Linkages, linkages

In my view the credit squeeze is not fully played out. If the “monoline” insurers fail – as some predict – things will be much, much worse.

Linkages, linkages

Large banks are madly recruiting corporate knee-cappers in anticipation of growing bad debts, and insolvency practitioners are starting to smile again. Clearly both expect the spillover into the real economy to be significant.

In my 1 February blog (What on earth is happening?) I promised an explanation of the links between the credit markets and equities market.

The most direct linkage is the impact on corporate profits. Higher interest costs reduce net profits, which in most cases will flow through to a low price (if price earnings ratios are maintained). Some corporates (more so in the US it seems) invested surplus cash in some of the CDOs, and so there have also been CDO write-offs by non-banks.

Less immediate, but still important, is the effect of leverage.

Many sharemarket investments are made using borrowed money. Some of these leveraged investments are large and complex structures used by investment banks and wannabe investment banks, but individual investors also participate via margin lending and re-drawn home loans used to punt the market.

If the availability of credit is reduced or interest rates rise, then leveraged participants are affected. At the happy end of the spectrum they are less likely to buy, and at the unhappy end they may be forced to sell. Over the last few weeks we have seen spectacular examples of margin sales forcing the price down, leading to further margin calls and further downward pressure.

The less direct but still important third impact is fear and uncertainty. After seeing big losses coming out of overly complex credit structures (CDOs), investors are worried about overly complex corporate structures – hence the stampede out of MFS, Allco and Centro.

Where to from here?

In my view the credit squeeze is not fully played out. (If the “monoline” insurers fail – as some predict – things will be much, much worse, by the way, but that’s a blog for another day.)

Some part of the turmoil in the credit markets will continue to spill over into the equities markets, and will eventually spill over into the “real economy” as it affects investments and capital expenditure plans.

With the “real economy” going gangbusters and arguably likely to begin to import inflation from China (now at an 11-year high), that’s probably a good thing. I say that because the Rudd Government’s jubilation over cutting $2 million funding from the Fishing Hall of Fame has me worried that they don’t quite appreciate the scale of the problem.

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