Monday, September 10, 2007

A "New" London Approach?

Credit risk has gone crazy. It appears to have emanated from the subprime meltdown in the US. What has struck me about the thirst for liquidity that has been brought about is that no one seems to have developed a secondary market in credit risk yet.

Last time there was a slump that had property as one of its causes--back in the late 1980s and early 1990s--(remember Olympia & York and Canary Wharf?) lawyers and bankers created a secondary market in distressed debt that became popular. (You can get a copy of my paper on this here.)

It had one side-effect which was to upset those grandees who managed the London Approach to corporate rescue. For those of you who know little of this, it is a set of principles coordinated by the Bank of England to enable banking creditors to institute a moratorium on debt payments, re-organize the failing company, and sell it off. As long as the business had little secured debt and was big, the bank creditors were able to restructure and refloat it.

It started coming apart when the vulture funds in the 1990s started buying the debt and trading it. The Bank of England never had quite the same control again as small creditors were able to sell out and avoid being trapped in a workout that had little benefit for them. The distressed debt traders did not have the same outlook as the bank creditors.

These vulture funds have mutated into hedge funds and other kinds of traders. ("Vulture fund" is a dirty word now for those who exploit the intricacies of sovereign debt of developing countries.)

Yet they haven't moved into the credit squeeze market. Banks are holding significant amounts of paper which their normal customers are refusing to buy. According to the FT trading volumes are too low for values to be properly estimated and so subject to manipulation and conflicts of interest.

If this crisis is to be overcome without the perils of moral hazard, a secondary market will emerge and begin to mop up. The debt traders will do well and the banks and private equity funds will suffer because they are too nervous to calculate risk. The banks will become traders when others have shown the way, which means they won't be able to get the big profits that the early traders will receive.

One last point on this: one professional group that will shine in this period will be the lawyers. After all, someone must do the restructuring work and who better than those who wrote the original agreements. The beauty of lawyering is that lawyers are simultaneously creators and destroyers, which is neatly summed up in this joke:

A surgeon, an architect an a lawyer are having a heated barroom discussion concerning which of their professions is actually the oldest profession.

The surgeon says: "Surgery IS the oldest profession. God took a rib from Adam to create Eve and you can't go back further than that."

The architect says: "Hold on! In fact, God was the first architect when he created the world out of chaos in 7 days, and you can't go back any further than THAT!"

The lawyer puffs his cigar and says: "Gentlemen, Gentlemen...who do you think created the CHAOS??!!"


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