Maintenant, nous sommes tous dans le noir

It’s become a case of the blind leading the purblind in the financial markets, according to a research note from State Street Global Markets. The two-page document — ominously published on Friday, 13th July — opened like this:

London is now reckoned to be a culinary capital to rival Paris. The palates of Londoners have become so jaded that restaurateurs are now resorting to ever more absurd gimmickry to get the punters through the door.

Perhaps the peak of this particular trend (or nadir, depending on your view) is an establishment called Dans le Noir in the fashionable district of Clerkenwell. There, blind waiters serve customers in the dark. The old northern saying “there’s nowt so queer as folk” springs to mind.

The very human desire for new experiences can lead to absurdity and excess. What is true in the restaurant industry also finds an echo in financial markets. The long period of low interest rates and compressed spreads has spawned a remarkable period of financial innovation.

However, some of these structures have gone too far. Even plain vanilla CPDOs (constant proportion debt obligations), launched last year, levered 15 times to pick up a 200 basis point spread over CDS indices. That’s not looking quite so clever now.

The trouble for investors and regulators is the opacity of these new markets. It is hard to say how much of this stuff is out there, let alone who holds it. Rather like diners in Clerkenwell, everyone is dans le noir.

One consequence forecast by the Boston-headquartered firm is that “market volatility” will increase over the rest of the summer. The volatility will stem, to an extent, from quoted companies’ over-dependence on exotic/opaque forms of debt — coupled with the fact some will struggle to service these borrowings (as a consequence of higher interest rates an/or weaker consumer demand).

There will be trouble ahead for banks that piled into the market for opaque debt parcels like CDOs and CPDOs, which will turn out to be worth far less than they thought. “Volatility” may well turn out to be an understatement for the coming correction, which could see sharp falls in asset prices.

The threat of private equity bids has fuelled corporates’ desire to get massively into hock themselves. However, as the private equity firms’ ability to borrow huge sums to fund buyouts evaporates, the rationale for corporates to get deep into debt will be less obvious.

And, all the while, the game of musical chairs being played out in the global credit markets is nearing a denouement.

Some of the participants — including the “bulge bracket” investment banks — are running scared of being left chairless (i.e. holding loans and investments that turn out to be toxic, and which they will no longer be able to pass onto gullible investors like Scottish banks or German landesbanks) when the music stops.

This is causing banks to clamp down on new loans, prompting media warnings that a “credit crunch” is imminent. For example New York-based hedge fund Cereberus Capital has been struggling to drum up much interest in the $12 billion of debt it needs to raise for its proposed buyout of car giant Chrysler.

If the senior Wall Street and City of London financiers I met last weekend are anything to go by, we should be bracing ourselves for another crash.

What’s more, they tell me that when the tide of liquidity goes out this time, the revealed mess is going to be a lot less savoury and more unsightly (in terms of the depth and breadth of the ensuing financial scandals) than anything we witnessed after the dotcom bubble burst in 2001-03.

Or as Warren Buffett, chairman and chief executive of Berkshire Hathaway. once said: “Only when the tide goes out do you discover who’s been swimming naked.”

This blog post was published on 16 July 2007