By James Saft
Dec 10 (Reuters) - What happens when credit conditions are far too loose, the banking system is fragile and interest rates start to rise?
Yes, I know you have heard this joke before, and yes, I know it is not funny.
The Bank for International Settlement's quarterly review of financial conditions is an exercise in nightmarish deja vu: familiar to those who watched the last crisis but just different enough to be plausible. ()
Not only are credit markets so loose that comparison with pre-Lehman Brothers days are fair, but this is happening within a context in which investors, on the whole, don't really have faith in the strength of banks.
This implies that if interest rates start to rise, and recent data and rumblings from central banks indicate they may, a reckoning of some kind will be at hand.
So how loose is credit?
"What is happening in corporate markets is unusual. It is as if the typical relationship with the macroeconomy has taken a holiday," Claudio Borio of the BIS said at a press conference.
While spreads, the premium investors demand to take extra risk, are very low, so are default rates, with only 2.5 percent of U.S. high-yield debt defaulting in the past year. That's just a bit more than defaulted in the go-go years before the crisis, when growth was much stronger and when memories had not been seared by a mini-depression.
Look no further for evidence of very easy conditions in lending markets than the renewed vogue for payment-in-kind notes, a kind of bond which gives borrowers the ability to pay interest to lenders with - get this - yet more debt.
Borrowers have issued record amounts of these securities so far this year, despite the fact that about one in three borrowers who sold similar securities before the crisis defaulted between 2008 and mid-2013.
The syndicated loan market, in which groups of banks band together to make loans, is also showing signs of overheating. About 40 percent of new loans signed between July and November were "leveraged", the riskiest class, a higher number than during 2005-2007.
These easy conditions and low default rates are self-sustaining. Who defaults when they can just issue more debt?
WHITHER THE BANKS?
We know, of course, what is driving this - quantitative easing. By buying safe securities using new cash, central banks engaging in quantitative easing hope to force investors to take on more risk. The idea is that, faced with cash to invest and very low rates in government bonds, investors will climb a bit further out the risk-reward branch. Do that long enough and taking more bonds in lieu of interest begins to sound not just reasonable but a smart play.