Weekend Economists Celebrate the Season! December 18-20, 2015

[Proserpina]

17. Are We Headed for a Credit Market Crash?

http://houseofdebt.org/2014/04/17/are-we-headed-for-a-credit-market-crash.html

In a series of speeches, Federal Reserve Governor Jeremy Stein emphasized the importance of financial stability concerns in monetary policy-making. But how does one measure whether threats to financial stability are lurking? Put differently, can we know that there is a credit bubble about to burst? In his speeches, Stein cites the work of two Harvard Business School professors, Robin Greenwood and Samuel Hanson. Their research argues that a good indicator of credit market overheating is the share of all new corporate debt issues coming from low-grade issuers. This measure is based on the quantity of credit issued, not just interest rates. Others focus exclusively on credit spreads, or the interest rate differentials between, say, junk and investment grade firms. Greenwood and Hanson argue that quantities of credit issued by low-grade versus high-grade firms add a lot of power when predicting credit market crashes.

So how big is the risk of a credit market crash today? Robin and Sam were nice enough to send us the updated data through 2013. This chart shows the high yield share of corporate debt issues. Or in other words, the fraction of all corporate debt issues by high yield (or junk) firms:



You can see right away that this variable predicts crashes pretty well. The high yield issue share peaks about two years before major meltdowns we’ve seen in credit markets. So when risky firms are issuing a ton of debt, bad things tend to happen. The high yield share in 2012 and 2013 indicates elevated risk, but not an impending disaster. For example, the 2013 high yield share is still below the peaks seen prior to other credit crashes. This may be driven in part by the fact that investment grade firms are also issuing a ton of debt. So in some sense the denominator is rising so fast that the high yield bond issues cannot keep up with it.

As mentioned above, another measure people use to predict credit market overheating is the interest spread between Baa rated-debt and Aaa rated-debt. If this spread narrows, then credit markets are willing to fund riskier firms at lower interest rates. Here is the chart showing this spread:



Looking at the long history, you can see why interest spreads don’t do as good a job predicting crashes as the high yield share. The interest spread falls before every crash, but the pattern is not nearly as stark as it is with the high yield share of debt issues above. As this chart shows, the interest spread has fallen substantially in 2012 and 2013, but remains slightly above the very low levels it reached before the 2001 recession and the Great Recession...

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