Corporate Debt: The Key Financial Vulnerability
The next financial crisis (there will always be a "next financial crisis" in capitalism) will not look like the last one. The reason is because working class consumers were mostly locked out of the credit markets from 2008 until recently.
The only exceptions for consumers were auto loans (which is too small of a market to cause a financial meltdown) and student loans (which is almost entirely backed by the federal government).
Yet Wall Street has made a killing during the past decade issuing debt. So someone had to be borrowing, and that someone was corporations.
A key regulator of Wall Street banks has joined the Federal Reserve in warning about risky corporate borrowing that has reached record levels as lender protections are eroded.
The Office of the Comptroller of the Currency cautioned in its Semiannual Risk Perspective released Monday that it’s looking at “transactions with increasing leverage, weaker capital structures, and looser credit agreements.” The report includes a special section highlighting emerging risks in corporate bonds and lending, after the preceding version released in May didn’t address this high-risk debt.
“The OCC remains attentive to the heightened risks in the corporate bond and loan markets, and in particular, the leveraged lending market,” the agency said, noting “near-record issuance” of such loans in the first half of this year, with the average leverage of large corporate loans at a record high.
Total corporate debt surged 86%, from nearly $4.9 trillion in 2007 to nearly $9.1 trillion halfway through 2018.
The key chart is this one.
Roughly half of the entire universe of investment-grade corporate debt is rated BBB, just one rating cut away from being junk.
Arguably, businesses with the most robust balance sheets sport investment-grade credit ratings, but BBB-graded bonds sit only one to three notches above so-called junk, or sub-investment grade, debt. If credit ratings firms do downgrade much of this tranche of debt into “junk” during the next recession, some conservative investors like pension funds and insurance companies may have to dump their holdings, sparking a wave of forced selling and seizing up the high-yield market.
“Such downgrades to the constituents of this credit rating segment would present a serious challenge to the broader [U.S. dollar] credit complex,” said Marrinan.
In an era of massive corporate profits and record stock prices, the only explanation for so many corporations being so fragile and debt-laden is corporate mismanagement on a criminal level.
“High leverage has historically been linked to elevated financial distress and retrenchment by businesses in economic downturns,” the Fed said in a section of its report highlighting how indebted companies are borrowing even more money. “Such an increase in financial distress, should it transpire, could trigger a broad adjustment in prices of business debt.”
The Fed also cautioned that escalating trade tensions could lead to a “particularly large” drop in asset prices because “valuations appear elevated relative to historical standards.” Equity prices, in particular, are “somewhat high” relative to corporate earnings forecasts.
Evidence of this borrowing binge being near its end can be found in this chart.
Leveraged loans are sub-investment grade debt with floating interest rates.
Does that sound vaguely familiar?
Investors started to pour into the $1.3 trillion-sized market to guard against the corrosive impact of the Federal Reserve’s hiking on the bond market, but the lack of written protections for buyers is worrying credit firms who warn that investors could take steep losses when the next downturn in the credit cycle arrives.
“Traditionally, leveraged loans would be accompanied by a range of covenants designed to limit the financial risk issuers could take. So far in this cycle, the majority of leveraged loans that have been issued contain weakened protections,” said Marrinan.
What we are seeing is many of the same elements that we saw in 2007, but manifesting themselves in different ways.