A man is reflected in the chart with stock prices at the Greek Stock Exchange in Athens, Monday, May 14, 2012.Petros Giannakouris/The Associated Press
I'll remember this phrase as long as I live: "Low volatility and tight spreads are what got us into this mess in the first place."
The source was credit and interest rate strategist Kevin Ferry during a 2013 phone interview. The sentiment foreshadowed a trend that's becoming evident now – sowing the seeds of a new credit crisis.
The term "vol", or volatility, is finance-speak for the fees a lender can charge for accepting risk. The CBOE Volatility Index (VIX), for example, is a measure of the premiums charged by underwriters of futures and options on individual stocks.
Tight spreads are best illustrated by mortgage lenders. The difference, or spread, between risk-free government bond yields and the mortgage rate is (loosely) an indicator of the profits the bank makes from mortgage policy holders. It compensates the lender for the risk that the loan will not be repaid.
Mr. Ferry was referring to the root cause of the credit system irresponsibility that led to the financial crisis. In simple terms, what he was saying was that lenders ignored credit risk (remember NINJA loans?) and loaned money cheaply – at levels close to risk free rates.
Pre-crisis, the result was lower bank profits and a desperate bid to enter new lines of business to maintain growth. These new businesses included selling highly leveraged structured products like collateral debt obligations (CDOs), and credit default swaps (CDSs), which blew up in everyone's faces in 2007 and 2008.
Writing for the CFA Institute, portfolio manager David Schawel suggests the same process is beginning again. Similar to 2006, volatility is low and spreads (notably in the corporate bond sector) are tight.
Mr. Schawel writes, "Investors can no longer achieve certain return hurdles with the current environment and thus are forced to turn to leverage." He cites two examples of highly leveraged products that were recently sold to hedge funds with a disturbing resemblance to the CDO hand grenades sold in 2005 to 2007.
A return to the market abyss of 2008 is very unlikely – regulators and lenders have at least learned not to allow CDS issuers to write insurance policies far beyond their ability to pay in event of a default. (This was one of the main drivers of the financial crisis – loan growth, particularly to dodgy borrowers, exploded because lenders thought they were insured by CDS). But current market conditions are similar to the pre-crisis years and some portfolio managers and bankers appear, if Mr. Schawel's blog post is any indication, just as venal and desperate as before.
For now, investment risk from this trend is limited to exotic credit-focused hedge funds and their unitholders. But if we stay in this "low vol, tight spread" environment for a long time, who knows?
Scott Barlow