The Corporate Debt Bubble

Over the past decade governments and bankers have tried to redesign the financial system so that it acts as a buffer that absorbs economic shocks rather than as an amplifier that makes things worse. Banks now face a stern test from the covid-19 virus and the economic ruptures it has triggered, not least a Saudi-led oil-price war. My concern is in the world’s ocean of corporate debt, worth $74trn. In October 2019, I quoted form an article titled Seeking Alpha, a Reprint August 14, 2019 by Ariel Santos-Alborna. What he said, is now truer than ever. “Corporate US debt to GDP is at its highest level in all of recorded history. 50% of that debt is BBB, or one level above junk. Decreased cash flows and less corporate debt demand in a US recession, will probably stop buybacks and lead to insolvency in the junk bond market.” THIS WAS BEFORE THE CORONA VIRUS!

From Julia La Roche Yahoo Finance March 14, 2020, titled:Bankruptcy expert Ed Altman: ‘A lot of marginal companies are going to be forced out of business’ Altman, who is a professor emeritus at NYU Stern School of Business added that even before the virus, the fundamentals of companies and markets were already showing “a lot of warning signs.” Altman told Yahoo Finance, pointing out that the average economist is now forecasting “around a 60% chance of a recession” within the next 12 months, up dramatically from before the outbreak. That means a lot of companies kept afloat by cheap borrowing costs could be in real trouble. Altman contended that many of them should actually go bankrupt, because “they are zombies and have been kept alive” by historically low rates.

Altman, who pioneered the financial-distress sniffing ‘Z-Score’, a formula he created more than 50 years ago for predicting bankruptcies , suggested ratings agencies are often slow to recognize when companies need to get downgraded. “We ran a Z-Score test on BBB companies in the United States year-end 2019. And, in a downturn, a big downturn which happened in ’08 and 2002 etc. , maybe 10% the rating agencies say get downgraded,” he said. “We ran our tests looking objectively at the health of BBB companies at the end of 2019 when everything was going great, and we came up with more than 30% looked vulnerable to a downgrade” Altman told Yahoo Finance. “And that’s going to happen…and when that happens, a lot of marginal companies are going to be forced out of business” THIS WAS BEFORE THE CORONA VIRUS!

From March 12 edition of the Economist Magazine: Companies came out of the 2007-09 financial crises in a relatively sober mood, but since then have let rip. Global corporate debt (excluding financial firms) has risen from 84% of GDP in 2009 to 92% in 2019, reckons the Institute of International Finance. The ratio has risen in 33 of the 52 countries it tracks. In America non-financial corporate debt has climbed to 47% of GDP from 43% a decade ago, according to the Federal Reserve. Underwriting standards have slipped. Two-thirds of non-financial corporate bonds in America are rated “junk” or “BBB”, the category just above junk. Outside America the figure is 39%. Firms that you might think have rock-solid balance-sheets—AT&T—have seen their ratings slip, while others have been saddled with debts from buyouts. Naughty habits have crept in: for example, using flattering measures of profit to calculate firms’ leverage.

In China over the past months, financial distress and forbearance has been widespread. One multinational says China has relaxed its payment terms with suppliers in China. HNA, an outrageously indebted conglomerate than runs an airline, has been bailed out. To get a sense of the potential damage in other countries The Economist has done a crude “cash-crunch stress-test” of 3,000-odd listed non-financial firms outside China. It assumes their sales slump by two-thirds and that they continue to pay running costs, such as interest and wages. Within three months 13% of firms, accounting for 16% of total debt, exhaust their cash at hand. They would be forced to borrow, retrench or default on some of their combined $2trn of debt. If the freeze extended to six months, almost a quarter of all firms would run out of cash at hand.

“The near-certainty of rating downgrades and defaults in the travel-related and oil industries, and the possibility of a broader crunch, is of concern. Credit derivatives, ( 5 x more than 2008), the most actively traded part of the fixed-income markets, have recoiled. The CDX Index, which reflects the cost of insuring against default on investment-grade debt, is at its highest level since 2016, as is the ITRAXX crossover, which covers riskier European borrowers. Out of the public eye, privately traded debt may now only change hands at heavily discounted prices. (NO liquidity)The issuance of new debt has “dried up”, says the head of a big fund manager. This could fast become a serious problem because firms need to refinance $1.9trn of debt worldwide in 2020, including $350bn in America.”

“Who, then, can act as a source of stability and fresh lending? Some big cash-rich firms such as Apple could grant more favorable payment terms to their supply chains. Private-equity firms have capital to burn. But in the end, much will rest on the banks, which have the relationships and flexibility to extend credit to tide firms over. America’s banks have their flaws (see above). Some banks like Goldman Sachs is sitting on $180bn of loans and lending commitments with ratings of BBB or below. Outside America the picture is less reassuring. Europe’s banks make puny profits, partly because interest rates are so low; Italian banks had a return on equity of just 5% last year. Since the virus struck, the cost of insuring their debt against default has flared up, hinting that they could yet become a source of contention. State-backed banks in China and India will do as directed by politicians. But they are already laboring under large bad debts.”

In my opinion, unless the U.S can avoid a recession (not with the corona virus shutting down the economy), or can legislate a massive bank bailout (Which is also doubtful. See ISL Letter #727 HAS EVERYONE FORGOTTEN ABOUT ONE OF TRUMPS FIRST EXECUTIVE ORDERS  “PREVENTING TAX-PAYED BAIL-OUTS”), the upcoming economic recession maybe worse than the ‘Great Recession ‘of 2008!

The Fed Acts

Now with the corona virus, our economic weakness worldwide will be exposed. What is worse is that in the US, we have used all our ‘bullets’ to prop up an already robust economy. The Federal Reserve and the federal government cannot use the normal monetary and fiscal stimulus to offset a recession, because interest rates are already low, taxes have already been cut, the annual budget is already at a 1.5 trillion dollar deficit and unemployment is at record lows.

In September 2019, the interest rate for the overnight money market — a short-term lending market where banks borrow cash from each other to meet reserve requirements at the end of a business day — surged to 10 percent. Banks weren’t willing to lend out capital for the Federal Reserve’s target interest rate of 2 percent. The Fed responded to the cash crunch by financing these so-called repurchasing agreements (repos, for short) directly. It offered the 2 percent interest on these short-term loans (they’re usually paid back in days or weeks) to bring the interest rate down and pump cash into a strapped lending market. It has been offering these overnight loans on a daily basis ever since.

When the Federal Reserve began offering these daily agreements in late September 2019 it was the first time it has intervened in repo markets since the Great Recession. Since then The United States’ central bank has funneled roughly $500 billion into the repo market in what was originally pitched as temporary operations that would end on October 10, 2019 — but the daily repo bids are still coming. Currently, there is $229 billion in outstanding repos on the Fed’s balance sheet.

On Wednesday March 11,2020, the Fed said it would increase the amount of overnight repo operations from at least $150 billion to at least $175 billion. In addition, it extended the date for a $45 billion two-week repo operation that was supposed to end  April 13. Finally, there will be three $50 billion one-month term operations, the first of which happened Thursday.

On Thursday March 12, 2020 The Fed announced a bold new initiative in an effort to calm market tumult amid the corona virus meltdown. In all, the new moves pump in up to $1.5 trillion into the financial system in an effort to combat potential freezes brought on by the corona virus. This was the second day in a row and the third time this week the Fed has stepped in. Stocks staged a sharp turnaround from earlier losses, though some of those gains were pared.

One part of the announcement saw the Fed widen the scale for its $60 billion worth of money the Treasury purchases, which to now had been confined to short-term T-bills. Under the new regime, the Fed will extend its purchases “across a range of maturities” to include bills, notes, Treasury Inflation-Protected Securities and other instruments. The central bank will begin purchasing coupon-bearing securities, something market participants have been clamoring for since late 2019.The purchases start Thursday and will continue through April 13.The second part of the new operations will see the New York Fed desk offer $500 billion in a three-month repo operation and a one-month operation. The offerings will happen on a weekly basis through the remainder of the program. In addition, the Fed will continue to offer at least $175 billion in overnight repos and $45 billion in two-week operations. Repos are short-term operations in which financial institutions provide high-quality collateral in exchange for cash reserves they use to operate.

The extraordinary moves came amid extreme market turmoil created by uncertainty over the corona virus pandemic. Government bond yields earlier this week cascaded to record lows amid reports of liquidity issues in the market and fears of a global recession. However, questions remain whether the Fed can arrest the market’s issues on its own. Wall Street has been looking for an aggressive fiscal response and has yet to get it from Washington lawmakers.

On Friday March 13, 2020 President Trump announced ‘A National Emergency’ and the Dow shot up 1985 points!

The question now is, when is enough too much?

As Gang Hu, managing partner at WinShore Capital hedge fund, told Bitcoin Magazine. , “If they (Fed) overdo it, then we’re going the other way” — economic downturn. “If you listen to the Fed, the Fed is aware of this,” Hu said, referring to the gravity of adding several hundred billion dollars into these markets. “If this $500 billion becomes $1 trillion or $2 trillion, then the average American should worry. But now, the Fed’s argument is that we’ve gone too far with shrinking the balance, that since September [2019] we’ve had too little in reserves and that this has hurt the system.”

Dennis Lockhart, former head of the Atlanta branch of the Federal Reserve, likened the Fed’s open market operations to a “trial and error” exercise in a CNBC interview. Lockhart also noted that he doesn’t equate these liquidity injections with quantitative easing — the Fed’s practice of purchasing long-term Treasury bonds to print new cash. Quantitative easing, Hu assented, tries to control long-term interest rates with reliable, long-term liquidity; repo market intervention, conversely, controls interest rates for immediate short-term liquidity. Still, the final effect is the same — the Fed purchases assets to flush banks with cash. And like the Fed’s quantitative easing during the Great Recession (which led to the inflated balance sheet of over $4 trillion we have today), the uncharted territory for these repos is that ultimate question: Where do they end?

Hu believes that they will begin winding down and the market will stabilize around April 15, 2020 — federal tax day. But he said that it will be a “challenge to unwind this thing” and that it will be a painstaking process. “I trust that they will do it slowly, gradually, because you can’t ask the bank to pay you $100 billion in one day,” Hu said. With no clear end in sight and billions in liquidity entering a little-known yet crucial market for the U.S. financial system, some Americans might be wondering if and when the dam is going to break. Or how much capital needs to enter the system to keep the leverage from flooding the levee. The banks were being stressed before the corona virus. Now what?

Now What?

On a short term basis, the market will probably continue to fluctuate back and forth by 500 to 1,000 point ranges. One must remember that over 80% of the market is controlled by algorithms of the Big financial firms.  They love the volatility, while the average investor detests it.

As stated above I worry about defaults on corporate debt and loans.  What worries me most is the collapse of many bank stocks, such as Deutsche Bank (DB), HSBC Holdings, (HBC1.BE), Credit Swiss (CS) and Barclays PLC (BCS). Credit Swiss is down from 78 in 2007 to 8.16. My 25 year charts doesn’t show the stock ever being so low! Barclays was as high as 55 in 2007, now 5.40.That’s a 35 year low! DB was as high as 149, now 5.97. Each rally is met with another new low! What are these falling bank charts telling me? Trouble!

On a longer term basis, the real economic fallout from the ‘corona virus’ outbreak won’t begin to be seen until the Second Quarter. A lot depends on government action and the extent of how many people in the US get the virus. I think the figures will be big, because there are many people without a health care provider or can’t afford the deductible and don’t forget the 11 million undocumented immigrants that won’t dare see a doctor. I think the markets will say affected for the rest of the year, as weakness in the BBB bond market and banks will have a sobering effect on the markets.

Remember ‘Don’t grab a falling knife.’  Hopefully there will be a lot of rallies. Use them to sell and go short. Our first goal of 22,500 has been achieved. If thing get as worse, as I think they will, real support won’t develop until  at least the 2016 Dow lows of 16,000-18,000 and maybe lower! This Bear Market will probably last six to nine month, so don’t expect everything to happen at once. The pain will probably be drawn out until at least the end of the year.

Once again, won’t it be ironic, that if a Democratic wins the Presidency, it will be the second time in a row (2008), that the Republicans leave him an economic disaster?

Carl M Birkelbach

Dow 23,185    3/14/2020

Mr Birkelbach does not offer investment advice, but merely his own personal opinion. This report has been prepared from original sources and data we believe reliable but make no representations as to the accuracy or completeness. Mr.Birkelbach , his affiliates and subsidiaries and/or their officers and employees may from time to time acquire, hold or sell a position in securities. Past performance is no guarantee of future success. Upon request, we will supply additional information.