Monday, June 4, 2007

[Latest Global Dollar Liquidity Measure: +14.4% annual growth rate; latest Endogenous Liquidity Index: +14.6%]

In the context of an exchange of ideas with Macro Man about the meaning of higher interest rates, I ventured that spreads matter as much as levels when it comes to the valuation of risky assets. Now, every time I check the numbers, I am struck by the sheer collapse of spreads (between high-yield bonds and treasuries) over the last couple of years. Absolutely amazing! Spreads are the best forecasters of corporate profits. But why are they so low?

Let me briefly discuss one of the least understood aspects of the current liquidity boom: collateralized debt obligations or CDOs. This technology —it is not a "product"— provides "a way of creating high quality debt from average quality (or even low quality) debt" (*). Financial innovation is creating a huge demand for average and low quality debt; in other words: the supply of loanable resources continues to increase.

In 2006 alone, $450bn of CDOs have been issued, and as much as $460bn in synthetic CDOs (portfolios of CDS packaged as CDOs). How does that relate to the valuation of risky assets, beyond the immediate impact of lower financial costs? I don't really pretend to know, but I just don't feel like betting against the market.

(*) John Hull. Options, Futures and Other Derivatives (Sixth Edition). Prentice Hill, 2006, p. 517.

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