Gabriel Crouse
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 to 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 nears $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 Q1 2019 ‘a little more than 50 percent of investment-grade bonds outstanding were rated triple-B [verging on junk], amounting to about $1.9 trillion’, a ‘near-record’ level.
And just as toxic mortgages produced systemic risk by being bundled and resold across the board as Collateralized Debt Obligations (CDOs), corporate debt is increasingly bundled and spread as Collateralized 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.
BIS general manager Agustín Carstens said ‘perhaps the most visible symptom of potential overheating is the remarkable growth of the leveraged loan market, which has reached some $3tn’.
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. When the buffet is so much smaller it is harder to disguise or hide poisoned eggs.
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’.
If you remember the movie Big Short, wizard investor Michael Burry (played by Christian Bale) ripped his hair out to clangs of heavy-metal because the increase in mortgage default rates did nothing to the nominal value of the CDOs they were bundled in. This is not what is happening now.
Don’t get me wrong, what is happening is worrying. Last year, Mail & Guardian editor Kevin Davie wrote a piece under the headline ‘Beware the Everything Bubble’ and the sentiment is (almost) sound. A crisis will not hit everything, but it is probably coming.
The New York Fed’s model of financial collapse forecasting looks at the spread (difference) between 10-year and 3-month treasury yields. Usually, the long-term yields should beat the short-term since this indicates higher faith in general long-term economic growth than the monthly swings of volatility. But the US has entered the ‘inverse yield curve’ signalling the opposite – now’s time to make a quick buck while long-term bets are more conservative, even gloomy.
According to economist Mike Schussler, this model has correctly predicted 9 out of the last 11 recessions – within a year of hitting the ‘inverse yield curve’, recession is likely to follow. So, if corporate debt is increasing but relatively stable while household debt is both reduced and more solid, whence cometh the crisis?
BIS’s data suggest an obvious answer. While the sum of household and corporate debt has remained flat as a portion of GDP, total debt has gone up. The pattern generally matches the increased global (non-financial) debt-to-GDP ratio of 250% that Davie considers to herald a bust, but, unlike his piece, they show where the new debt has really come from.
The big new borrowers are governments. The domestic picture is even more stark when you realize that a significant portion of the ‘corporate’ debt increase in SA is really in Eskom.
In the US, the doubling of state debt, now 1 year of GDP, forces the tough choice sooner. Either cut spending or increase taxes. Doing either at scale would easily cause recession. However tough the situation will be, at least the US would go into recession with record low levels of unemployment and a stock market that had grown by 300% in the last decade, two nice cushions.
In SA, state debt, including SOEs', has more than doubled and now is almost 1 year of GDP too. Unlike in the US, no competitive SA party proposes spending cuts, and a greater tax yield is near-impossible.
So we might debase the currency or force ‘prescribed assets’. Both probably turn recession into depression. Or we might seek institutional bailouts from the IMF or China.
Whichever, we approach the crisis with record high unemployment, an underperforming JSE, and three times less accumulated wealth, relative to GDP, than the US.
Worse, even an IMF bailout might be impossible. According to one estimate, by Nedbank, our budget deficit is set to climb beyond 5.5% unless there is a fundamental shift from policy and the realisation of the SONA promise regarding Eskom. 5.5% would likely need to be reined in before the IMF would begin to help filling the remaining gap.
In short, not business, not households, but government seems to remain the most likely answer to the question, whence the impending crisis?
Gabriel Crouse is the George F D Palmer Financial Journalist Trust Fellow at the Institute of Race Relations (IRR), a liberal think tank that promotes political and economic freedom. Readers are invited to take a stand with the IRR by sending an SMS to 32823 (SMSes cost R1, Ts and Cs apply).
