Déjà Vu: The New Debt Threat to US Economic Growth Bears a Striking Resemblance to the Old
Despite the stock market volatility of recent months, the underlying health of the US economy reflects a decade of historic growth since the Great Recession of 2008. As lending rebounded following the crisis, American business activity expanded dramatically on the shoulders of easy money policy at the Federal Reserve and other central banks. But the very credit markets responsible for driving the expansion hide a ticking time-bomb that threatens the future of American economic stability: the growing US corporate debt bubble.
In the wake of 2008, aggressive Federal Reserve policy saw the U.S. Federal Funds interest rate drop to an historic sub-1%, where it remained for nearly 10 years. Simultaneously, the Fed’s Quantitative Easing (QE) injected trillions of dollars into the global and US credit markets in a bid to keep the economy afloat, as lending ground to a halt following the American housing market collapse.
Over the following decade, US growth rebounded, as investors seeking to capture high-yields in the corporate sector extended credit to businesses in hopes of fueling further growth. Abetted by low borrowing costs, corporate debt soared to an all-time high in 2019, at 45.3% of GDP, and competing demand for further high-yield investments has driven lenders to issue increasingly low-quality leveraged loans to businesses. Commentators, including the International Monetary Fund and former Fed chairwoman Janet Yellen, have pointed out that high debt levels are often correlated to overinflated supporting-asset values, and that, in addition to the sheer size of the US corporate debt market, current market behavior suggests that corporate debt may be less secure than most investors acknowledge.
If this sounds familiar, one could be forgiven for pointing out similarities between the current business loan market and the early-2000’s mortgage-loan boom. As growth fostered by post-crisis measures continues to rise, the economy again runs the risk of inflationary overheating, necessitating the interest rate increases of the past several years.
This time around, however, the players have changed. Instead of buying up large quantities of dubious debt for derivative-repackaging as they did before the ’08 crisis, big banks have largely shied away from direct involvement in high-yield corporate loans, fearing regulation passed in the wake of the meltdown. Instead, the demand for risk-taking creditors bred by the last decade’s easy-money environment has been met by a new class of enablers: non-bank lenders and less-regulated banks.
The loans that make up this flood of business credit are originated by companies that make business loans despite not being in the primary business of banking, in addition to smaller, more obscure banks. They are happy to deal with imperiled corporate borrowers, even if they fall outside of their traditional customer pool, without fear of regulatory retribution. Take for example CoBank, a member of the United States Farm Credit banking system, and its ongoing $665 million in loans made to Frontier Communications Corp., the BB-rated national telecom group with a $208.99 million market cap. The CoBank-Frontier relationship (hardly the kind of agricultural lender-rural infrastructure business relationship that Farm Credit Union was intended to foster) is a prime example of dubious easy credit practices in action. Frontier still owed CoBank $504 million as of March 2018, and in July of that year it took out another $240 million loan from a different source to pay down some of its CoBank debt.
A similar situation played out with even grimmer results in 2018 for Toys-R-Us and Sears, as rising interest rates squeezed those highly leveraged giants of corporate America and forced them into bankruptcy. Countless smaller, low- and sub-investment-grade companies face similar scrambles for liquidity when rates move upward consistently: a 2018 survey from private non-bank lender Credibly indicates that, of a pool of 343 small and mid-sized business that received non-bank loans, 62.5% did not even attempt to secure a traditional bank loan beforehand, while 48.6% did not believe they would have qualified for a traditional loan anyway. A lack of Federal regulation makes is difficult to determine the true creditworthiness of those loans.
Non-bank corporate lenders and debtholders include pension and mutual funds, private equity funds, and insurance companies. It’s a loose term, often used to describe mortgage lenders who operate in the same, alternate-financial system. In the current economic climate, however, corporate lending represents an arguably greater threat, as the housing market and its surrounding activity have been closely watched by the government and the investing public. Much like the big banks in 2008, non-bank lenders hold the vast majority of debt derivative securities compiled from vast quantities of corporate loans, known as Collateralized Loan Obligations (CLO’s). CLO’s are the direct equivalent of the mortgage bond Collateralized Debt Obligations (CDO’s) that amplified the 2008 mortgage defaults in the US housing market across the whole economy and turned the housing crisis into a phenomenon with worldwide implications.
The same structures have again cropped up in the US and global credit markets, and the stakes are similarly large: corporate debt in the US has reached $6.2 trillion, with much of the underlying risk packaged up in CLOs and their derivatives and dispersed across the market. As the easy money era slowly tightens, companies that have relied overmuch on such credit stimulus will eventually be forced to obtain debt restructuring assistance; failure to do so would doom them to the fate of Toys-R-Us and Sears. If forced restructurings or defaults occur on a large enough scale, vast pools of private investor capital, insurance companies, and individual lending bodies, not to mention the thousands of workers employed by at-risk firms, would be in peril. The ultimate effects of an explosive end to the corporate debt bubble in America are unknowable.
However, not everything is as it was leading up to 2008. Should a large-scale default occur, the outcome would likely differ significantly from the mortgage bond crash: the big banks are better protected and less exposed to the derivative markets for corporate debt, and experience has laid the groundwork for policy action at the Fed and Congressional level that is specifically aimed at avoiding a similar meltdown. Paradoxically, the rise in interest rates affords some protection as it leaves cushion space should another emergency call for another round of decreases.
In light of this, policymakers need a firm but agile hand in determining how quickly to pump the brakes on the economy. Should the Fed act too quickly in raising rates, or should unforeseen turmoil severely impact consumer spending, a flood of defaults from highly-leveraged companies could trigger capital flight and a recession. Done with appropriate speed relative to investor sentiment and market indicators, however, a soft slowdown could give companies, their investors, and their creditors time to reallocate and restructure their obligations while weeding out the worst players to avoid unwanted inflation. Prudent regulation of lending outside of the banking sector, too, could further discourage risky lending into the future.
In this era of uncertain economic and political outcomes, we should all be made aware of the threat lurking below the headlines: the danger posed by the enormous size and questionable quality of the business credit market in America. Bearing in mind the lessons of 2008, it is crucial that everything possible be done to avoid provoking the conditions that triggered the last recession.
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