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January 19, 2007

Never Mind the Price Tag, Part II
by Adrian Ash

"...Fancy a St.Tropez villa with its own infinity pool? Keep your eye on the junk bond market..."

The real estate agent blinked into the warm winter sunshine.

"In 34 years in the St.Tropez market I've never known anything like it," he smiled.

Interviewed for British television, the realtor looked every inch ' old money'. But he didn't mind the nouveau riche of bonus-rich bankers and traders now driving property prices higher in the South of France.

Every villa he showed to the film crew came with an infinity pool and a view to die for. None of them cost less than $3 million.

"The financial traders and bankers from the City used to be discrete, anonymous," he laughed. "But not now. They like to flash their money around..."

Today's bubble in money beggars belief for the old hands at home in London, too. "I have been working in the leveraged credit and distressed debt sector for 20 years," says an email sent - anonymously - to Gillian Tett at the Financial Times.

"I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is."

But it's hard to remember risk when you're having so fun much! In London, the top restaurants are seeing lots of flash cash, for instance. They just enjoyed their best December growth for nearly a decade, with trading up 15%.

"It's been exceptional," says a spokesman for the hospitality industry, and no wonder. City bonuses reached record levels in 2006. Staff at Goldman Sachs in London made an average of £300,000 - more than $590,000 each. Staff at Lehman Brothers got an average bonus of $335,000.

Out of this new pot of money, magicked from nowhere by financial wizardry, one of London's leading estate agents reckons almost $11 billion will flood into the property market. The average price of central London property on Savills' books is now valued at £1.37 million...nearly $2.7 million.

How long can it go on? Does it ever have to end? So long as the investment industry keeps bidding up bond prices, perhaps not. Or so everyone thinks.

Nearly 16% of all US bonds are now rated CCC or below, reports the Financial Times. The Wall Street Journal says these high-risk bonds make up 42% of all US tradable debt. The European market has certainly seen record issuance of these near-default bonds. But the newspapers can't even agree about the size of the bubble!

So maybe the flood of junk debt isn't a bubble at all. Perhaps it's merely a "symptom of a booming market" as one strategist at Barclays Capital says.

Put another way, "liquidity is there when you don't need it," according to Martin Fridson, a researcher with the beautifully-titled Leverage World magazine. And the excess of money, always used if un-needed, is spilling out of the City into French villas and fine wine prices.

"A rational bubble," explains Richard Dale in his excellent history of 1720's South Sea Bubble - The First Crash - "is characterised by the continuing rise in the price of an asset, generated by the belief that this price rise will persist...Investors understand that the bubble will eventually burst...[but] they expect to be compensated for the risk of a price collapse."

And an irrational bubble? It arises, says Professor Dale, "where the relationship between asset prices and fundamental values breaks down...Investors have totally unrealistic expectations about a company's future profitability and therefore dividend-paying capacity."

In other words, irrational bubbles display the most rational behaviour according to the academics. Investors keep buying because they believe - wrongly, as it turns out - that they're making a rational investment in rock-solid investments. Rational bubbles, on the other hand, mean everyone knows that things have got out of hand. But they keep holding anyway, hoping to exit before the last fool catches on.

Surveys from just before the '87 stock market crash, for instance, show that most US investors - both private and professional - felt the market was over-valued. But they chose not to liquidate. Why sell if nobody else was selling? That was pure reason at work, but it led to the most irrational choice.

In April 1999, a staggering 72% of professional money managers on Wall Street polled by Barron's said that the stock market was in a speculative bubble. But the Dotcom Mania kept running until the spring of 2000.

And today? "I am not sure what is worse," says the anonymous email to Gillian Tett at the Financial Times - "talking to market players who generally believe that 'this time it's different'...or to more seasoned players who privately acknowledge that there is a bubble waiting to burst but hope problems will not arise until after the next bonus round."

Rational or not, everyone will look crazy in hindsight. "In Deutsche Bank's latest survey of investor attitudes," says the Financial Times elsewhere, "more than half of respondents felt comfortable locking up their money with a hedge fund for two years or more - double the proportion in 2005. [Yet] hedge fund indices suggest average returns for the industry last year of 13-14 per cent - less than the S&P 500."

Never mind performance - just keep investing!

"Banks in Mongolia and Georgia are approaching international bondholders for the first time," reports Bloomberg. "The sales are being spurred by the lowest yield premium [meaning the highest prices] for emerging-market securities on record, dropping to an average 1.84 percentage points over US Treasuries from 7.71 percentage points five years ago..."

But who cares if interest rates rise? Just keep buying bonds!

"Japan's five-year government notes rose after an auction of the debt drew the highest demand in almost a year," says another newswire report. "Yields are likely to edge lower," says Satoshi Yamada, who runs $6.7 billion-worth of assets in Tokyo. "This week's [likely] rate increase is already priced in."

And so what if all bubbles blow up? Today's financial wizardry really does mean that this time it's different...

"This is not just a cyclical phenomenon, says Amany Attia, head of structured finance at Lehman Brothers. "This genie simply will not go back into the bottle. The entire thinking process of financial institutions has changed."

What Ms.Attia really means, we guess, is that the entire financial industry has boxed itself into a corner. Prices simply have to keep rising to make the leverage look rational - and route one to pushing up prices is to raise gearing again. And so runs every bubble, from the South Sea Bubble with its part-paid subscriptions right through to the 2000 top with its margin-trading and brokerage accounts opened by credit card.

And even if today's strategists, dealers, innovators and traders all thought the leveraged bond market had stopped making sense, what could they do? Bond funds buy bonds. They sure can't buy gold.

The end can't be far off. St.Tropez's real estate agents will get whacked. If you can't afford $3 million for your own villa just at the moment, bide your time.

London's top traders might be buying their French holiday homes in cash. But that doesn't mean they aren't geared to the gills.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events and should be verified elsewhere if you choose to include it in your own analysis.

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