This credit cycle is much like any other—a protracted period of low credit spreads lulling investors into a false sense of security, a sharp spike in credit spreads as investors made a mad dash for the exit doors, followed with a marked increase in default rates.
What is a little different this time is the extent to which excessive leverage, insufficient liquidity and complex credit structures exaggerated the impact once the market imploded. As a result, spikes in credit spreads reached as high as 9,500 bps on five-year GMAC CDS spreads last fall when aggregate credit spreads were “forecasting” default rates as high as 40 %.
Think about it – those spreads meant you would receive all your capital back over the one year term on GMAC (not quite there yet but still holding your breath) and that if you bought a basket of credit risk the default experience would have to be at least twice as bad as that experienced in the Great Depression for you to miss breaking even.
I have written in previous columns about “credit” investors who blindly follow public market agency ratings, review SEDAR filings after purchase or not at all, or who reserve any financial statement analysis capability for their equity teams. Those are not the managers you want on your team.
I was also recently reminded of the difference between those who take long-term credit risk—like insurance companies or pension funds—and those who take short-term credit risk, like commercial banks. Recall that bankers often have or can demand extensive information through their business relationships with potential lenders and have the benefit of standing at the front of the line when trouble happens.
Long-term investors in credit markets assume a totally different type of risk—and need to protect their interests by extensive analysis and forecasts as well as considering customized structures that protect investors who would otherwise be subordinated in any liquidation. A lot can happen over longer-term horizons, as we are reminded now that Nortel, the jewel in the Canadian crown as recently as ten years ago, is struggling to survive.
Other institutions (like AIG) undertook credit risk assuming behaviours that should have set off alarm bells. I was reminded recently that insurance companies, when writing policies on human lives, require the buyer of the policy to demonstrate a level of “insurable interest” so as to avoid moral hazard. This means that the policyholder has to have a financial (or significant other) interest in the survival of the life insured and that the insurer requires the level of coverage purchased to be commensurate with these financial interests. The CDS market enabled huge volumes of credit insurance to be written at notional amounts well in excess of the physical markets and in cases where the contract was more speculative than fundamental.
Are there opportunities today in credit markets? Absolutely. But there are only a few managers out there who have the skill and experience to take advantage of them. If there’s one thing the recent market turbulence should have taught us is that nothing beats good old fashioned due diligence.