CreditSights: Leverage Creeps Back The massive high-beta rally that started in October 2002 and continued through 2003 generated some of the most-spectacular returns ever seen in the credit markets. The further down the credit spectrum, the more impressive the results. Predictably, money moved in the direction of the returns as indicated by the mutual fund flows and investors reconfigured to take advantage of new opportunities. Investment-grade buyers with flex are taking a harder look at potential crossover opportunities; those who can't dabble in four- and five-B credits have a steady stream of structured deals from the investment banks to choose from that offer higher yield. As room runs out for spreads to tighten meaningfully, leverage is continuing to creep back into the system. Although leverage in credit markets is nowhere near as endemic as pre-Russia/Long-Term Capital Management in 1998, it is worth considering what might happen if the liquidity punch bowl gets taken away. We have already had a glimpse of some of the potential impact as several speeches from the Federal Reserve and some strong economic data earlier in the year spooked the market into thinking that interest rates might start heading up sooner rather than later.
When pondering leverage in the system compared to 1998, the consensus seems to be that traditional measures of leverage (the size of repo books, etc.) would suggest levels currently that are about 2/3 to 3/4 of levels that prevailed in 1998. That said, there are several indications that leverage may be higher. First, is the dramatic increase in both the number of hedge funds and their assets under management. Total assets under management were estimated at $750 billion at year end. This compares to only about $300 billion in 1998. We have also noted an explosion of net foreign purchases of credit assets from the Cayman Islands reported in the U.S. Treasury's monthly data (given the prevalence of hedge funds registered in the Caymans, we use the Cayman data as a proxy for hedge fund activity.) This is also corroborated by the Bank for International Settlements data, which shows a big increase in claims of foreign banks on offshore banking centers, with the Caymans accounting for the bulk of the increase.
A second development is that banks are also using their balance sheets more for prop trading than lending these days. Commercial and industrial loans have been essentially flat after a precipitous drop in 2002. There is evidence that the banks themselves are making investments in hedge funds, preferring to keep some of the leverage effectively off balance sheet.
A third development that makes it more difficult to judge leverage levels is the growth of the credit derivatives market. Credit default swaps have become the vehicle of choice for expressing a view in the credit markets, especially for leveraged players. At this point, it is often very difficult to determine whether CDS is the tail that wags the cash market or vice versa. Lots of leverage playing the high-yield convergence game has a familiar ring. Most of the larger and more established players in the market on the bank and brokerage side have extremely sophisticated hedging strategies in place for their default swap exposure; smaller banks and new market participants may or may not be as well hedged. In any event, it wasn't the known credit exposure that typically killed the banks in 1998, it was the counterparty risk that suddenly became credit exposure that in the end was more expensive.
