Too big to fool again? Don’t be too sure about debt
Corporate leveraged debt is more than double the size of the bad loans that caused the 2008 financial crisis
Sometimes we just can’t resist the urge, even if we know it’s going to end in tears, to make the same mistakes. It all came into fashion in the first decade of this century. The mortgage subprime crisis came to a head in 2007/8 and nearly caused the total collapse of the entire financial system. Well, it’s coming back – the corporate debt subprime crisis is only another interest hike away, maybe?
Like all these dambusters, it starts with a trickle, a manageable little stream which we could deal with, but choose to feed. On the fundamentals the mortgage loan crisis might not have happened – it was the contamination, the spread of the disease, that turned it into a plague, greed its catalyst. Leverage, generous leverage had fuelled what became the housing price bubble, and bubbles, in order not to be found out, must be fed.
There will always be clever accomplices around, at a price, to repackage specific risk into asset class risk, in the name of diversification, if not confusion.
Mixing these different risk profiles into one vegetable soup of leftovers created an infected, toxic brew. The cost of mortgage finance went up for everyone, even the previously safe and serviced loans became threatened. You can’t make a bad apple good by throwing more good apples into the basket – you must take the bad apple out and destroy it. Adding one bad apple, however, is enough to destroy the basket.
Only the intermediaries – the purveyors of bundles of debt, the vultures of circumstance, who took no risk – made money, for a while.
When the collapse seemed inevitable, governments came to the rescue. Major financial institutions, such as Lehman Brothers, were at risk and a new concept was introduced into the world of finance: “Too big to fail”.
We’ll regret that, as often as we rely on it.
Central banks had little choice but to pump money into the system to protect innocent retail depositors from the “clever” greedy risk takers that were their banks. The mistake they made was to bail out the banks, rather than letting them fail and bailing out the depositors directly, who could have then exercised their collective monetary vote to decide which responsible banks they’d fund instead. Banks are never too big to fail, it’s the depositors who deserve the protection.
A fundamental precedent was set that would ensure that it could happen again, and it’s about to, perhaps on a grander scale: corporate subprime debt.
Corporate leveraged debt (those two words used together should give us a clue) in the US is already more than double the size of the bad loans that caused the 2008 financial crisis.
The same, first step leniency is creeping in now – easier covenants, longer terms, lower upfront instalments, for existing exposure and then even easier new credit approvals. Nobody dare call up. Again, intermediaries rush in to package costly deals. Again, diversification is the logic – surely loans to companies in different geographies are unlikely all to suffer losses at the same time, is the argument. Not so unlikely, I think.
The biggest problems are the two biggest economies, US and China, and they just happen to be each others’ biggest bankers, to boot. When the weapons of trade war get drawn, and middle ground seems less popular than a fight, the day of reckoning is brought forward.
At some point the numbers for some major corporate (even beyond the most imaginative application of accounting treatments) will simply not add up. This will start a chain reaction of cost cutting – jobs, maintenance spending, marketing, research and development, which all contribute to the crumbling of the economic stack, and with it the confidence of the very investors required to stem the tide.
Smart, experienced, corporate leaders, who know better, presiding over established businesses, are already starting to talk about stress testing, about battening down the hatches, about restraint. As ever, these will be the survivors who will be around to pick up the bargains in the wake of the storm.
Too good to be true must be tested now.
Too big to fail is not too big to cause failure, and it’s with us again. Let us not make the same mistake. Failures must not be rescued, they must be replaced. Survival of the weakest simply won’t work.
We must give alternatives a chance. Too big to fail must stand aside and give those better able a chance – that’s where the scarce capital must flow.