Deleveraging and asset prices – the ‘Minsky moment’ revisited

I think it’s worth looking back at a comment I wrote in November last year on how the global economy had reached a ‘Minsky moment’. In brief, economist Hyman Minsky unerringly predicted the boom and bust of tech stocks, and events of the last few years have followed the same classic Minsky pattern. Minsky argued that periods of stability breed periods of instability, where prolonged economic stability results in investors taking on more and more risk. The economy becomes increasingly leveraged, thus making the whole system inherently unstable. The ‘Minsky moment’ is when risk appetite goes into reverse, leading to a collapse in asset values. As I argued last year, the Minsky moment occurred in July 2007, and I stated our team’s strong belief that the repricing of risk had only just begun.

We’re now more than a year down the road from when the Minsky moment occurred. Deleveraging has continued, but as Richard argued on Wednesday, leverage in the banking sector is still extremely high, particularly when you add back all banks’ off balance sheet assets. It’s the fall in the value of these assets that has caused so much distress in the banking sector over the past few days/weeks/months. The process of deleveraging will continue to cause pain, with economies shrinking, and crucially for us bond investors, inflation falling.

A significant side effect this week has been the complete seizing up of liquidity. Corporate bond markets have been illiquid for over a year, but this week has been truly exceptional. Anyone wanting to trade anything but the biggest, most liquid bond issues has been penalised heavily, with bid-offer spreads of up to 5% in some cases. Needless to say, the subordinated bank bonds have been particularly illiquid, and forced sellers of these bonds are in an extremely difficult position (these are bonds that we’ve been very heavily underweight, for reasons that Ben listed in August).

The seizing up of the cash bond market and the serious problems facing banks and investment banks has inevitably had an impact on the liquidity of the credit derivatives market too. Credit Default Swaps (CDS) are over-the-counter instruments, so anyone entering into a contract is exposed to counterparty risk, albeit this risk is mitigated with regular posting of collateral. Investment banks are increasingly unwilling to hedge out CDS exposures with eachother, owing to the recent increase in counterparty risk. The result of this is that liquidity in the CDS market has fallen, although the CDS market remains more liquid than the underlying cash bond market.