Proof of corporate toxic debt in the eating

WHENCE cometh the next global financial crisis?

A silly question in one sense, much like asking where the next criminal attack will come from. And yet, we are all bound by planning ideas about the future, whether these ideas come in the form of single-outcome forecasts or diverse scenarios. One troubling scenario to consider is that financial collapse will emanate from the implosion of dodgy corporate debt in the US.

This scenario was highlighted last week by the Bank of International Settlements (BIS), which represents the world’s reserve banks. Its latest report was summed up nicely in Britain’s Guardian newspaper, which noted: “Corporate borrowing poses a danger to the global financial system and could trigger a crisis in the same way US sub-prime mortgages sparked the 2008 banking crash, (BIS) has warned.”

It would be the same great 2008-2009 recession movie played over, just with different actors. Much like mortgage debt leading to 2008, corporate debt has increased in the US at an average rate of $1.7 trillion per year over the last decade, which is twice the rate pre-2008. Corporate debt now tops $10 trillion and by some accounts is nearer $14 trillion.

Just as with mortgages during the previous growth-cycle, this company debt is increasingly dubious. According to the May Financial Stability Report of the US reserve bank (“The Fed”), “the most rapid growth in debt over recent years concentrated among the riskiest firms”. The report goes on to illustrate that by the first quarter of this year “a little more than 50% of investment-grade bonds outstanding were rated triple-B (verging on junk), amounting to about $1.9trillion”, a “near-record” level.

And just as toxic mortgages produced systemic risk by being bundled and resold across the board as Collateralised Debt Obligations (CDOs), corporate debt is increasingly bundled and spread as Collateralised Loan Obligations (CLOs). Moreover, due to the increasingly poor quality of the debt issued, companies and investors turn in great volume to “leveraged loans” that are high-risk bets on shaky premises.

In the event of a chunk of corporate debt turning toxic or of a slew of ratings downgrades to junk, firesales would trigger and panic would, in the dire scenario, not be contained. Instead it would pump ice into the veins of global finance.

These in turn would be difficult to rewarm with monetary easing like last time because low-interest conditions continue to shape so much of the developed world post-2008. In other words kaboom – like last time – only worse. This scenario might, however, be misleading. For example, fans of Regulation 28, which caps pension funds’ ability to invest offshore, might look to it as a way of saying SA Inc is in trouble but so is the world, so you might as well keep your money inside the country like a “patriot”.

This mistaken view supposes a false equivalence between the last US housing crisis and the next possible US corporate crisis. CDOs, for example, bundled together thousands of mortgages that were almost entirely overlooked by investors, whereas CLOs generally pool only 100-250 loans while taking extra precautions against default.

Another difference is that listed companies are more scrutable than subprime mortgage candidates. While all companies, listed and unlisted, have accounting teams that can manipulate the books, the proof of toxic debt is in the eating.

Are corporates failing to service new debt? As Forbes noted earlier this year, default rates on leveraged loans “are at a 7-year low”.

In SA, state debt, including SOEs, has more than doubled and now is almost one year of GDP too. Unlike in the US, no competitive SA party proposes spending cuts, and a greater tax yield is near-impossible.