This could be the start of subprime 2.0

A falling oil price should have a pretty logical effect on stocks…

Essentially, it’s supposed to be very positive. Falling oil is good for consumers, and it’s great for business (unless that business is oil!).

Even more importantly, its deflationary effect could be great for the authorities, for whom it may well provide the excuse for yet more doses of the old money-printing.

And we all know by now how that works. The central banks use that money to buy bonds. The sales proceeds are recycled into all manner of financial investments (thus pushing up asset prices) – and the cherry on top – interest rates on government borrowings fall dramatically. Everyone’s a winner!

But this time round, the falling oil price isn’t helping to soothe markets. On the contrary – markets are tanking.

Clearly there’s something else going on. Something that’s got many shrewd investors running scared.

This is all starting to seem a bit familiar

We all remember subprime well enough – after all, this small but important part of the US housing credit market nearly brought the whole financial edifice crashing down.

But this market didn’t just appear out of nowhere. It was concocted as far back as 1998, during the Asian crisis. Suddenly the US was the ‘safe haven’ of choice as money flooded to the US from the world over.

Not least from China, whose trade surplus needed to be put to use somewhere. Well, the USA was the place. After the dotcom bust, money continued to flow into the US – again, a perceived safe haven.

And what did the money-managers do with this surfeit of cash? What was needed was a safe type of investment, but one with the prospect of a decent yield. Enter, subprime. It thus created mortgages for homeowners that mostly shouldn’t have been homeowners at all.

Excess liquidity finds its own home; usually where it shouldn’t be. Case in point.

Roll on ten years, and the USA has been filling up with money once again. This time, it was a product of both quantitative easing (QE), and a fresh move into ‘safe’ US Treasuries as a result of the 2008 collapse.

Where was the money headed this time? Nobody was going to fall for subprime housing again…

Introducing: subprime energy!

There’s always something new for the investment community to get their teeth into. Something that looks (and perhaps is) great.

This time, the story was fracking.

It’s a story with many facets – many of them genuinely wonderful. Cheap energy to revitalise the US economy. Cashflows from an economy that would then be able to repay interest on considerable US debt. And to top it all, an industry that would need investment funds to get it all going.

We’re talking about massive new lines of credit aimed not at subprime homeowners, but energy companies. Especially small and medium sized oilers – ready, willing and able, to take other people’s cash and invest it in all manner of high-tech drilling projects.

The banks were only too willing to help. And just as with subprime, these loans were sold throughout the globe.

In fact, it’s something I warned about just a few months ago.

This isn’t about equity – it’s about (bad) debt

In my recent piece, I said to beware of the countless ‘utility and energy’ funds launched right here in the UK. I’d seen plenty of these funds launched and marketed on the basis of exposure to energy and utilities. Sectors that one might consider a useful inflation hedge.

But as I pointed out at the time, many of these funds aren’t stuffed full of infrastructure equity. No, they’re filled with infrastructure debt. And bonds aren’t an inflation hedge.

Quite the opposite, in fact. Bonds do poorly in the event of inflation.

And here’s the real ripper – these things are getting smashed right now, during deflation too! It now turns out that a deflationary oil price presents a devastating credit risk to said bonds. A veritable lose-lose situation for investors.

You see, fracking can be quite a costly affair. Not in exploration, of course. In the US, it’s mostly a case of simply retargeting old wells, using new technologies to stimulate them into fresh activity.

The cost comes from the energy and resources required for this ‘stimulation’.

With oil crashing, many US fracking projects now look awful

The point is, oil has now taken a massive plunge, a plunge that would have seemed inconceivable only a few months ago.

The result? Many of these projects suddenly look awful. At around today’s oil price, profits can quickly turn to losses for many.

The yield on this debt has gone stratospheric as investors fear the worst. As ZeroHedge reports: “The energy sector is entirely frozen out of the credit markets at this point with desk chatter that there is no bid for this distressed debt at all…”

There’s no doubt that many of the high-rollers at the big trading desks will be affected. As with subprime, as one area of the credit market falls, its sucks in other parts of the market – contagion!

It could be margin calls, it could be fear, or it could just be that some traders sell other assets to top up on what now looks like cheap energy credit.

The big problem is that much of this sort of investment is conducted ‘off-market’ – that is, trading figures aren’t published in the normal way.

So for most players (including professionals), we won’t know the extent of the mess until it’s too late.

It’s time to ride out the storm

At this stage, I would urge caution. Personally, I’m not playing the usual game of topping up as the market falls out of bed.

That said, I’m definitely not selling either. These Christmas markets have a habit of going too far one way, or the other – this time, the Santa Claus rally seems to be a Santa Claus crash.

Not much Christmas cheer for investors. But until we know more, it’s not worth over-reacting to events.