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Response to Proserpina (Reply #17)

Sat Dec 19, 2015, 01:40 PM

18. The Next Financial Crisis Will Start Here

 

http://daviddayen.tumblr.com/post/135158683211/the-next-financial-crisis-will-start-here



(Note: this is an article I wrote for The Progressive for their July/August 2014 issue that was never put online. Because we’re actually starting to see the beginnings of a fallout in high-yield corporate debt, the subject of the article, I thought I would put it online. I think it holds up pretty well.)

“When will the next financial crisis happen, and where will it occur?” This trillion-dollar question remains firmly implanted in the minds of every financial analyst, business reporter and government regulator in America today. If I knew the answer precisely, I could either prevent a lot of suffering or make a lot of money betting on the collapse. I don’t have that answer. The specifics of where and when financial crises will originate are obscure. But we do know that such crises normally result from an excess of risk. Widespread borrowing accumulates somewhere in the financial system, everyone believes it will only lead to profit, and when it goes sour, borrowers cannot cover their debts. From there, our endlessly inter-connected financial system spreads the cascading losses across many institutions, and suddenly everyone becomes afraid to lend for fear of getting caught holding the bag.

In 2008 that excess risk rose up from subprime mortgages. Today, risk is pooling in a different area: corporate debt. From multinationals to small businesses, corporate debt has exploded over the past two years, alarming regulators and policymakers. “In many ways, this is a test of all the mechanisms that caused the financial crisis,” said one fearful Senate Democratic aide. “If there’s another crisis, this is where it might start.” A clear example of this gold rush can be seen in Apple’s recent $17 billion corporate bond sale, the largest on record and the tech giant’s first since 1996. Apple, with $158 billion in cash reserves, has little need to borrow money. But thanks to several years of low Federal Reserve interest rates, it’s become so cheap for corporations to borrow that big firms who resist just leave money on the table. Tellingly, Apple plans to use the funds not to develop new products or finance new capital investments, but simply to boost returns to shareholders. So the increased borrowing risk doesn’t even improve the economy; it goes straight from the fruits of worker productivity into the accounts of the top one percent.

Much of this corporate debt is more dangerous than Apple’s, however. In fact, Wall Street describes it as “junk bonds,” which offer a higher return because of the higher risk of default. That’s attractive to investors, who have been “reaching for yield” above what safer investments will produce. Since March 2009, the junk bond market has doubled to $2 trillion, as worries about risk have flown out the window. Got an idea for a vegan restaurant on a cow farm or a lingerie shop in a nunnery? No problem, some investor will lend you lots of money. In fact, loading up companies with massive debt is a business strategy for the kinds of companies that will be familiar to anyone who paid attention during the 2012 Presidential election to Mitt Romney’s exploits at Bain Capital. Private equity firms like Bain take over companies and borrow lots of money to make the acquisition, a process known as a leveraged buyout. The assets of the company become the collateral for the loans. This puts the company and all its workers at great risk, because if their operating revenue cannot pay off the high interest payments on the debt, their assets get sold in bankruptcy and everyone loses their jobs. Even in that situation, private equity firms can walk away with a profit, as they put up nothing to acquire the company, and they make their money through management fees. It’s an old story: the big money boys come to town, suck out the value from a company and then leave its dried husk by the side of the road.

Loans in private equity deals are often “covenant-lite” leveraged loans, a type of junk bond that offers fewer safeguards for investors. Given the desperation for higher yields, investors foolishly accept higher risk to get their hands on low-grade corporate debt. So under the terms of these loans, investors do not get informed when the underlying companies run into financial trouble, making it harder to avoid losses. Leveraged loans hit a new record last year, and covenant-lite loans exploded, comprising over half of all leveraged loans, according to the New York Federal Reserve. Demand was so high, in fact, that the spread between “high yield” corporate debt and risk-free securities like Treasury bonds fell to all-time lows, making it even crazier to purchase riskier debt for a small additional reward. Smaller and smaller firms were the beneficiaries of these loans, like Learfield Communications, a media group with $40 million in annual revenues that received an incredible $330 million in covenant-lite loans last October. It’s correct to call this the “subprime of the corporate world.” Deutsche Bank and GE Capital brokered that deal for Learfield, an example of how managing corporate debt has become a profit center for big banks. The Volcker rule and other restrictions from the Dodd-Frank financial reform decreased trading revenues, sending big banks scurrying for other sources of revenue. Big banks profit from all sides of these leveraged buyout deals. They get fees for advisory work from the private equity firms and from the corporations who ultimately issue the debt.

Because they’re so lucrative, banks have ignored regulator concerns around leveraged buyouts. Last March, the Federal Reserve and the Office of the Comptroller of the Currency issued specific guidelines to banks not to finance leveraged buyouts that saddle companies with debt exceeding six times their earnings. Yet 40% of private equity deals this year have vaulted past that ratio, the highest level since before the 2008 financial crisis. Senior Federal Reserve official Todd Vermilyea said in prepared remarks in May that “terms and structures of new deals have continued to deteriorate.”

We have history as a guide for what happens when risky corporate debt spikes. Economics professors Atif Mian and Amir Sufi show that increases in low-grade corporate debt almost always leads to recessions and crashes. Right now, low-grade debt is on the way up, but has not peaked at the same levels we have seen prior to other recessions. However, it’s clear that things are moving in the wrong direction, which is why banking regulators have been unusually public in warning about the risks. Daniel Tarullo, a Federal Reserve governor and their point person for financial regulation, said in a speech in February that leveraged loan spikes “raise the possibility for large losses going forward,” and new Fed Chair Janet Yellen has put Wall Street on notice about the worrying trend...

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