Debt threat

Ris­ing loan lev­els cast shadow over US economy

Financial Times USA - - FRONT PAGE - Gil­lian Tett gil­lian.tett@

What is it about the Ameri can economy that keeps hedge fund lu­mi­nar­ies awake at night? A cou­ple of weeks ago I put that ques­tion to Ken Grif­fin, head of the Citadel group.

His an­swer was il­lu­mi­nat­ing: “Re­ces­sion.” This is not be­cause Mr Grif­fin is braced for a down­turn right now; like most ex­ec­u­tives, he ex­pects mod­er­ate growth this year, partly be­cause he is ex­cited about Pres­i­dent Don­ald Trump’s re­fla­tion plans.

But Mr Grif­fin wor­ries about maths — and his­tory. Over the past cen­tury, the av­er­age length of an Amer­i­can re­cov­ery has been six years. How­ever, the cur­rent ex­pan­sion has lasted eight, so the charts im­ply that a re­ces­sion is over­due.

Of course, there are many rea­sons why these his­tor­i­cal charts might be wrong. Mr Trump’s re­fla­tion plans are one. An­other is the fact that the postcri­sis “re­cov­ery” has up­ended his­tory by be­ing un­usu­ally weak.

But what is also strik­ing is that there are hints in the data of an im­pend­ing cycli­cal peak. Con­sider the is­sue of debt. Al­most ex­actly a decade ago, Amer­i­can con­sumer debt ex­ploded, spark­ing the fi­nan­cial cri­sis when that bub­ble burst.

After that drama, con­sumers delev­ered. But this week, the New York Fed­eral Re­serve re­vealed that con­sumer debt bal­ances have risen again, touch­ing $12.73tn at the end of the first quar­ter of this year, above the 2008 peak of $12.68tn.

There is no rea­son to panic about this: most Amer­i­can con­sumers are ser­vic­ing this debt well, not least be­cause un­em­ploy­ment has fallen to a mere 4.4 per cent. The ra­tio of house­hold debt to gross do­mes­tic prod­uct is still well below the peak.

And if you look at the is­sue cen­tral to the last cri­sis — mort­gage debt — the picture is very be­nign: only 3.5 per cent of home loans went into ar­rears in the first quar­ter, com­pared with 10 per cent a decade ago.

But what is alarm­ing is stu­dent debt: this has ex­ploded in re­cent years to un­sus­tain­able lev­els, and “se­ri­ous delin­quency” rates are al­ready 10 per cent, shat­ter­ing the con­fi­dence and spend­ing power of one seg­ment of the pop­u­la­tion. If in­ter­est rates rise or growth slows, these prob­lems could spi­ral.

Cor­po­rate lever­age presents wor­ries too. This has not grabbed many head­lines this decade, partly be­cause it did not play a role in the last cri­sis. But in re­cent years com­pa­nies have been stealth­ily load­ing up on debt. The Se­cu­ri­ties In­dus­try and Fi­nan­cial Mar­kets As­so­ci­a­tion, for ex­am­ple, says that cor­po­rate lever­age is $8.52tn, or 57 per cent above the last 2008 peak, with a par­tic­u­larly dra­matic in­crease in risky bor­row­ing in the last year.

Right now, this is not cre­at­ing any drama; or not with in­ter­est rates at rock bot­tom lev­els and the US economy grow­ing. In­deed, in­vestors are so re­laxed about the out­look that the Bank of Amer­ica Mer­rill Lynch US High yield in­dex tum­bled to 5.56 per cent this week, its low­est level since 2014, and lever­aged lend­ing covenants are be­ing ripped up.

Mean­while, Gold­man Sachs and Mor­gan Stan­ley also re­vealed this week that there is so much fevered de­mand for lever­aged fi­nance that it is a key factor driv­ing their profits.

But that news should, in it­self, ring alarm bells. A decade ago, banks were mak­ing big profits by slic­ing and dic­ing mort­gage loans. And, as the In­ter­na­tional Mone­tary Fund warned in its re­cent Global Fi­nan­cial Stability Re­port, this bor­row­ing boom could be frag­ile if in­ter­est rates sud­denly rise, or growth slows down.

The IMF cal­cu­lates, for ex­am­ple, that com­pa­nies ac­count­ing for 10 per cent of US cor­po­rate as­sets are al­ready strug­gling to meet in­ter­est pay­ments out of cur­rent earn­ings. More strik­ing still, 22 per cent of com­pa­nies would be “weak” or “vul­ner­a­ble” if bor­row­ing costs rose. “[US] Cor­po­rate credit fun­da­men­tals have started to weaken, cre­at­ing con­di­tions that have his­tor­i­cally pre­ceded a credit cy­cle down­turn,” the IMF notes.

It is im­por­tant to stress again that nei­ther the IMF nor Mr Grif­fin is ac­tu­ally pre­dict­ing a slow­down in growth or sharp rise in rates. On the con­trary, the main­stream view is that growth will stay be­nign.

But the key point is this: with so much growth al­ready baked into fi­nanciers’ fore­casts — the sunny as­sump­tions of the cor­po­rate ex­ec­u­tives who keep rais­ing all this debt — a sud­den re­ces­sion would cre­ate a nasty shock. In­vestors ig­nore this at their peril, par­tic­u­larly in a week when the world is con­fronting more un­cer­tainty about Mr Trump and whether he can ac­tu­ally im­ple­ment any of his bold plans to stave off any re­ces­sion.

With so much growth baked into fore­casts, a sud­den re­ces­sion would cre­ate a nasty shock

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