Last year’s ‘bêtes noires’ were private equity funds. They had seen the light in terms of leverage and were using debt to fund major acquisitions, taking advantage of ridiculously low credit spreads and getting tax relief on their interest payments into the bargain. The Danish government’s corporation tax revenues fell by an estimated 12% when a consortium of private equity firms bought the Danish telecom operator, TDC for over Euros10bn. Too late, the Danish – and German – governments have introduced legislation to limit corporate tax relief on debt interest.
But other market players have been using leverage in a big way. Hedge funds leveraged with cheap short-term debt to make money out of the yield curve. Building societies spurned retail deposits for cheaper money-market funding of long term lending. Banks and building societies took loans off balance sheet, turning over capital more often for a higher return.
There are two common threads in all this. The first is regulation, or the lack of it. One of the attractions for investors in private equity was the lack of disclosure compared with listed companies. Hedge funds have replaced conventional investment institutions such as mutual funds, without the same regulatory framework. International banking regulation, such as Basel II, became less restrictive, as banks boasted that their risk management controls were cast iron. In the UK, the tripartite regulatory split between the Treasury, the Bank of England and the FSA meant that no-one’s eye was on the ball when Northern Rock’s business model failed.
The second common thread is the under-pricing of risk. This boom and bust has echoes of the junk bond era. No-one realised then, and no one realised this time, least of all the credit rating agencies, that if you multiply the number of corporate fixed interest securities by a huge multiple, the amount of risk in the system has to go up, not down. It doesn’t matter that a small proportion of the bonds are backed by real real estate.
Unwinding these leveraged positions has meant volatility in markets far removed from money market instruments. For example, hedge funds have been forced to sell equities to meet margin calls on loans. The Bombay stock exchange has fallen 20% in the past few months in response to such sales, despite a booming local economy. Now, commodities are feeling the heat. The sub-prime crisis has led to a volatile dollar, directly feeding the oil price.
The more volatile a market, the more attractive it is to speculators. Lots of hedge funds, with fingers burned on money markets, bonds and equities are looking for pastures new – preferably uncorrelated with their other investments. Even pension fund trustees are being encouraged to invest part of their funds in commodities. Low interest rates – seen as a solution to the banking liquidity crisis – have made speculation in commodities cheaper to fund. Analysis of past returns shows that the oil price is poorly correlated with bond and equity market returns. But oil is currently negatively correlated with the dollar and that makes it even harder for European investors. One thing is sure, whichever way the oil price goes, investors need to be on the right side of oil price volatility to make money.
Guest Commentary: Professor Janette Rutterford, Professor of Financial Management, Open University Business School