August 17, 2018
August 17, 2018
America’s economic expansion is now old enough that people are wondering what will cause the next crash. There are no obvious culprits. But one suspect lurking in the shadows arguably deserves more attention than it receives: the rise in corporate borrowing.
Simply put, corporate America has taken on a record $6.3 trillion in debt.
The previous peak in total corporate debt was 45% of GDP in 2008. US companies surpassed this threshold in March of this year.
The conventional wisdom of financial analysts is that this peak is not like the previous one. Interest rates were 5.25% at the start of the Great Recession, but they are only around 1.9% today. And the Federal Reserve increased them very slowly. This makes the debt burden easier to fund than it was in 2008, despite its larger size.
“Red flags aren’t going up yet because to a large extent the level of interest rates is actually quite benign,” said Francesco Curto, chief researcher at Deutsche Bank’s asset management arm. , to CNBC in June. “So I wouldn’t say there are major concerns there.”
But dig below the surface, and things don’t look so good. “The more we get into debt [firms] are, the less resilient they are to shocks and turbulence in the economy,” said Gregg Gelzinis, a research associate who focuses on finance at the left-leaning Center for American Progress. shock will be and when it will occur.”
Gelzinis pointed to several aspects of corporate leverage that make it riskier than it first appears.
First, the overall share of junk corporate debt is larger today than it was at the last peak. Since 2007, the debt of safe, well-rated companies has actually fallen by about $1 trillion. Mid-rated debt has skyrocketed over the same period, by nearly $3 trillion. Riskier high-yield debt remains below both categories, but has also risen steadily between yesterday and today.
But there are also leveraged loans – essentially, loans taken out by companies that already have a lot of debt on their books. They are not always counted with standard high yield debt. But leveraged loans are also quite risky, and they’ve doubled since 2010. Leveraged loans combined with high-yield debt account for 37% of all corporate debt.
Meanwhile, available cash reserves are concentrated among the top 1% of companies. There’s a wide range of riskier businesses that now have $1 in cash for every $8 in debt, a record high (yes, worse than 2008). But hoarders at the top skew the average cash-to-debt ratio for all companies, making it less risky than it is. And the problem is getting worse.
The terms of this debt are also deteriorating. Creditors are sacrificing various guarantees, in particular their priority to be repaid in the event of the company’s bankruptcy, all in order to have the possibility of granting more high-yield loans. Collectively, these standards have gradually deteriorated over the past few years. This means that the ripple effects through the financial system will be worse if there is a large wave of corporate defaults.
Riskier corporate loans are also repackaged into secured loan obligations which are then sold as low-risk instruments to investors. Nowhere is the problem as serious as the reconditioning of mortgages in the housing crisis. But the similarities are obviously troubling. And the practice is spreading.
Gelzinis pointed out that all of this is happening in a broader shift towards banking deregulation. Congress and President Trump recently passed a partial rollback of Dodd-Frank’s tougher financial rules. Under the direction of the White House, other regulators like the Federal Reserve and the Office of the Comptroller of the Currency have relaxed stress tests, capital requirements and other safeguards. Again, this only increases the risks of wider contagion if many companies go bankrupt.
Just to add insult to injury, that’s why this accumulation of debt is happening. Apparently, the reason companies borrow is to finance expansions. Yet business investment in the economy has fallen over the same period that borrowing has increased, and is now at surprisingly low levels. But even as the correlation between borrowing and investing has collapsed, the correlation between borrowing and shareholder payouts has tightened considerably. Part of the reason is dividends. But an even larger part is made up of share buybacks, which were deregulated in 1980 and have now reached epic proportions.
In other words, companies are not just cutting salaries and investments in order to send more money to shareholders. They are literally borrowing more and making their collective financial positions even more risky, to further fuel the payment frenzy. As William Lazonick, an economics professor at the University of Massachusetts Lowell, told The Week, the small number of well-leveraged companies are gorging on takeovers. This sets shareholder expectations and puts pressure on the wider world of less well-positioned companies to keep pace.
So what could trigger this corporate debt bomb?
A sudden spike in inflation could cause the Fed to panic and raise interest rates faster. Trade wars, like the one Trump is instigating, can also cause inflationary pressures by raising import prices. An unforeseen shock could also occur unexpectedly.
But even at its current pace, the Fed is expected to return to 5% interest rates around 2022. Two fairly large waves of riskier corporate debt will mature in 2021 and 2022, and another just before 2025.” For the most part, these businesses won’t have the cash to repay the loans,” Gelzinis said. They’ll have to refinance, at a significantly higher interest rate. If they miscalculate, it could spark a whole wave business failures.
Between the spread of riskier corporate debt, the effect of defaults on the financial system, and the number of American households that are still struggling with high levels of debt and depressed wages, the cascading effect in the economy as a whole could be significant. “That’s where I see the vulnerability,” Lazonick said. “A whole set of institutions and practices that allow revenue to be concentrated at the top.”
Reducing the threat will not only require stricter regulations. This will require making payouts less attractive, likely by raising taxes on the wealthy and corporations. And that will require drastic corporate governance reforms, so that corporations stop cannibalizing each other for the sake of shareholders and start investing again in jobs and the economy.
