Today’s question is this: Are we looking at a gathering credit storm of Katrina-like proportions or merely another peaceful sunset in this never-ending credit cycle?
Although the recent quarterly financial releases for the largest Canadian Banks show that in aggregate, gross impaired loans and provisions for credit losses have increased somewhat year over year, 2006Â must nevertheless be regarded as the most successful year by most commercial standards for the leveraged debt markets. New issue volume is at record levels, defaults remain low by historical measures, and market liquidity continues to be strong, fed by sizable new sources, including cross-border flows.
The success of the current market is however accompanied by a potentially troubling pattern, while the supply of ‘B’ and ‘CCC’ rated new issue volume new all-time highs in traded leveraged credit markets. ($131 billion in 2006, up sharply up from $87 billion in 2005) credit spreads have remained flat or have declined. While the significance of this has yet to play out, it is worthwhile noting thatÂ in both the US and in Europe, banks have recorded significant increases in the size of their loan loss provisions.Â
Thus we conclude, unlike some commentators, that the credit cycle has not been permanently repealed so much as deferred and potentially intensified, as current market liquidity appears to have led to an indifference to objective measures of credit risk . As represented by the historically low default incidences across all credit classes, the objective evidence suggests that default risk is in fact at unprecedented levels .
To be sure,, risk has been accumulating in the system, not in the least because of the significant macroeconomic imbalances that are being run in the US. The “Sage of Omaha” Warren Buffett, described the situation in his annual report to shareholders several days ago:
“The ‘investment income’ account of our country – positive in every previous year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the [United States] will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest.
“Our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future, U.S. workers and voters will find this annual ‘tribute’ so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a ’soft landing’ seems like wishful thinking.”
While everyoneÂ in the casino has been leveraging up, Buffett has been quietly cashing out – and accumulating a $40 Billion war chest….Heady stuff indeed!