It’s a quote that encapsulates the bankers’ hubris: “As long as the music is playing, you’ve got to get up and keep dancing,” Chuck Prince, at the time chief executive of Citigroup, said about overheating credit markets.
The chief executive made his statement in the middle of 2007, when the world stood on the precipice of the worst financial crisis of the century. Citigroup would be one of its biggest victims.
Eight years later, the music is playing very loudly again. Fueled by the lowest interest rates the Western world has experienced since industrialization and a flood of money from the central banks, debt has risen to record levels. In emerging markets alone, companies have seen their debt more than quadruple from $4 billion (€4.5 billion) to $18 billion, according to the International Monetary Fund.
At the same time, investors and banks have become increasingly careless. Whether it’s German mortgages or U.S. junk bonds, lower interest rates were accepted and standards became lax. Money flowed to debtors that had little means to meet their obligations.
Signs are growing that this incredible accumulation of money is coming to an end. Since the summer, the bond markets in the United States and Asia have become more risk averse. Interest rates for less credit-worthy companies have clearly risen.
Viewed historically, a rise in interest surcharges is often the beginning of an unholy spiral.
The energy sector was affected first due to the collapse in commodity prices. In the meantime, more secure investment-grade bonds have become more expensive. The growing investor caution was stoked by a chain reaction of negative developments over the past few months.
Weak growth in emerging markets, the collapse in commodity prices, the fear of rising interest rates in the United States, stock market turbulence, and idiosyncratic events like the Volkswagen emissions scandal and the problems at the commodities company Glencore.
Investors have begun to differentiate for the first time in a good long while, and not just on the stock markets, but also when it comes to credit and loans. That’s a good sign at least initially. Debtors who aren’t as credit worthy as others have to pay more – risk carries a price again. But unfortunately, there are even more reasons why this trend should cause concern.
For one, central banks appear to have lost their power over credit markets for the first time since the financial crisis. In contrast to years prior, credit surcharges are rising although the central banks have left the money spigot running.
For another, investors are beginning to hesitate at a time when billions have already ended up in the wrong hands – risky companies that pay extremely low interest, highly indebted states and mortgage markets.
Viewed historically, a rise in interest surcharges is often the beginning of an unholy spiral. Debtors can’t afford their rising rates, which leads to more defaults and, as consequence, rates rise more and standards become even more strict. The default rate hasn’t risen yet, but given the long credit boom, there’s a high probability that this will be the case as early as next year.
The bond markets normally foreshadow what will happen in the commercial debt market. Credit requirements, which right now are as lenient as they haven’t been in a long time, will become strict again and as a consequence there will be more defaults, initially in the United States and then in Europe.
Credit surcharges are still below the levels seen during the Greek debt crisis, but Europe will not escape the effects of a downward spiral in the United States or Asia.
What’s unsettling is that Germany’s banks are not sufficiently prepared for such a development. While some are still struggling with losses from the last financial crisis, others have created earnings by reducing the amount they set aside to insure themselves against potential losses.
Since the turning point in the debt bubble is approaching, the banks should begin setting aside more money today in anticipation of losses instead of waiting until tomorrow. Though the music of the credit markets continues to play loudly, some have already stopped dancing.
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