Lex in theatrical mode reminds us that Hamlet said: “If it be not now, yet it will come: the readiness is all”. The tragic prince was of course talking about death. But the same is true in today’s apparently benign credit markets, says Lex.
Everywhere, financiers are holding their collective breath, waiting for the dreaded turn in the cycle. Even bank bosses are becoming more and more candid about the dangers. Bank of America’s Ken Lewis, talking about private equity, last week called for “a little more sanity in a period in which everyone feels invincible”.
So how are banks and broker-dealers readying themselves? Broker-dealers have less capital to play with than the big banks, and lack deposits to fall back on if they suddenly need more liquidity. If the credit markets seize up, their funding is at greater risk, warns Lex.
It is worth noting, therefore, that Morgan Stanley and Goldman Sachs have both upped their excess liquidity “pot” to record highs of $52bn and $55bn respectively for the latest quarter. This cushion allows the broker-dealers to fund cash outflows in crisis without having to sell off assets, and would cover things such as client commitments, the principle and interest on unsecured debt and any extra collateral required. Such an “insurance policy” does not come cheap: probably several hundred million dollars of margins foregone. “But it’s worth it to those bosses still scarred by the memory of 1998,” says Lex.
They can also extend the average life of long-term unsecured debt – as Goldman has done – or buy more credit protection in the derivatives market. JPMorgan Chase, for instance, has gone from $18.9bn of protection purchased in 2005 to $41.5bn in its latest quarter.
The problem with credit default swaps, however, is that they are of limited use to protect against really scary loan commitments, such as leveraged loans to fund big private equity deals, while the deal is not yet public.
Indeed, concludes Lex: Mr Lewis echoed the secret wishes of many, when he said: “We need a deal to go bad as long as we’re not in it.”