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

The Daily Telegraph - Business - - Business Comment - garry white Garry White is chief in­vest­ment com­men­ta­tor at wealth man­age­ment com­pany Charles Stan­ley

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

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