It was 10 years ago in September 2008 that the worst of the financial panic crashed through the US economy. Where might the next financial crash be lurking? In a speech last week, Federal Reserve Governor Lael Brainard pointed to some possible candidates. She said:
"The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. The Federal Reserve's assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates. Rising risks are notable in the corporate sector, where low spreads and loosening credit terms are mirrored by rising indebtedness among corporations that could be vulnerable to downgrades in the event of unexpected adverse developments. Leveraged lending is again on the rise; spreads on leveraged loans and the securitized products backed by those loans are low, and the Board's Senior Loan Officer Opinion Survey on Bank Lending Practices suggests that underwriting standards for leveraged loans may be declining to levels not seen since 2005."A few points are worth emphasizing here. As Brainard is pointing out, the last couple of decades suggest that the primary risk of recession in the US economy is not likely to arise from a jolt of inflation. Instead, the last two recessions were associated with financial market stress: the end of the dot-com boom in 2001, and the end of the housing price boom in 2008-2009.
Since the Great Recession, a number of steps have been taken to assure that banks are safer and more resilient (higher capital requirements, stress testing, and the like). But the US financial system is a lot bigger than just the banks, and financial troubles can come from a number of directions. What about the two risks that Brainard specifically mentions: corporate debt and leveraged loans?
The financial press has a number of recent articles on the risk that a corporate debt bubble is happening: for example, here's a take from Jesse Colombo in Forbes (August 29) or here is Steven Pearlstein in the Washington Post on June 8:
"Now, 12 years later, it’s happening again. This time, however, it’s not households using cheap debt to take cash out of their overvalued homes. Rather, it is giant corporations using cheap debt — and a one-time tax windfall — to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks. As before, the cash-outs are helping to drive debt — corporate debt — to record levels. As before, they are adding a short-term sugar high to an already booming economy. And once again, they are diverting capital from productive long-term investment to further inflate a financial bubble — this one in corporate stocks and bonds — that, when it bursts, will send the economy into another recession."A report from the McKinsey Global Institute last July put some of this in global perspective. Compared to other regions of the world, US corporations are more likely to raise money using bonds:
"[I]f companies in Western Europe and China were to match the appetite of US corporations for bond financing, their markets would double and triple in size, respectively. ... A shift toward bond financing has been observed in all regions. In the United States, bonds accounted for 19 percent of all corporate debt financing in 2000; by 2016, that share had jumped to 34 percent. ... Companies in the United States still lead the world in issuance with $860 billion issued in 2017 ..."A larger share of US corporate bonds are being issues with lower ratings, and by companies that already have higher levels of debt. These bonds promise to pay high interest rates (to make up for their higher risk of default), and a large volume of such bonds will need to be refinanced in the next few years:
"In the United States, almost 40 percent of all nonfinancial corporate bonds are now rated BBB, just a few steps above noninvestment grade, up from 22 percent in 1990 and 31 percent in 2000, according to Morgan Stanley. Overall, BBB-rated US nonfinancial corporate bonds outstanding total $1.9 trillion—almost twice the size of the high-yield bond market. Issuers are also more heavily indebted than before. The net leverage ratio for BBB issuers rose from 1.7 in 2000 to 2.9 in 2017 ... Noninvestment-grade bonds carry higher default risk, which increases the vulnerability of the corporate bond market.15 In the coming years, a record amount of speculative-grade corporate bonds could need refinancing. In the United States, for instance, the share of maturing bonds that are high yield is expected to grow from 11 percent in 2017 to 27 percent in 2020. The absolute amount—at least $180 billion of high-yield bonds coming due in 2020—will be almost three times the amount in 2017. If current high-yield issuance trends continue, that share will rise even more."Behind the scenes, what's happening here is that with bank regulation tightening up and interest rates so low, companies have turned to borrowing with bonds, including higher risk bonds that promise higher interest rates. There are dangers here for past investors in these bonds. But perhaps the bigger danger for the economy is that US companies have become accustomed in the last few years to the idea that they can raise large sums in corporate debt markets at relatively low cost. If investors decide that these corporate bonds actually are riskier than they had thought, the amount of capital flowing to the corporate sector could dry up rather quickly. This is a scenario discussed by William Cohan in an interview at the Wharton School on the topic: "How Dangerous is the Corporate Debt Bubble?" (August 20, 2018). Cohan says:
"One never knows what the catalyst is going to be for the next financial crisis. ... But the truth is nobody rings a bell at the top of the market and says, `That’s it. It’s over. It’s been fun, guys. It’s all downhill from here.' When I was a banker 27 years ago, the management of United Airlines (UAL) was trying to take it private in what was then one of the largest management buyouts of all time. They had got the commitment letter from Citibank to finance that deal. But suddenly Citibank went back to the management and said, we can’t finance this deal, the market is not there for this buyout. This was in 1991, four years after the stock market crash of 1987. It became a huge problem and shut down the credit markets for the next two or three years. The fact that the UAL buyout could not be financed in the market was the signal that the party was over, and that we were now heading into a severe credit crunch. Anything could be a catalyst. Maybe Tesla trying to go private will be a catalyst for this market shutting down. And that is when real trouble happens. Because people who had nothing to do with it, with the excess, can’t get access to capital."If this kind of scenario emerges, it will be made more difficult by the archaic ways in which corporate bonds are still traded, which makes it more difficult for them to be easily bought and sold in liquid markets. The McKinsey report notes:
"Bond markets need to enter the digital age. Despite being worth $11.7 trillion, the market is surprisingly antiquated, with little transparency or efficiency. While equities can be traded at the click of a button, buying and selling corporate bonds often requires a phone call to a trading desk at an investment bank, and there is little transparency on the price the buyer is quoted. This method of trading still accounts for more than 80 percent of volume in the United States."
Concerns about leveraged loans have been around for a few years now: for example, here are some comments I made back in 2014. The issues here also relate to corporate debt, but in the loan market, rather than the bond market. In the case of leveraged loans, a group of banks get together and make a loan to a company. The banks then package this loan (or a group of similar loans) into financial securities that are then re-sold to investors across all financial markets. Those who remember the experiences of 2008, when mortgages from subprime housing loans were packaged together and sold to investor and financial institutions around the world, will see some worrisome parallels.
Again, the financial press has a number of recent articles warning about issues with leveraged loans. For example, here's an article from the Credit Union Times (August 21, 2008) citing estimates that leverage loan market is now at $1.4 trillion, bigger than the market for high-yield bonds. Here's Pearlstein from the Washington Post pointing out the dangers (July 28, 2018).
For variety, I'll describe these issues by quoting a few remarks from Robin Wigglesworth in the Financial Times (August 24, 2018).
"But the leveraged loan boom is storing up some nasty problems. In their desperation to gobble up higher-yielding loans from riskier borrowers, investors have — initially reluctantly so, but recently with reckless abandon — accepted fewer and fewer of the legal protections that typically guard their rights. These `covenants' restrict how much a creditor can pay shareholders in dividends, how much more debt they can take on, or what security lenders can seize in a bankruptcy. But the average covenants are now `distressingly weak', according to Moody’s. Indeed, the rating agency’s index that measures the average quality of legal protections hit its worst-ever level this year. ...
"Before the financial crisis, about a quarter of the leveraged loan market was termed “covenant-lite”; today it stands at almost 80 per cent, according to Moody’s. Almost two-thirds of the entire market now has a lowly credit rating of B2 or worse, up from 47 per cent in 2006. In other words, an already junky market has deteriorated further. ... Christina Padgett, senior vice-president at Moody’s, warned: “The combination of aggressive financial policies, deteriorating debt cushions, and a greater number of less creditworthy firms accessing the institutional loan market is creating credit risks that foreshadow an extended and meaningful default cycle once the current economic expansion ends.” ...
"Specialised investment vehicles known as “collateralised loan obligations” are the biggest buyers of leveraged loans. Issuance of CLOs reached $69bn in the first half of the year, leading S&P to lift its full-year forecast to a record $130bn. But there are a multiplying number of mutual funds and ETFs dedicated to leveraged loans. At the start of 2000 there were only 15 such funds. On the eve of the financial crisis there were less than 90. Today, there are 272 different loan mutual funds, and another eight ETFs that buy loans, according to AllianceBernstein. These have sucked in more than $84bn just since 2010. This looks like an accident waiting to happen. While CLOs have locked-up investor money, mutual funds and ETFs promise investors the ability to redeem whenever they like, despite the underlying loans trading rarely. Even the trade settlement process takes weeks. A loan market downturn could therefore escalate into a severe “liquidity mismatch” between the investment vehicles and their underlying assets, which turns a fire-sale into an inferno."Dealing with financial stresses before they turn into crises is hard to do. But not doing so can have harsh consequences, as I hope we learned 10 years ago in the Great Recession.
