Our previous post, “Risky Business,” warned that the global and domestic issuance of low-grade, corporate-debt obligations have become extreme and could be seriously destabilizing at the end of this cycle. This is not an unacknowledged risk, but the situation’s particulars—those that ought to be most concerning—do not always make the headlines.
From the numbers provided by the Federal Reserve, corporate debt levels have surpassed the 2008 level of 44% of GDP, now reaching 48%. This is an increase, but not a wildly alarming one. Remember that the last crisis was caused mostly by housing debt, not that of corporations. If those businesses could survive the Financial Crisis intact, surely a modest increase in debt without a mortgage crisis is more manageable.
Nonfinancial Corporate Debt as Percent of GDP
Figure 1: Data from U.S Federal Reserve and Goldman Sachs
Such an assertion seems to be the opinion of multiple commentators, but details complicate the picture. The Fed’s sum of corporate debt excludes the debts of businesses not publicly listed. When those other totals are included, the corporate-debt burden jumps to $15.5 trillion, or 74% of GDP. That is versus 68% in 2008. Again, the 6 percentage point rise is significant, but perhaps it isn’t a serious matter. So what drives our concern?
Rates Have Consequences
The low interest rates since the last crisis, courtesy of the Fed, were intended to stimulate investment spending by encouraging borrowers to take on new debt. Corporations borrowed but with two undesirable outcomes. First, the funds they borrowed were rarely used for capital spending. They more often repurchased shares (which were often reissued to executives) or paid out as dividends. This restructured the balance sheet—euphemistically known as “financial engineering”—but it didn’t increase productivity in the real economy. Therefore, growth in GDP remained anemic. On this count, Fed policy failed to achieve its objective.
Second, the low rates led investors, long accustomed to yields that exceed the underlying inflation rate, on a desperate search for investment income. To earn something above the U.S. Treasury rate, the Fed’s policy left them no alternative but to buy riskier assets. This demand has allowed companies with uncompetitive business models, colloquially known as zombies, to continue limping along—literally on borrowed time. It also has opened the door to companies with unproven business models to hype their stories to win the dollars of managers eager to enhance the returns on unproductive cash. These are the famous, and rapidly becoming infamous, unicorns.
Some consequences of this situation are well known. Toys-R-Us was one such zombie company. It was overleveraged and unable to adapt to the changing retail climate. We’ve examined that story before. Below we’ll return to the current saga unfolding around untested business models. Before getting granular, however, we must examine the consequences of the aggregate.
The Ugliness of Grade Inflation
When bonds are issued, they are given a rating regarding their quality (AAA, AA, A, BBB, BB, B, CCC, CC, C, D). The four bolded varieties are considered investment-grade. In our 2018 annual letter, we warned that the volume of BBB bonds, the lowest rung of the investment-grade ladder had grown disproportionately in relation to the whole.
Pouring money into BBB bonds represents investors’ seeming willingness to accept escalating risk in exchange for yields approaching pre-crisis levels. This dynamic also has not been ignored by the news cycle. Major publications now openly admit that in a downturn, the BBB bonds could be downgraded in quality, automatically triggering various kinds of fire sales—many financial intermediaries have limitations on the ownership of below-investment-grade debt. This would cause the highly illiquid below-investment-grade market to swell. It is unclear who would step up to buy in that market and at what price. As long as interest rates remain low, however, and corporate profit margins do not contract too much, all will be well. Or so the argument goes.
While the premises of that optimistic assessment are themselves uncertain, there is a further wrinkle in the BBB sector not widely discussed. That is the inflated ratings these bonds are assigned already. In 2000 the net leverage of a BBB bond was, on average, 1.7x, as derived below:
(total debt – cash – short term investment) / EBITDA
This is basically a measure of a company’s financial capacity to service its debt. Cash and short-term investments easily convertible to cash are subtracted from gross debt to arrive at net debt. The funds available would include earnings before deducting interest, taxes, and non-cash charges of depreciation and amortization. By 2017 the average leverage was 2.9x. That means ratings agencies have seen fit to assign the same rating to a bond with 70% higher leverage than allowed just 17 years ago. Essentially, while the volume of BBB bonds, as an absolute amount and as a percentage of corporate debt, is unprecedented historically, it is also of lower quality than that same grade of bond historically. This willful negligence by the rating agencies, driven by the competition for market share, was one of the precipitating causes of the mortgage-backed security (MBS) meltdown, which itself played a major part in the financial crisis. The aggregate is uglier than ever.
Coming to Terms
The debt markets may finally be coming to terms with the risks in the bond complex. While BBB-, BB-, and B-rated bonds continue to trade in tandem, the yield on CCC bonds has been rising since the equity market selloff of Q4 2018.
The average BBB bond yields just 1.45% more than a Treasury. That is essentially unchanged since September 2018’s 1.43%. However, a CCC bond, which offered 6.62% more than a Treasury last year, must give investors over 10.5% today. We’ll keep a close eye on these spreads. It’s always lower quality issues that begin to move first. This is also why we continue to feel uncomfortable with allocating money to corporate bonds, even though that means we must sacrifice yield for clients. There is far more risk in the space than meets the (untrained) eye.
Under the Microscope
Malinvestments became increasingly common during this ever easier credit cycle. The spate of IPOs over the last two years has pulled the curtain back on some truly dismal investments, typically those with unproven business models. Lyft is down 50% from its IPO price. Pinterest is down 33% and Uber 25%. Investors who purchased equity soon before the IPO likely overpaid. And those are the companies that have actually listed.
Perhaps no company better demonstrates this unfortunate trend than headline-grabbing WeWork. WeWork is a real estate company that leases work space to companies and freelancers in major global cities. You can rent a spot at a table, an individual office and conference room, or even a whole floor from which to run your enterprise. In exchange for your dues, you receive a coffee bar, printer access, and other office amenities. Ostensibly, you also have the opportunity to network and participate vicariously in the hip, laidback, creative office space for which the Silicon Valley titans are renown. That is to say, WeWork has ping-pong.
Its concept is not bad. People should spend more time connecting and less time absorbed in their desktop screen. It makes them better people and also makes them better workers. Further, WeWork supplies workspace to major corporations like IBM and Samsung. Outsourcing office space is a major trend. The problem is that the business is simply not worth $47 billion, at least today. But that was the valuation given the company by outside private-placement players. The “tech startup,” which does a lot more leasing of office space than technological innovation, was one of the hottest businesses of the last two years. Its locations have ballooned, not just across the U.S., but in Europe and Asia as well. A Wall Street analyst preaching the prowess of WeWork could be forgiven. It leases more than 5.3 million square feet in Manhattan alone, an increase of 3 million since 2017. Since analysts typically don’t have ping-pong in-house, their fascination is perhaps understandable.
But WeWork has never been profitable. Beyond that, even if it were to become profitable, real estate-management companies are not high-margin businesses. Just because you house nascent tech startups doesn’t mean you have the margins of successful tech companies! As the IPO neared, investors balked—and WeWork withdrew its offering. Suddenly, the darling was facing a cash crunch. Without the cash infusion from going public, it would need to borrow more from banks or through bonds. With earnings negative, there is no guarantee that further growth will make the company profitable. This affects two industry participants: bondholders and equity holders.
In reverse order, investors like pension funds and insurance companies require an actuarily mandated return on their investments. They employ various strategies to meet their obligations. We have discussed some of them previously, like selling volatility—a trade that first blew up in February of 2018 and likely will do so again. Since the last recession, private placements have been one of the hottest markets for these investors. With equity valuations at record highs and dividend yields near the risk-free rate, these large funds have instead looked to investments in which either multiple expansion can be expected or earnings have an opportunity to rise materially. This is the private equity and venture-capital space. These investors provided the funding that satisfied the equity side of WeWork’s balance sheet. The point is that fund returns, unfortunately for pensioners, also will be seriously less than required if all these assets are fairly priced.
Those equity haircuts, though, are not necessarily economically destabilizing. It’s in the debt complex, a murkier space in which interconnectedness and its corresponding fragility reign, that the real threat lies.
WeWork also has debt holders. Its bonds were rated B before the IPO. They are currently at CCC+, trading at a 27% discount to par. To stabilize itself, the company needed cash. SoftBank, already a major investor, agreed to provide more capital after U.S. banks balked. That infusion, though, valued the company at only $4.6 billion, more than a 90% reduction since January 2019. It posted a $1.6 billion loss last year. To pay the coupons on its bonds, it needs to reduce expenditures fast and focus on profit rather than growth. Complicating matters, the company has received $2.8 billion in unearned revenues—a billion more than its current cash. These are prepayments by customers it would have to repay were it to fail to deliver the contracted service.
WeWork is now selling off its non-core businesses to raise more cash, understandably. It has halted its growth plans and will likely attempt to exit some of its current locations. It has had an enormous impact on the commercial real estate market, though, leasing 2% of office space in both New York and San Francisco. Its demand for space has pushed up property values in those areas, upon which landlord financing is based. Should it exit its contracts, the serviceability of its landlords’ liabilities could be affected. This is a worst-case scenario, but it goes to show how markets are interconnected, and overvaluation in one space can mutate to stress in another.
The Poorly Engineered Structure of Debt
WeWork is a microcosm of a much larger story. Junk debt yields more than debt issued by companies with strong and stable cash flows. WeWork has no free cash flow and so falls into the former category, but it’s by no means alone. What’s startling is how many well-known U.S. stalwarts find themselves bordering on a junk rating, including GE, AT&T, and Anheuser-Busch. This puts the scope of the problem in perspective. A recent IMF report says a recession half as severe as 2008 would see companies that owe some 40% of total global corporate debt—about $17 trillion—unable to meet interest payments from earnings alone, as per our last post.
Remember, debt needs to be productive enough to repay itself, or it’s a drag on the business. If it cannot sufficiently do so when earnings decline and margins contract, the borrower is left high and dry of the funds needed to service it. With the financial condition of these borrowers already compromised, as the standards for BBB bonds illustrated earlier, they simply don’t have the cushion necessary to easily weather tough times. To raise cash, they, like WeWork today, will be looking to sell assets. If one borrower is in trouble, though, it’s likely not alone. One of the abiding aphorisms in our profession is this: “There is never just one cockroach in the kitchen.”
Financial intermediaries—pension funds and insurers—are aware of the problems in the corporate-debt world. They are conflicted, though, because of the pressure they feel to meet their actuarily-determined required rates of return. The conundrum in which they find themselves is certainly not without recent and admittedly unnerving precedent. Chuck Prince, the former Citigroup chief executive, infamously said in July 2007, referring to the firm’s leveraged lending practices: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
They will try to clean up the credit quality in their portfolios when the sustainability of the return becomes questioned, but at that point willing buyers will be in short supply. Someone must hold these instruments at all times. Not everyone can run for cover. The credit quality of the bonds, however, and the deterioration of standards, implies that cover will likely be required eventually.
In the 2011 film on the Great Financial Crisis, “Margin Call,” Kevin Spacey lines up his traders in the morning and informs them the firm needs to liquidate its holding of mortgage-backed securities (MBS). “For those of you who’ve never been through this before, this is what the beginning of a fire sale looks like,” he says. By the end of day, demand has evaporated, markets have locked up, and no one wants MBS. That is Hollywood drama. The real action plays out somewhat slower—and is actually far scarier.
That’s because a movie cannot convey within the limits of its story-telling genre the complexity that is the fuel for the fire. Popular retellings of the last crisis have left almost no one with a comprehensive understanding of the real mechanisms that crippled markets. When the Great Financial Crisis is truly probed, it becomes difficult to fully articulate how a small minority of mortgages across suburbia caused Apple’s stock price to halve.
The answer is leverage in portfolio construction. As was true of MBS (and could prove hugely destabilizing in the corporate bond world), so it is with the leveraged holding of fixed-income securities. In 2008 investors funded their purchase of MBS with borrowed funds. When the lender refused to renew the loan, they had no choice but to sell.
Today bond positions are still financed with borrowed funds. This is the very basis for the risk-parity strategy of the famed Bridgewater Associates (BA) fund. Since the volatility of bonds has been historically lower than that of equities and the two classes have often been inversely correlated, BA leverages its bond holdings so that it can commit less capital to them while maintaining greater theoretical protection against an equity decline. If that description sounds, well, incomprehensible, simply know that leveraged positions in anything carry more risk and force an investor to unwind a holding more quickly, making the sale largely immune to price.
This strategy has gained wide popularity, but most investors don’t realize that stocks and bonds aren’t always inversely correlated. In market crashes, as in 2008-09, panic tends to supersede reason, and correlation coefficients often approach 1.0; investors with leveraged portfolios will again find their lenders issuing a margin call. Unable to pay back their loan, they will be forced to sell something, anything. Thus, stocks, bonds, and all other assets are affected.
All this is emblematic of a complex system. Each part is connected to some other part until some new stressor is introduced to the equation and all those relationships begin to break. This is not a tangled web. A web has flexibility in the network of connections. This is a rigid bridge of brittle and irregular trusses spanning the abyss of required return. Unsupported, its ties invariably crack under the weight of investor sentiment turning to head in the other direction.
The Financial Crisis Inquiry Commission published its backward-looking findings in January 2011. It is the nature of governments to perform postmortems on crises in hopes of learning something to avoid repeating them in the future. The recent exposé in the Washington Post, “The Afghanistan Papers: A Secret History of the War,” is the latest in a series of examples of the futility of such endeavors.
That said, it’s clear that that the actions of those in positions of highest authority would suggest they haven’t studied the Financial Crisis Inquiry Commission’s report in hopes of avoiding the failings of the past in the future. From our vantage point, the report may not be a blueprint, as history never repeats itself predictably, but this summary is worthy of a thoughtful investor’s time. The parallels with today—many of which are subtle, not easily adapted to the present circumstances, and couched in language unfamiliar to many readers—are distressingly apparent to us. We suspect that if you read the summary you will conclude as we have when asked to express in a word what has been learned collectively by the investment community in 2019 from the Financial Crisis more than a decade ago: “Nothing.”
Here are the Commission’s nine conclusions.
- “We conclude this financial crisis was avoidable.”
“There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term ‘repo’ lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner.” The Commission especially singled out the Fed’s “failure to stem the flow of toxic mortgages.”
- “We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets.”
“More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor.”
- “We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis.”
“Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. … [Large investment banks and bank holding companies] took on enormous exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and selling trillions of dollars in mortgage-related securities, including synthetic financial products.” The report goes on to fault “poorly executed acquisition and integration strategies that made effective management more challenging,” narrow emphasis on mathematical models of risk as opposed to actual risk, and short-sighted compensation systems at all levels.
- “We conclude a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis.”
“In the years leading up to the crisis, too many financial institutions, as well as too many households, borrowed to the hilt. … [A]s of 2007, the leverage ratios [of the five major investment banks] were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe out a firm. To make matters worse, much of their borrowing was short-term, in the overnight market—meaning the borrowing had to be renewed each and every day. … And the leverage was often hidden—in derivatives positions, in off-balance-sheet entities, and through ‘window dressing’ of financial reports available to the investing public. … The heavy debt taken on by some financial institutions was exacerbated by the risky assets they were acquiring with that debt. As the mortgage and real estate markets churned out riskier and riskier loans and securities, many financial institutions loaded up on them.”
- “We conclude the government was ill-prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets.”
“[K]ey policy makers … were hampered because they did not have a clear grasp of the financial system they were charged with overseeing, particularly as it had evolved in the years leading up to the crisis. This was in no small measure due to the lack of transparency in key markets. They thought risk had been diversified when, in fact, it had been concentrated. … There was no comprehensive and strategic plan for containment, because they lacked a full understanding of the risks and interconnections in the financial markets. … While there was some awareness of, or at least a debate about, the housing bubble, the record reflects that senior public officials did not recognize that a bursting of the bubble could threaten the entire financial system. … In addition, the government’s inconsistent handling of major financial institutions during the crisis—the decision to rescue Bear Stearns and then to place Fannie Mae and Freddie Mac into conservatorship, followed by its decision not to save Lehman Brothers and then to save AIG—increased uncertainty and panic in the market.”
- “We conclude there was a systemic breakdown in accountability and ethics.”
“In our economy, we expect businesses and individuals to pursue profits, at the same time that they produce products and services of quality and conduct themselves well. Unfortunately … [l]enders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. …” And the report documents that major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators. Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this critical information was not disclosed.
- “We conclude collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis.”
“Many mortgage lenders set the bar so low that lenders simply took eager borrowers’ qualifications on faith, often with a willful disregard for a borrower’s ability to pay. … While many of these mortgages were kept on banks’ books, the bigger money came from global investors who clamored to put their cash into newly created mortgage-related securities. It appeared to financial institutions, investors, and regulators alike that risk had been conquered. … But each step in the mortgage securitization pipeline depended on the next step to keep demand going. From the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough skin in the game. When borrowers stopped making mortgage payments, the losses—amplified by derivatives—rushed through the pipeline. As it turned out, these losses were concentrated in a set of systemically important financial institutions.”
- “We conclude over-the-counter derivatives contributed significantly to this crisis.”
“The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis. … OTC derivatives contributed to the crisis in three significant ways. First, one type of derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline. CDS were sold to investors to protect against the default or decline in value of mortgage-related securities backed by risky loans. … Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were merely bets on the performance of real mortgage-related securities. They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread them throughout the financial system. … Finally, when the housing bubble popped and crisis followed, derivatives were in the center of the storm. AIG, which had not been required to put aside capital reserves as a cushion for the protection it was selling, was bailed out when it could not meet its obligations. The government ultimately committed more than $180 billion because of concerns that AIG’s collapse would trigger cascading losses throughout the global financial system. In addition, the existence of millions of derivatives contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions.”
- “We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction.”
“The three credit rating agencies were key enablers of
the financial meltdown. The mortgage-related securities at the heart of the
crisis could not have been marketed and sold without their seal of approval.
Investors relied on them, often blindly. In some cases, they were obligated to
use them, or regulatory capital standards were hinged on them. … [T]he forces
at work behind the breakdowns at Moody’s … includ[ed] the flawed computer
models, the pressure from financial firms that paid for the ratings, the
relentless drive for market share, the lack of resources to do the job despite
record profits, and the absence of meaningful public oversight.”
[*] Hyman Minsky was a twentieth-century American economist and prolific thinker and author whose work I greatly admire and is particularly apropos today. Minsky argued that a sequence of financial events can foment a “Minsky Moment,” often enveloped in the fog of uncertainty. The stage is first set by “a prolonged period of rapid acceleration of debt” in which more traditional and benign borrowing is increasingly replaced by borrowing that depends on new debt to repay existing loans. Then the “moment” occurs, “when lenders become increasingly cautious or restrictive, and when it isn’t only over-leveraged structures that encounter financing difficulties. At this juncture, the risks of systemic economic contraction and asset depreciation become all too vivid.”
Martin, Frank K.. A Decade of Delusions (pp. 353-354). Wiley. Kindle Edition.
 Standard & Poor’s rating system.
 Earnings before interest, taxes, depreciation, and amortization
 Warren Buffett has no interest in companies that report results using EBITDA. “… They are either trying to con you or they are conning themselves.”
 Rosenberg, Breakfast with Dave, 11/25/2019.
 This is not to suggest that we think AT&T is in any danger of insolvency—merely that the problem of poorly rated debt could require companies to rearrange their balance sheets at a time most disadvantageous to equity investors.