This blog post originally appeared on RealMoney Silver on Sept. 12 at 7:56 a.m. EDT.
Over the past five to 10 years, a surplus of cash has led to a shortage of common sense in the credit markets.
The outgrowth has included the following:
- the emergence and funding of thousands of hedge funds, many of them levered;
- the proliferation of junk bonds and leveraged loans;
- the mushrooming of private-equity funds, with attendant high rates of returns;
- the "new age" of residential real estate, with the emergence of subprime lending, and nonresidential real estate, with cash yields or cap rates falling fast; and
- a soaring and unregulated derivative market characterized by opaque securitizations and investment "tranches."
The ability to leverage in all facets of our economy and in financial instruments multiplied in a world where investors overreached for yield. As credit got easier and leverage was ever-more accepted, "investors" took their collective guards down by accepting abnormally low returns by taking abnormally high risks.
There was, until recently, an absence of risk-awareness, leaving few investors prepared for the morphing of the subprime mess into an early summer
black swan of credit
as the aggregate leverage employed in our financial system provided little margin for error. In swift order, concerns of return on capital shifted to return of capital in many asset classes as risk-aversion replaced risk-taking.
Private-equity's merger and acquisition activity stopped on a dime as hundreds of billions of bridge loans became hung and are still unsold by commercial and investment banks. Leveraged "quant" hedge funds reported awful returns, and many have gone or will go out of business.
The lack of availability of mortgage credit hit home sales, and those hedge funds/investment firms/money market funds that owned or inventoried mortgage-backed securities and collateralized debt obligations saw financing pressure intensify due to their dependency on the commercial paper market, and so on and so forth.
Stated simply, anyone who had previously bet that "the good times would (continue to) roll," with the status quo of low volatility and an increasing appetite for risk, suffered ... and continues to suffer.
The list of victims of the credit unwind should grow longer in the months ahead.
I think it's unwise to believe that the summer of 2007 is simply a bump in the credit road. Despite protests by many, such as
New York Times
, the excesses were long in the making, and given their magnitude, the ensuing unwind will not be resolved in short order -- even regardless of the
Though it rarely pays to invest for a full-scale meltdown or disaster, at the very least, one should steel oneself for a mean regression in credit that will dampen growth for some time to come as markets typically swing for a longer period of time than is generally expected. They did so on the upside to credit creation, and they will likely do so on the downside of credit contraction.
The pendulum swing back to normalcy in the availability-of-credit market and in credit losses is by no means the only factor contributing to what I believe will be, at the very least, a limited upside to equities.
Away from a deteriorating credit cycle, an all-time high in oil futures, ripping grain prices, a plunging U.S. dollar and the likelihood of
are some additional headwinds facing investors over the next few months.
My long-held view of a period of
(i.e., uneven and lumpy economic growth that both investment managers and corporate managers will find hard to navigate) remains my investment mantra.
In such a setting, unpredictable roller-coaster moves should be the market's mainstay, not a sustained uptrend.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.