Bailing out struggling firms will come at a high price
US is squandering money on businesses that should go bankrupt rather than tempting new investors
Is the treatment worse than the disease? The Federal Reserve’s massive money-printing programme has significant long-term consequences. Not only is it saddling future generations with stratospheric debt in a country where tax rises are anathema, it is creating a horde of undead, zombie companies that are certain to come back to bite.
Significant financial losses for investors being are deferred, but financial resources are being allocated to companies that probably should not exist. This will dampen US productivity and competitiveness for years. A zombie company has so much debt that any cash generated is being used to pay off the interest on the debt. Should interest rates go up, these businesses will not be able to survive. Experienced investors, overall, tend to know how to avoid such traps.
This week US shale pioneer Chesapeake Energy finally filed for Chapter 11 protection from bankruptcy. Yet on June 8 its shares soared a staggering 180pc after Opec agreed production cuts to shore up the oil price. Investors, particularly younger investors using commissionfree apps such as Robinhood, piled into the shares.
The investment was underpinned by confidence in the Fed’s pledge to go to “infinity” in its plans to support US economy. The rising tide of Fed liquidity was lifting all boats, after all.
Fed support has resulted in indiscriminate share price rises in the US, encouraging investors to pile into stocks as they feared missing out. Shares in shale oil groups have been particularly well bid after the collapse in US oil prices at the end of April. Young investors lured into buying shares in the company are about to learn a particularly harsh lesson about where equity investors stand in the pecking order in a company restructure. It will clearly hurt.
Chesapeake’s inevitable bankruptcy has been clear for some time. In May the group warned that it probably would not be able to carry on as a going concern.
It has a $23bn (£20bn) of borrowing after a debt-fuelled expansion and the relatively high cost of producing shale oil means it is troublesome finding the cash to pay its bills. The company, under its former chief executive Aubrey McClendon, was at the vanguard of the US fracking industry. The company was a disrupter, bringing to life an industry that would lead to US energy independence. However, the US fracking industry also helped create a global glut of oil, hampering its own profitability. Many companies producing hydrocarbons by fracking need an oil price higher than current levels to break even.
The company is also no stranger to controversy. Mr McClendon left the company in 2013, as questions about the company’s business practices emerged. In March 2016, the former chief executive was indicted on Federal charge of conspiring to rig bids on energy leases in Oklahoma. Mr McClendon died the day after his speeding SUV hit a highway embankment and the vehicle burst into flames.
Basically, no rational investor would have gone anywhere Chesapeake’s shares for quite some time. Unfortunately, novice investors attempting to ride the wave of Fed liquidity are unlikely to receive a cent for the investment they made in Chesapeake just a few weeks ago.
Delisting procedures have already been started by the New York Stock Exchange. Stimulus measures are now supporting many businesses that should have been left to go bankrupt. This will impact productivity and future economic growth because capital is being misallocated to these companies instead of being invested in businesses that are more likely to prosper. The business backdrop following the pandemic will be very different to the one we saw before.
High streets have been devastated as consumers seek goods and services online. The rise in homeworking means that cybersecurity and cloud computing will be growth areas, while stimulus measures from institutions such as the European Union involve a “green deal” to boost investment in clean energy.
Low interest rates and corporate welfare also lead to “moral hazard”.
“Moral hazard” in economics, happens when an entity such as a company has an incentive to increase its exposure to risk because it does not bear the full costs should things go wrong. If managers know they will be bailed out it will change their behaviour and it encourages excessive risk taking, which can have a major impact on a country’s economy.
This is not a major concern for some, as measures introduced are aimed to prevent job losses and keep consumers spending to aid the recovery. But not only is the Federal Reserve bailing out zombie companies and prolonging the pain, the central bank’s corporate bond buying programme is giving financial support to companies that do not really need it, leading to more misallocation of capital. Yes, the Fed is buying bonds issued by struggling companies, but it is also expanding its balance sheet to buy bonds in some of the strongest companies in the world.
It now directly owns the debt of companies such as Microsoft and Visa and it holds indirect holdings through exchange-traded funds in companies such as Goldman Sachs. This is not a sensible allocation of cash if preserving jobs is the aim, rather than supporting equity markets in the short term. It certainly isn’t capitalism in any form that we know it.
Keeping companies alive for the sake of it will have a major effect on productivity – and as we have seen with novice investors and Chesapeake – many individuals will also be lured into investing in companies for spurious reasons.
Boosting the stock market today will come with a cost tomorrow.
‘The Federal Reserve’s moneyprinting is creating a horde of zombie companies that will come back to bite’
Jerome Powell, chairman of the Federal Reserve, and Steven Mnuchin, Treasury secretary, bump elbows at a hearing