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NEVER
MIND THE PRICE TAG, PART II "...Fancy a St.Tropez villa with its own infinity pool? Keep an eye on the junk bond market..." "In 34 years in the St.Tropez market I've never known anything like it..." The estate agent, interviewed for British television, looked every inch 'old money'. But he couldn't help smiling as he talked about the 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 added. "But not now. They like to flash their money around..." Back in London, the top restaurants are seeing lots of flash cash. They just enjoyed their best December for nearly a decade, in fact, 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 ฃ300,000 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 prime London property on Savills' books is now valued at ฃ1.37 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 even 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 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. And today? Rational or not, it will all look crazy in hindsight. "In Deutsche Bank's latest survey of investor attitudes," says the Financial Times, "more than half of respondents felt comfortable with 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 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. Even if the strategists, dealers, innovators and trader thought the leveraged bond trade 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, but it might take a long time to get there. Martin Hutchinson at PrudentBear.com reckons a "wimpy" quarter-point rate hike by the US Fed would panic the junk bond markets domestic and international. Martin Fridson of Leverage World says default rates could rise 8-fold to more than 17% of all junk bonds in a US recession. What would happen to the price of St.Tropez villas? If you can't afford $3 million just at the moment, bide your time. London's top traders might be buying in cash. But that doesn't mean they aren't leveraged with cheap money. Adrian
Ash
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