Five Things You Need to Know: The Return of Risk Appetites

By Kevin Depew  APR 06, 2010 12:45 PM

A bad end is coming, but that bad end will come later -- possibly much later than many believe.


1. The Return of Risk Appetites

FTAlphaville yesterday pointed to an apparent contradiction contained in two mainstream media reports on the bond market. First, Bloomberg reported that bonds with built-in protection against rating cuts -- so-called "step-up bonds -- are making up a record share of debt issues. Second, the Wall Street Journal reported on the return of "pay-in-kind" bonds which enable companies to issue more debt as interest payments rather than cash.

The apparent contradiction between these two pieces, which FTAlphaville notes, is that the Bloomberg article paints a picture of a more staid appetite for risk, with credit buyers demanding more protection in the event of a renewed economic slowdown, while the Journal observes an increase in some of the more exotic securities that appeared during the most recent credit bubble.

So who's correct? Are credit buyers, still fearful of another slowdown, demanding more concessions before buying debt, or are risk appetites gaining enough traction to support the more questionable credit products in the debt food chain? The answer is yes and yes. Let's explain.

To fully understand the credit market dynamics at work, we have to go back a bit; credit is cyclical, and sometimes those cycles have more severe peaks and troughs, as was the case last February when credit finally bottomed in the aftermath of an extraordinary bubble. Credit bulls are correct when pointing to the strength and rapidity of the recovery in credit markets. In many cases, it's been even stronger than the post dot-com and telecom credit recoveries in 2002 and 2003.

Meanwhile, credit bears are correct in pointing to the same mistakes being made as were made between 2003 and 2007. Leverage is again increasing. The reversal of the "sell it all" trade where corporate debt was dumped willy-nilly in a panic has now led to a different type of panic, one where credit buyers are finding it difficult to find enough "risk inventory" to satiate demand for increased returns. The result is almost identical to the early stages of past credit recoveries where credit buyers, once they run out of things to buy intelligently, start buying whatever they can find, wherever they can find it.

Make no mistake: The financial system remains fragile, far worse than it was in 2002. But the important point to understand is that the debt crisis was never about the economy; it was about credit, leverage, and debt. The weak economy is the result of that crisis, not the cause of it. It's an important point to understand, but one that's easy to miss now that the focus in the media has turned away from credit markets, which are difficult for reporters to see and understand, and back toward more transparent economic issues such as jobs and manufacturing reports.

Similarities to the last credit cycle remain, despite the fact we're in a more fragile ecosystem and damaged economy. As was the case last time, stock market participants refuse to believe the credit bull market story, instead focusing on everything that can possibly go wrong, from Greece to Portugal to sovereign defaults, municipal bond market implosions, and basically everything but what should be the current focus -- namely, the transition from corporate balance sheet repair back to share buybacks, mergers and acquisitions and other pursuits that actually benefit shareholders longer-term.

Again, this is a credit cycle, unique in the strength of its reversal from near-death a year ago, but hardly different in how it will ultimately unfold. A bad end is coming, but that bad end will come later, possibly much later than many believe.

2. The Coming Municipal Bond Market Collapse

Paul Kedrosky and a few others yesterday pointed readers to a Rick Bookstaber piece on The Municipal Market. In the post, Bookstaber outlines six lessons we should have learned from the last crisis:

So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:

1. Problems occur when things get leveraged and complex (and thus opaque).

2. If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.

3. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine -- until it doesn’t.

4. A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.

5. Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.

6. Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages -- even when that income was fairly stated -- became committed to other areas (like second mortgages).

The most obvious candidate to meet those six criteria is the municipal bond market, he says. Which is true. Pull up a municipal bond screen on a Bloomberg terminal. It can make some of the inscrutable structured finance products from the credit-bubble heyday look almost tame by comparison; in most cases it's unclear how much leverage is involved in the muni market and the opacity is even worse compared to corporate debt since, as Bookstaber notes, municipalities aren't held to the same disclosure standards as corporations.

While municipal bond market concerns are indeed legitimate, stock market participants aren't getting the fact that this cycle's conclusion will take years to unfold, not weeks or months.

In the meantime, you can while away the hours brushing up on Chapter 9 basics.

3. The Collapse of Complex Business Models

I ran across an interesting piece by Clay Shirky on The Collapse of Complex Business Models. In it, Shirky cites someone I'm very interested in -- Joseph Tainter, author of the 1988 book, The Collapse of Complex Societies.

Tainter’s thesis is that when society’s elite members add one layer of bureaucracy or demand one tribute too many, they end up extracting all the value from their environment it is possible to extract and then some.

The "and them some" is what causes the trouble. Complex societies collapse because, when some stress comes, those societies have become too inflexible to respond. In retrospect, this can seem mystifying. Why didn’t these societies just re-tool in less complex ways? The answer Tainter gives is the simplest one: When societies fail to respond to reduced circumstances through orderly downsizing, it isn’t because they don’t want to, it’s because they can’t.

It's an intriguing line of thought, and one that is directly related to credit markets and their near-collapse. Here's another extract:

Tainter doesn’t regard the sudden decoherence of these societies as either a tragedy or a mistake -- "[U]nder a situation of declining marginal returns collapse may be the most appropriate response," to use his pitiless phrase. Furthermore, even when moderate adjustments could be made, they tend to be resisted, because any simplification discomfits elites. When the value of complexity turns negative, a society plagued by an inability to react remains as complex as ever, right up to the moment where it becomes suddenly and dramatically simpler, which is to say right up to the moment of collapse. Collapse is simply the last remaining method of simplification.

The conditioning we receive is to view "collapse" as a negative. (Going back to 2008, the criteria for the initial government bailout and crisis rescue plan was the potential "collapse" of the market, even though it was never made clear what that might entail.) Certainly, there are negative attributes, or at the very least negative perceptions to such a violent, but simplistic end. However, there are new emergences from the collapse that are positive, if inestimable. After all, the conditions necessary for collapse -- what Tainter calls "declining marginal returns" -- demand a level of negativity that ultimately reaches the limits of acceptability in its familiarity.

4. In Praise of Non-Linearity

One school of thought about optimizing our behavior is that exercise, eating -- just about everything we do -- is best performed in brief spurts, not in discrete, programmed time blocks. Follow me for a moment. These programmed time blocks were essentially the offspring of the industrial revolution. Today, they're the remnants of a mode of production that only barely exists. Why do you eat lunch at noon? Because that's when your lunch break is scheduled. Why? Because stuff needs to get done between 9:00 a.m. and noon.

Studies have shown that the most efficient way to lose weight and develop body tone is not to set off on a five-mile jog every morning, but instead to walk, a lot, at different times, with those walks punctuated by random bursts of sprinting for as long as comfort allows.

I believe the structure to our daily life, and the problems created by the Internet and the increased flow and availability of information in non-linear bursts, is responsible for some of the unrest we feel; like a presence that seems to be lurking just behind us, turning in on itself; one we can't quite turn and catch before it escapes.

The problem may be that many of those old industrial-based modes of engaging in human behavior are being challenged and disrupted. One of the reasons there's so much strife and a growing feeling of unease in society is that we're being chained to structures that no longer function -- economically or socially -- the way they were designed.

Socionomics captures this sea-change, but it's not easy to describe to a mainstream audience. Put in friendlier terms, one of the main reasons people feel disconnected and ill-at-ease, even angry, is that we're chained, literally and figuratively, to structures that no longer help us create economic value. After all, that was the promise of the production line -- to help create efficiencies that would in turn help create economic value, both for the owner and the worker. But those promises have become antiquated and broken thanks to emerging networks and a host of new technologies that basically have unlocked time-dependence of the production line and the linear model of productivity.

The more we become a truly non-linear society, the more critical it will become to detach from the old structures and open up to new modes of non-linear work and play.

5. To Wit: It's Not All About 9 to 5

As if on cue: "The millennial generation -- about 50 million people between ages 18 and 29 -- is the only age group in the nation that doesn't cite work ethic as one of its principal claims to distinctiveness," according to a new Pew Research Center study, "Millennials: Confident. Connected. Open to Change," according to an article I ran across in the Washington Post

"Maya Enista, 26, chief executive at, a District-based advocacy group for young adults, said the term 'work ethic' is misleading. 'It's not about being at a desk from 9 to 5. I work part of every hour I am awake.' Enista said her fellow 20-somethings' constant connection to technology keeps them at least as tethered to their jobs as older workers are. 'It's a given that we work hard, because the reality is that millennials are the most educated and most in debt.' "

Although couched in the familiar economic (and religious) terms of a "work ethic," this piece isn't really about a work ethic at all, but about the disruption created by technology and the fracturing of the linear workspace and production schedule.

No positions in stocks mentioned.

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