ways, including in interest and fees extracted from consumers directly, and in fees extracted by Wall Street, for example in repackaging risky consumer or corporate debt into highly rated asset-backed securities that are then spread to institutional investors who use proceeds from leverage to acquire them. But no problem; it’s just OPM (other people’s money).