Bubbles are forming in the credit market

Where is the next bubble going to form? And will it hurt when it bursts?

After all the bubbles of the last two decades, it is tempting to find them everywhere. But even if stocks are overpriced, it is hard to call them a bubble. Low interest rates push investors into stocks, but the wild enthusiasm that accompanied history's classic bubbles is absent.

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But the next bubbles do seem to be brewing in credit. The asset class that drove the financial crisis in 2008, has been inflated again, by the same heady mixture of ingredients.

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The knock-on effects for the economy should be far less severe than they were after the US housing bubble burst; but the trend is still alarming.

The most worrying place to look is in US auto loans. So says the University of Chicago's Amir Sufi, co-author of the House of Debt – a book published this year. It showed the Great Recession of 2008 and 2009 was driven by a fall in US house prices that inflicted levered losses, and not by the subsequent banking crisis.

Those levered losses were driven by excessive lending to "subprime" borrowers with poor credit histories, which in turn was encouraged by rising securitisation and the need to offer low-risk products with a high yield.

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The good news, says Mr Sufi, is that there is no repeat of this pathology in the housing market, even with house prices rising. Spending on home appliances and furniture has grown far less than spending as a whole over the past five years. And the use of houses as "ATMs" for equity withdrawal via second mortgages is minimal, running at barely a fifth the rate seen before the credit crisis. So unlike the boom of the last decade, the recent rise in house prices has not spurred excessive credit.

In the auto loans market, however, it seems that lenders are staging a re-run of the credit crisis. Sales of subprime auto loans were higher last year than in 2007, as were sales of prime auto loans.

Auto sales tanked in 2009, to hit a level lower than they had seen a decade earlier. Their subsequent rebound has been central to the US economic recovery.

Mr Sufi shows that US sales of new cars in the first four months of this year rose more than twice as fast in the districts with poorest credit histories than in the areas where people had the best credit history. There are also reports that defaults are rising.

To be clear, the subprime auto loan boom cannot cause as much damage as the subprime housing boom. The sums involved are much smaller, people do not expect their cars to rise in value, and cars are easily repossessed. There is no equivalent of the costly dramas of foreclosure.

Some growth might even be healthy – fleets are ageing, and many deferred car purchases during the recession, and so this may be in part a healthy catch-up. We will soon know; the longer the growth in auto loans goes on, the harder it is to view it as anything other than a bubble.

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But there is still reason to fear that a burst auto bubble would have serious economic consequences. Stripping out spending on cars, the US may well have had negative real sales growth in the first half of this year. The recovery in the auto sector may well have been helped by the cheap finance that is available – which implies that a burst bubble in the sector would hurt.

Credit's problems are not limited to car loans. Jan Loeys, JPMorgan's chief market strategist, suggests that future bubbles often appear in asset classes that have expanded the fastest.

On this basis, corporate emerging market debt has expanded far more than any other asset class since the close of 2008; by some fivefold. US high-yield or "junk" bonds and emerging market government debt are next on the list.

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All have expanded far faster than commodities or equities. Like equities, the price of these asset classes has been helped by the rock bottom rates available from "risk-free" bonds, making investors far more willing to take a risk and look elsewhere.

There is ample room for emerging market corporate debt to grow. Companies need more financing, and their economies are growing faster than in the developed world. But these are just the conditions in which bubbles can form. The internet drove much real growth, but it still created one of history's greatest bubbles because people grew excited and overestimated that growth.

There is further reason to worry about debt. When the balloon went up in 2007, credit was a vehicle used mostly by institutions. Now, thanks to exchange traded funds, credit is available at a low price to retail investors.

Even though corporate debt in emerging markets tends to be much less liquid than equities, it is available through ETFs, which promise to be as liquid as any stock. What would happen if large numbers of investors tried to exit at once?

Credit is still a long way from the mad overextension it had reached by 2007. But some corners of the credit market are bubbling over and that should cause concern.

By John Authers, The Financial Times