WHAT COULD CAUSE THE NEXT FINANCIAL CRISIS? Financial crisis rerun?
Ten years after the fall of Lehman, corporate debt may be next bubble
Adecade after the financial crisis, the seeds are being sown for the next potential meltdown. ❚ This time, the tinder isn’t subprime mortgages but a mountain of risky corporate debt that looks eerily similar. UBS estimates there’s a record $4.3 trillion in lower-quality corporate loans and high-yield bonds – up from $2.4 trillion in 2010 – that could begin to see rising defaults if the healthy U.S. economy starts to wobble. ❚ “I view this as the most severe threat to the economy and financial system,” says Mark Zandi, chief economist of Moody’s Analytics. ❚ Saturday marks the 10th anniversary of Lehman Brothers’ bankruptcy filing, a seismic event widely viewed as the trigger of the financial crisis as it rapidly caused investors to lose confidence in banks and the financial system.
Banks not at center of troubles
One consolation is the nation’s largest banks aren’t the biggest players in the lower-grade corporate debt market as they were during the mortgage mess. That somewhat limits the potential damage to the economy, which depends on sound banks making loans to consumers and businesses. The shaky corporate debt is largely held by an assortment of private equity firms, hedge funds, insurance companies, mutual funds and other financial companies.
Yet banks are participants as well,
and if those loans go bad in large numbers, it still could tip the economy into recession, Zandi says.
In the run-up to the financial crisis, banks provided risky subprime mortgages to questionable borrowers, packaged them into securities and sold them to investors. When housing prices started tumbling, homeowners could no longer refinance their loans to avoid higher payments and millions defaulted. That left Lehman and other large investment banks with billions of dollars in mortgage-backed securities whose values were plummeting.
The Dow Jones industrial average, which already was down 19.4 percent from its 2007 peak, plunged 504 points, or 4.4 percent, in the first trading day after Lehman’s demise. The blue chip index fell another 40 percent before finally reaching a bottom on March 9, 2009.
The government bailed out the banks. And the Federal Reserve cut short-term interest rates to near zero. It also began snapping up hundreds of billions of dollars in Treasurys and mortgage securities to lower long-term interest rates and provide funding for the decimated housing market.
Ironically, it’s largely those Fed purchases that set off the corporate debt bubble, says Matthew Mish, head of global credit strategy for UBS.
Since the Fed was gobbling up most of the mortgage securities, private investors went hunting for a new investment that could provide higher returns as low rates spelled meager bond yields.
Enter leveraged loans: They have been doled out to large corporations
with lower credit ratings and already high debt levels, typically to fund mergers and leveraged buyouts.
Banks began stepping up their approvals of such loans and bundling most of them into securities called collateralized loan obligations, or CLOs, which they sold to hedge funds, private equity funds, insurance firms and other private investors. Yes, that sounds a lot like what they were doing with mortgages leading up to the financial crisis.
Meanwhile, private equity funds themselves provided similar risky loans to midsize companies, packaging some of them into CLOs and unloading the assets. Banks also began giving out more traditional loans to companies with less-than-stellar ratings. Together, all of this lower quality corporate debt totals about $3 trillion, UBS estimates, up from $1.6 trillion in 2010.
With the economy humming and interest rates at low levels, the market for these loans has worked smoothly. Corporate earnings have risen, providing more than enough cash for firms to pay off the loans.
But the Fed already has raised its benchmark rate twice in 2018 and expects to hike it two more times this year and three more in 2019. That will increase the monthly payments on the loans, whose rates can reset after just a few months.
The average interest rate on leveraged loans already has climbed about a percentage point over the past year to about 5.5 percent, according to UBS.
And if the economy starts to slow in late 2019 or early 2020, as many analysts expect, earnings are likely to decline, especially for companies on shakier ground, even as rates on their loans drift higher, Mish and Zandi say.
“This is ground zero” for businesses that will be hurt by higher interest rates, Mish says.
Corporate debt could worsen economic dip
If the profits of these weaker companies narrow in a year or two and their borrowing costs rise, defaults on the lower-quality corporate debt are expected to rise, Mish says.
That’s likely to lower the value of CLOs and dry up the market. While the private investors could approach banks for more funding, tougher global rules since the financial crisis should prevent most banks from stepping in, Mish says.
The problem, he says, is that a big chunk of the corporate debt market could stall, further slowing an already sputtering economy.
“Rising risks are notable in the corporate sector,” where increasing debt “could be vulnerable to downgrades in the event of unexpected adverse developments,” Fed Governor Lael Brainard said in a recent speech.
Further compounding the risk: Investors increasingly have included loans to the lowest-rated companies in the CLOs they’ve purchased. Banks have relaxed approval criteria on leveraged loans. And their restrictions – which require a minimum amount of collateral, for instance – have been easing, Zandi says. Toss into this mix another $1.3 trillion in highyield corporate bonds, up from $781 billion in 2010, which is debt issued by lower-rated companies and sold to investors as securities. Mish says this category is less vulnerable to a meltdown because bond issuance has leveled off in recent years and the interest rate is fixed for several years.
Zandi, however, says they still pose a hazard as they mature and their rates ratchet higher.
A corporate debt crash isn’t inevitable. A steady rise in corporate earnings would allow borrowers to continue to pay off their loans. And the Fed could issue guidance warning banks to reduce their approvals of leveraged loans as it did about five years ago.
“In theory it is possible, but not likely given the (Trump) administration’s deregulatory agenda,” Mish says.