Coronavirus pandemic exposes the next financial crisis: leveraged debt


Wall Street took a beating Monday as collapsing oil prices and fears about the impact of the coronavirus almost nudged the American economy out of the longest bull market in history, exactly 11 years to the day since it began. Dow closes with decline of 2,000 points, almost ending 11-year bull market. The Dow Jones Industrial Average closed the day with a loss of around 2,000 points Monday, part of a global market rout that saw spiraling sell-offs in the energy sector amid the biggest drop for crude oil since the Gulf War in 1991.

Axios reports that “Coronavirus is already the most serious threat to the U.S. economy since the financial crisis, and the dominoes are aligned for a severe recession that could erase much of the 11-year recovery.” The next dominoes in the coronavirus economy:

What’s happening: While the outbreak itself is unlikely to drive an economic collapse, the U.S. has been something of a ticking time bomb for some time.

      • Growth has declined over the last two years despite higher government spending and a $23.4 trillion national debt.
      • While the labor market has boomed, many of the jobs added have been hourly service-industry positions that offer limited scope for savings or health insurance.
      • 44% of all U.S. workers earn barely enough to live on, a Brookings Institution study found in January.

Where it stands: While President Trump said late Monday that he would work with Senate Republicans on a “very substantial” payroll tax cut and relief for hourly workers, such measures — if they can be enacted — could still be insufficient to fend off a recession.

At the same time, corporate America is more heavily indebted than ever before, due to years of record-low interest rates and increased borrowing.

      • The Federal Reserve has repeatedly warned that this spike in leveraged lending — combined with loosening covenants — has created risks not only to bond issuers, but also to the wide network of hedge funds and mutual funds (yes, mutual funds) that actually hold the debt.
      • In short, it’s an economic haystack awaiting a match.

Bloomberg Businessweek adds, Coronavirus Exposes the Danger of Corporate America’s Debt Binge:

The coronavirus is threatening to expose the Achilles heel of the U.S. economy: heavily leveraged companies. As the economic expansion stretched into a record 11th year, and interest rates stayed at ultralow levels, business debt ballooned and now exceeds that of households for the first time since 1991.

What’s more, the borrowing has increasingly been concentrated in riskier companies with fewer financial resources to ride out virus-driven difficulties. A wave of defaults would intensify the economic impact of the contagion. “It will add to recessionary pressures in the U.S.,” says Nariman Behravesh, chief economist at consultant IHS Markit Ltd.

Energy companies are especially vulnerable, thanks to a collapse in oil prices.

American shale oil companies are over-leveraged and debt-ridden, and a steep drop in oil prices will hurt their cash flow. This will have a direct impact on their ability to service debt. Collapsing Crude Prices Will Bankrupt U.S. Shale Oil Stocks: U.S. oil stocks were already in terrible shape, and the crude crash can prove to be the final nail in the coffin. The industry already experienced a sharp surge in the number of bankruptcies in 2019. The previous year saw a staggering 50% of them go belly up. Texas and North Dakota will be hardest hit.

But they’re not alone. Debt tied to travel companies such as American Airlines Group Inc. and Hertz Global Holdings Inc. has been hit hard, as have the obligations of movie theaters and casinos.

Federal Reserve Chairman Jerome Powell … has acknowledged that some debt-laden businesses could face severe strains if the economy deteriorates and that they could amplify any downturn by laying off workers and cutting back on investment.

* * *

There are about $1.3 trillion of high-yield bonds outstanding, up from $786 billion a decade ago. The investment-grade credit market has more than doubled to $6 trillion in the same period. Almost half the investment-grade bond market is now rated BBB, which means it could be downgraded to junk levels if the economy falters. Should that happen, many investors would need to sell the debt to comply with restrictions on the quality of their holdings.

In the $1.15 trillion leveraged loan market—where companies already carrying a lot of debt get more—borrowers have used adjustments to their earnings to reduce their apparent level of indebtedness. A downturn could expose their weakness. Analysts at Barclays Plc estimate that buyers of U.S. leveraged loans will be able to recover only 55 to 60 cents on the dollar, compared with 67 cents historically, because of companies’ dubious earnings math and rising debt loads.

With broad financing markets shut for now, desperate companies are turning their attention to the $812 billion private credit market. In times of stress, these lenders—private equity firms and others—often step in to provide financing to borrowers that would otherwise go without, at a cost.

But that might not be a cure-all. A slowdown in consumer and business spending could be particularly damaging for broadly syndicated loans and private credit, much of which is debt rated B and below, according to UBS credit strategist Matthew Mish. That debt is among the riskiest in the high-yield market because downgrades can put it in CCC, the lowest tier.

“Companies with vulnerable balance sheets—meaning little cash, high maturing debt—are going to have difficulty refunding themselves,” Mohamed El-Erian, chief economic adviser at Allianz SE, told Bloomberg Radio on March 9. “There is going to be an increase in credit defaults.”

Axios continues:

One big difference between 2020 and 2008 is breadth. The financial crisis began with financial services companies and insurers, which meant bailouts and structural fixes could be aimed at Wall Street. But this crisis is hitting the entire economy with a single blow — harming not just the Fortune 500, but also mom-and-pop businesses.

Between the lines: The cavalry may not be coming to the rescue this time.

      • The Federal Reserve, which helped rescue the economy after the 2008 crisis, is effectively out of ammunition.
      • Starting in 2007, the Fed cut interest rates by 500 basis points, bought an unprecedented amount of U.S. debt and unleashed a flurry of stimulus programs that propped up the economy.
      • Rather than winding them down, the Fed has had to extend the programs throughout the recovery.
      • As a result, after last week’s emergency rate cut — and possibly another that’s expected at next week’s policy meeting — the central bank has limited ability to take action.

Threat level: Government also increasingly looks broken. The dysfunction in Washington is dimming hopes for major fiscal stimulus that economists say will be needed to offset the outbreak’s negative impact.

      • The $8 billion allotted to coronavirus so far “is an insult,” Claudia Sahm, who formerly served as top economist for the Fed’s Board of Governors, tells Axios. “It has to be hundreds of billions of dollars, and it has to be now.”
      • “I want to see it — and maybe I will,” Sahm, now director of macroeconomic policy at the Washington Center for Equitable Growth, says. “But without that piece, we are in a recession before the end of the year.”

The payroll tax cut that President Trump floated on Monday will do little to nothing to soften this recession. It will take a sizable stimulus package — something to which Republicans are ideologically opposed — and Republicans already gave away the tools to do this with their corporate welfare tax cut bill in 2017, ballooning the federal debt to record levels.

The Federal Reserve is out of tools as well, and will be forced to consider negative interest rates. Former Treasury Secretary Larry Summers warned in a recent CNBC interview that the U.S. economy is perhaps “one recession” away from a turn to negative rates. “It’s a very different world when everyone’s stuck at zero interest rates,” he said. Japan’s Topsy-Turvy Economy Is the United States’ Economic Future. “That very different world, with its strange new economic risks and its own inexorable force of gravity, has long been evident in Japan, where negative rates have become the norm. Japan offers the clearest preview of the economic fantasy world that the West may soon enter, whether it wants to or not.”