Saturday, June 30, 2007

Beware the gurgles as liquidity starts to drain

Beware the gurgles as liquidity starts to drain
By Francesco Guerrera
Copyright The Financial Times Limited 2007
Published: June 30 2007 03:00 | Last updated: June 30 2007 03:00

To understand the recent setbacks in debt markets and takeover activity, imagine taking a bath in a luxury hotel.

As you slosh around in the warm water, nothing seems to matter other than that moment of relaxation. But things can change quickly. With one wrong move, you hit the plug and the hotel's super-efficient draining system leaves you shivering and wet in an empty marble tub.

Over the past fortnight or so, the plug that has kept the global financial system warm and liquid for the past few years has endured repeated knocks.

The question is whether "liquidity" - the flow of money that has lubricated capital markets and fuelled the recent takeover frenzy - is about to disappear down the plug hole.

This is not a trivial matter: an abrupt draining of liquidity would put an end to these boom times, hurting investors and companies. There certainly have been some worrying leaks from the global financial bathtub.

The first whiff of trouble came from the US a couple of weeks ago, when two hedge funds run by Bear Stearns hit the rocks. The news should not have been a surprise: the two funds had heavy exposure to troubled subprime mortgages - loans to people with poor credit records.

What spooked the market, though, was that the funds' losses were magnified by their liberal use of debt. The Bear funds' debacle reminded Wall Street of a simple truth that had been trampled in the thundering herd's stampede towards ever juicier returns: debt is a double-edged sword.

Leveraging companies and funds up to the hilt supercharges returns in a bull market but it also amplifies losses in times of trouble. Still, after initial dithering, Bear offered $3.2bn to bail out the less leveraged of the funds.

The move staved off the feared meltdown in parts of the credit market but did not ease investors' anxiety on leverage. This quickly spread. Concerns about leverage in a small part of the US mortgage market quickly became a global retreat from risk in credit markets. The contagion was particularly nasty in a sector that had been in rude, almost arrogant, health: the buy-out market.

For more than two years, private equity groups have been exploiting investors' low risk-aversion and feasting on cheap debt. Large firms such as Blackstone have ruled the roost, buying ever-larger companies and forcing banks to lend them vast amounts of money with no strings attached. Not anymore.

This week - for the first time in years - investors said "thanks, but no thanks" to risky bonds issued by buy-out groups to fund takeovers. Companies such as US Foodservice, a caterer, Dollar General, a US retailer, and Arcelor Finance, part of the Arcelor Mittal steel group, had to shelve their debt offerings.

Put simply: investors got fed up with taking on risk without being adequately paid for it. They took particular issue with bubble-like features such as the one allowing private equity-owned companies to stop paying interest on debt when cash flow was low.

In this case, however, it was the over-eager investment banks, not the buy-out funds, that were left carrying the can. But that will soon change. The latest rout should persuade even the most short-sighted of lenders to share the financing risk with private equity groups.

That, in turn, is likely to have a chilling effect on the buy-out bonanza. As for the fate of the rest of the market, keep an eye both on the global economy and investors from emerging markets. Healthy economic growth across the world will help companies and markets to weather the credit downturn. That is why stock markets were relatively unaffected by the recent turmoil.

And as long as investors from the Middle East, Russia and China keep pouring their petrodollars and foreign exchange reserves into the West, there should be a well-stocked source of liquidity. I would not, however, subscribe to the complacent optimism emanating from self-interested sources.

The mellifluous words that came from several heads of Wall Street banks this week for example, should be taken with a shaker of salt. The truth is that we are facing a mini-liquidity crunch. We should be able to weather it without too much pain but the plug at the bottom of the bathtub is wobbling. Be wary of any unexpected gurgling sounds.


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