Credit ‘Bubble’ Boosting Equity Prices? 

Terry Flanagan

Willem Buiter, global chief economist at Citi, said there is a bubble in credit markets and which has led to valuations being too high in equity markets.

He spoke on the panel, “Have central banks created an asset bubble?”, at the Milken Institute London Summit on October 28. Buiter said asset bubbles are created by the private sector but can be fed by the public sector, as central banks had no choice but to flood the world with money after the financial crisis.

“The private sector grew up in a world where they expected a 7% benchmark on their portfolio when the risk-free policy rate was 4% to 4.5% without taking unacceptable risk,” added Buiter. “In today’s world the policy rate is the equivalent of zero and for  taking the same risk they get a 3% to 4% return which is unacceptable.”

Buiter said that the private sector had gone into denial about risk and a credit bubble has been created with the issuance of products such as payment-in-kind loans and covenant-lite loans at record levels.

“This collective denial is referenced in other markets and equities are only generously valued because the discount rate is too low,” he added. “The over-valuation in equities is because there is a credit bubble.”

Robert Seminara, senior partner at private equity firm Apollo Global Management, was also on the panel and said he largely agreed with Buiter. The system incentivises participants to achieve returns so people are starting to ignore risk.

“In 2006 when the bubble burst we found ourselves in the situation when people said never again will we issue covenant-lites, never again will we pay over six times [EBITDA] for a company, never again will we issue PIK debt,” Seminara added. “Never again is three to five years because that is exactly where we are. The same silly deals are happening again.”

Some private equity deals are being done at more than 10 times Ebitda, just like before the crisis, and multiples on European deals are the same as in the US despite the US economy being stronger according to Seminara.

‘When the spike happens, there is so much risk packed into the system that it will be very ugly for investors,” he added.

Seminara said one change has been that buyouts are now much smaller than before the financial crisis. “When the music stops they will not bring down the entire system, but individual companies,” he added.

Zak Summerscale, chief investment officer, European high yield at Babson Capital Europe spoke on the panel and disagreed there was credit bubble. He said that although there were signs of froth the market, is nothing like between 2006 and 2007.

Summerscale said that in the high-yield market the average leverage is around four times and enterprise value is ten, which are not bubble statistics. In addition spreads were at their tightest were 190 basis point in Europe and 240 in the US, and are now much wider at 400 to 450 basis points while default rates remain low.

“In the first half of the year we did see some shocking deals get done but in the last three months the market pulled back and some people lost money.” Summerscale added. “The recent volatility has taken some risk off the table which is also a healthy sign.”

On the Euro area, Buiter said: “It is a tragedy, a train wreck in slow motion and it is completely self-inflicted by a massive four-dimensional policy screw-up.”

Buiter said action is needed on several fronts including redoing the stress tests and raising enough capital for the banking sector.

“If we ever get our mojo back in the Euro area the banking sector is incapable of supporting growth,” he added.

Periphery countries with the biggest output growth need helicopter money, which would require a change in the European Central Bank treaty, and there should be structural reforms.

“Countries like Italy have a 0.5% potential output growth rate which is unsustainable unless there is a supply size revolution,” said Buiter. “Employment protection policies, which are really employment killing policies, need to canned and without that, the Euro area will move from cyclical to secular stagnation. It is the only part of the world with this material risk and it is purely self-inflicted, it is completely unnecessary.”

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