America’s energy independence was an illusion created by cheap debt. All that’s left to tally is the damage.
Ever since the oil shocks of the 1970s, the idea of energy independence, which in its grandest incarnation meant freedom from the world’s oil-rich trouble spots, has been a dream for Democrats and Republicans alike. It once seemed utterly unattainable — until the advent of fracking, which unleashed a torrent of oil. By early 2019, America was the world’s largest producer of crude oil, surpassing both Saudi Arabia and Russia. And President Trump reveled in the rhetoric: We hadn’t merely achieved independence, his administration said, but rather “energy dominance.”
Then came Covid-19, and, on March 8, the sudden and vicious end to the truce between Saudi Arabia and Russia, under which both countries limited production to prop up prices. On March 9, the price of oil plunged by almost a third, its steepest one-day drop in almost 30 years.
As a result, the stocks that make up the S.&P. 500 energy sector fell 20 percent, marking the sector’s largest drop on record. There were rumblings that shale companies would seek a federal lifeline. Whiting Petroleum, whose stock once traded for $150 a share, filed for bankruptcy. Tens of thousands of Texans are being laid off in the Permian Basin and other parts of the state, and the whole industry is bracing for worse.
On the surface, it appears that two unforeseeable and random shocks are threatening our dream.
In reality, the dream was always an illusion, and its collapse was already underway. That’s because oil fracking has never been financially viable. America’s energy independence was built on an industry that is the very definition of dependent — dependent on investors to keeping pouring billions upon billions in capital into money-losing companies to fund their drilling. Investors were willing to do this only as long as oil prices, which are not under America’s control, were high — and when they believed that one day, profits would materialize.
Even before the coronavirus crisis, the spigot was drying up. Now, it has been shut off.
The industry’s lack of profits wasn’t exactly a secret. In early 2015, the hedge fund manager David Einhorn announced at an investment conference that he had looked at the financial statements of 16 publicly traded shale producers and found that from 2006 to 2014, they spent $80 billion more than they received from selling oil. The basic reason is that the amount of oil coming out of a fracked well declines steeply after the first year — more than 50 percent in year two. To keep growing, companies have to keep plowing billions back into the ground.
The industry’s boosters argue that technological gains, such as drilling ever bigger wells, and clustering wells more tightly together to reduce the cost of moving equipment, eventually would lead to a gusher of profits. Fracking, they said, was just manufacturing, in which process and human intelligence could reduce costs and conquer geology.
Actually, no. The key issue is the “parent child problem.” When wells are clustered tightly together, with so-called child wells drilled around the parent, the wells interfere with one another, resulting in less oil, not more. (This may not surprise anyone who is attempting to be productive while working in close quarters with their children.)
The promised profits haven’t materialized. In the first half of 2019, when oil was around $55 a barrel, only a few top-tier companies were profitable. “By now, it should be abundantly clear that the current shale oil business model does not work — even for the very best companies in the industry,” the investment firm SailingStone Capital Partners explained in a recent note.
Policymakers who wanted to tout energy independence disregarded all this, even as investors were starting to lose patience. As early as 2018, some investors had begun to tell companies that they wanted to see free cash flow, and that they were tired of compensation models that rewarded executives with rich paydays for increasing production, but failed to take profits into account. As a result, fracking stocks badly underperformed the market.
But with super-low interest rates, investors in search of yield were still willing to buy debt. Over the past 10 years, the entire energy industry has issued over $400 billion in high-yield debt. “They subprimed the American energy ecosystem,” says a longtime energy market observer.
Even as the public equity and debt markets grew cautious, drilling continued. That’s because one big source of funding didn’t dry up: private equity. And why not? Private equity financiers typically get a 2 percent management fee on funds they can raise, so they are incentivized to take all the money that pension funds, desperate for returns to shore up their promises to retirees, have been willing to give them.
In the Haynesville and the Utica Shales, two major natural gas plays, over half of the drilling is being done by private equity-backed companies; in the oil-rich Permian Basin, it’s about a quarter of the drilling. From 2015 through 2019, private equity firms raised almost $80 billion in funds focused mostly on shale production, according to Barclays.
Until the capital markets began to get suspicious, private equity investors could flip companies they had funded to larger, public companies, making a profitable exit regardless of whether or not the underlying business was making money.
That, too, is ending, as investors in such funds have become disillusioned.
You can see how all of this is playing out by looking at Occidental Petroleum. In 2019, Oxy, as it’s known, topped a competing bid from Chevron and paid $38 billion to take over Anadarko Petroleum, which is one of the major shale companies. Since that time, Oxy’s stock has plummeted almost 80 percent in part due to fears that the Anadarko acquisition is going to prove so wildly unprofitable that it sinks the company.
On March 10, the company announced that it would slash its dividend for the first time since the early 1990s, when Saddam Hussein’s invasion of Kuwait sent oil prices plummeting.
Occidental is just one piece of the puzzle. In April, the Energy Information Administration cut its forecast for U.S. oil production, estimating that it will fall both this year and next — suggesting that the days of huge growth in production from shale are over.
On March 10, Scott Sheffield, the chief executive of Pioneer Natural Resources, a major driller in the Permian Basin, told Bloomberg that U.S. oil output could fall by more than two million barrels per day by next year if prices remain where they are today.
“This is late ’80s bad,” a close observer of the industry says.
After the United States engaged in a high-stakes negotiation with Russia and Saudi Arabia to curtail production, a tentative deal was struck on Thursday. Certainly, President Trump, who has staked so much on the American shale industry, wants to save it. “We really need Trump to do something or he’s going to lose all the energy states in this election,” Mr. Sheffield told CNBC in late March.
A deal, and higher oil prices, might help the industry. But they won’t fix its fundamental problem with profitability. Energy independence was a fever dream, fed by cheap debt and frothy capital markets.
All that’s left to tally is the environmental and financial damage. In the five years ending in April, there were 215 bankruptcies for oil and gas companies, involving $130 billion in debt, according to the law firm Haynes and Boone. Moody’s, the rating agency, said that in the third quarter of 2019, 91 percent of defaulted U.S. corporate debt was due to oil and gas companies. And North American oil and gas drillers have almost $100 billion of debt that is set to mature in the next four years.
It’s still unclear where most of this debt is held. Some of it has been packaged into so-called collateralized loan obligations, pieces of which are held by hedge funds. Some of it may be on bank balance sheets. Investors in the equity of these companies have already seen the value of their holdings decimated. Pension funds that have poured money into private equity firms may take a hit soon, too. All we know for sure is that fracking company executives and private equity financiers have made a fortune by touting the myth of energy independence — and they won’t be the ones who have to pick up the pieces.
Covid-19 has exposed our financial fragility
An orgy of borrowing, speculation and euphoria has left the markets on the verge of catastrophe
Financial markets have experienced the fastest ever crash over the past few weeks. Even during the dotcom bust and the Lehman crisis, stocks did not fall this quickly. In less than a month, we have seen major indices fall almost 30%, and stocks in sectors such as oil and travel down by 80%. We are experiencing terrifying daily declines not seen since the 1929 stock market crash that preceded the Great Depression.
We are at a watershed moment: the coronavirus Covid-19 is a catalyst fast bringing many long simmering problems to the boil. It is exposing the creaking financial systems around us and it will change the way economies function. Economic and financial pundits, however, have been focusing almost exclusively on the short-term effects of coronavirus and so are missing the much bigger themes at play.
Epidemiologists tell us that when it comes to the virus, we are looking at a once in a century event. It is highly contagious and highly lethal. Experts are not comparing Covid-19 to SARS or Swine Flu, but to the Spanish influenza of 1918 that killed between 50 and 100 million people worldwide.
We do not have good data on what the stock market did during the 1918 flu, but we do know that it led to a severe recession. The connection between influenza and recessions is well documented. Going as far back as the Russian flu in 1889-90, the Spanish flu in 1918, the Asian flu in 1957-58 and the Hong Kong flu of 1968-69 — they all led to recessions. This one will be no different.
But this recession will not only be driven by the economic loss of able-bodied workers, it will be helped along too by the steps political leaders take to avoid the spread of the coronavirus. In medicine, the immune system’s response can often be worse than the disease. When the body goes into septic shock, the immune system overreacts, releasing what doctors refer to as a cytokine flood, which can reduce blood to vital organs and lead to death. Sepsis is common and kills more than 10 million people a year. Today, the political reaction to Covid-19 is causing something akin to a septic shock to the global economy.
The recession is likely to be very sharp and but brief. Recessions are self-regulating. De-stocking of shelves and warehouses leads to re-stocking. Collapsing low interest rates and oil prices eventually spur spending and borrowing. Government spending and central bank easing eventually feed through to the real economy. While there will be massive panic and bankruptcies today, there is little doubt that markets will be better in a year, and certainly will be in two to three years,
But the structural changes to how our economy operates, however, will be felt for decades to come. And this is in large part because we didn’t learn the lessons of the last crash.
Over the years since the 2008 crisis, central banks have been trying to stamp out every single small fire that flares up (the European crisis in 2011-12, the Chinese slowdown in 2015-16, the slowdown last year); but suppressing volatility and risk only creates bigger fires. Risk is like energy and cannot be destroyed. It can only be transformed.
Forest fires are a useful analogy. California has infrequent, devastating forest fires; the Mexican state of Baja California has many small frequent fires and almost no major catastrophic fires. Both states have a similar climate and vegetation, yet they have vastly different outcomes. That’s because when there are very few small fires, underbrush grows, vegetation increases and creates greater kindling for the next fire. Suppressing small risks only makes them emerge eventually as very big ones.
In politics and economics, massive change events tend to happen not in orderly sequences, but in sudden spasms, like the Arab Spring, or the collapse of the Eastern Bloc. Watching events unfold is often like watching sand grains pile slowly on top of one another until a final, random grain causes the entire pile to collapse. People knew the Arab countries were fragile and that the Eastern Bloc might eventually fall, but predicting which grain of sand would do it precipitate either was impossible.
Physicists call these transitions critical thresholds. Critical thresholds are everywhere in nature. Water at moderate temperatures is disorganised and free-flowing, yet at a given critical value, it has an abrupt transition to a solid. It’s the same with the sandpile: one grain too many can trigger collapse — but which one?
In 1987 Per Bak, Chao Tang, and Kurt Wiesenfeld found that while sandpiles may be individually unpredictable, they all behave the same way. The critical finding of their experiments was that the distribution of sand avalanches obeys a mathematical power law: The frequency of avalanches is inversely proportional to their size. Much like forest fires, the less frequent they are, the more catastrophic they are.
It’s the same with financial markets and the economy. We will experience years of quiet, interrupted by sudden avalanche. Years of slowly adding grains of sand can end abruptly — to our great surprise. Today in financial markets, many unsustainable trends have been building, and the coronavirus is merely the grain of sand that has tipped the sandpile.
It would be controversial to say that the stock market reaction to the coronavirus would not have been very big had we not been in the middle of an orgy of borrowing, speculation and euphoria. Of course, stocks would have fallen with coronavirus headlines, but it is unlikely they would have crashed the way they did without those exacerbating factors. Furthermore, without enormous underlying imbalances of high corporate debt, the prospect of poor sales would not have driven so many stocks to the verge of collapse.
This aspect of the current crisis has so far gone unreported. But not unmentioned. A few weeks before the crash, Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s longtime business partner, issued a dire warning, “I think there are lots of troubles coming,” he said at the Los Angeles-based Daily Journal annual shareholders meeting. “There’s too much wretched excess.”
Speculative euphoria was at record highs. As Sir John Templeton once said, “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” Investors were all on the same side of the boat, and it capsized, as happens in market crashes.
- Investors were buying a record amount of call options, or bets on stock prices rising further. According to SentimenTrader, by early February, “We’ve never seen this level of speculation before. Not even close.”
- Asset managers were betting in record quantities on stock futures, which are instruments to bet on underlying indices. Positioning in S&P futures hit a new high as of February 11.
- Hedge fund borrowing to buy stocks was at a 24-month high. They were highly confident markets would keep rising.
Asset Manager positioning in S&P futures hit a new high as of February 11 in both net contracts and value. S&P futures comprises the bulk of equity futures positioning by these funds.#SPX #NDXSee QF Research’s other Tweets
It was not a coincidence that there was such euphoria. Retail brokerages had announced over the past few months that they were eliminating all commissions on trading activity. Buying and selling stocks was suddenly “free”. It was like pouring truckloads of kerosene on a blaze. At Charles Schwab, daily average trading revenue exploded 74% after the change.
In scenes reminiscent of the dotcom boom, stocks were doubling overnight. Virgin Galactic Holdings, with no revenue, was worth over $6 billion dollars. Tesla, which has never made money selling cars, had a market capitalisation greater than any other car manufacturer. Its stock price quadrupled in less than three months. The market was so stretched that it would have crashed due to its own absurdity — with or without coronavirus.
The source of this “free” trading came from high frequency trading firms that are supposed to act as market makers, executing buys and sells for clients. Except that they are not really disinterested middlemen; they are running their own trading strategies to make money off retail investors. They execute the order flow of so called mom and pop investors and profit from these “dumb money” retail traders, in the words of Reuters.
The brokerages which sell retail orders receive hundreds of millions of dollars in return from the market makers. This means that, essentially the market makers are bribing the brokerages to profit from retail traders. For example, E*Trade received $188 million for selling its customer order flow last year, while TD Ameritrade made $135 million in the fourth quarter alone. The market makers are willing to pay so much because they almost never lose money — they trade fast and know where the market is going.
As Warren Buffet once said, “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” Retail is the patsy.
Ken Griffin is the owner of Citadel Securities the biggest market-making firm, and his business is so profitable that he has gone on one of the greatest property buying sprees of all time. In 2015 Griffin paid $60 million for multiple condo units in Miami. He paid a U.S.-record $239.96 million penthouse in New York City, a $122 million mansion in London, and over $250 million in Palm Beach properties. Market making against “dumb money” is a fabulous business.
As the mania deflated in late February, though, mom and pop were abandoned. As the crash started, market makers pulled back and provided less liquidity. Retail investors were left high and dry. It is no wonder prices fell so quickly.
The high frequency market makers have since been pleading for more capital, and rumors swirl that many are experiencing financial difficulties. The illusion of benign market makers looking after retail investors has vanished.
There are echoes here of the old problems from the Lehman crisis; but they have mutated into different forms. During the Lehman crisis, mortgage bonds were pooled together, and insurance companies and pension funds bought them. Today, retail investors have been buying popular funds known as Exchange Traded Funds (ETFs). These are easy to trade and cheap, but they have a fundamental problem. While ETFs have simple tickers like HYG, JNK, LQD that the average retail broker can trade on their screen, they are really holding hundreds of individual bonds inside of them that the investor is unaware of. These bonds are not easy to trade at a moment’s notice and are highly illiquid. But while the ETFs rose slowly and steadily, and investors poured more money in, lulled by a false sense of security.
While the ETF shares trade daily by the second, the underlying bonds are not easy to trade on their own. In the old days, insurers and pension funds bought these bonds, put them away in a drawer and never traded them. Today, though, investors expect instant liquidity from an illiquid investment. Liquidity mismatches are as old as banking itself (deposits and cash are highly liquid, while mortgages and loans are often completely illiquid); the problems of ETFs have been known all along, and the outcome has been inevitable.
As the coronavirus panic spread, the ETFs started trading at big discounts to the underlying value of the baskets of bonds. Markets are broken, and the gap is a sign of how illiquid the underlying holdings really are.
But these ETFs should never have been allowed in the first place. In the words of Christopher Wood, an investment strategist at Jefferies, “they commoditise equity and bond investing in an insidious way which ultimately creates a dangerous illusion of liquidity. True, ETFs are cheap. But so is fast food.”
While ETFs may appear technical and unrelated to the broader problems in markets, they share the same underlying problem. We have had the illusion of safety and liquidity for some time, and it is the coronavirus that has exposed the gaping holes in financial markets.
The coronavirus won’t kill companies. But it will expose their bloated, overleveraged balance sheets. Corporate debt in companies has never been higher and has now reached a record 47% of GDP.
Rather than encouraging moderation, central bankers and policy makers have been reloading the all you can eat buffet and persuading everyone to come back for third and fourth plates. The European Central Bank and the Bank of Japan have been buying corporate bonds, and central banks have kept funding at zero rates, which has encouraged a massive increase in indebtedness over the past decade.
Central bankers have long promoted high corporate leverage because they see it as a way to stimulate demand. Even now, many economists see no problems on the horizon. In the New York Times, Nicolas Veron, a senior fellow at the Peterson Institute for International Economics in Washington, was openly mocking anyone advocating prudence, “The prophets of doom who thought that more debt was more risk have generally been wrong for the last 12 years.” Like most central bankers for the past decade, he argued, “More debt has enabled more growth, and even if you have a bit more volatility, it’s still net positive for the economy.”
But while debt has encouraged growth, it has also introduced much greater financial fragility, and so the growth is fundamentally unsound. We are now finding out that less debt, rather than lower rates is better for financial stability.
The global economy has gone mad
According to FactSet, 17% of the world’s 45,000 public companies haven’t generated enough cash to cover interest costs for at least the past three years. Debt has been used to finance more debt in a Ponzi fashion. The Bank for International Settlements looked at similar economic measures globally and found that the proportion of zombie companies — companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt — is now higher than 12%, up from 4% in the mid 1990s.
Entire industries are zombies. The most indebted and bankruptcy prone industry has been the shale oil industry. In the last five years, over 200 oil producers filed for bankruptcy. We will see dozens if not hundreds more bankruptcies in the coming year. They were all moribund with oil at $50 dollars; they’re now guaranteed to go bust with oil at $30.
Only now, belatedly, are groups like the IMF waking up to the scale of the problem. In a recent report they warned that central banks have encouraged companies to pursue “financial risk-taking” and gorging on debt. “Corporate leverage can also amplify shocks, as corporate deleveraging could lead to depressed investment and higher unemployment, and corporate defaults could trigger losses and curb lending by banks,” the IMF wrote.
According to the IMF, a downturn only half as bad as 2008 would put $19 trillion of debt—nearly 40% of the corporate borrowing in major countries—at risk of default. The economic consequences would be horrific.
Corporate debt has doubled in the decade since the financial crisis, non-financial companies now owe a record $9.6 trillion in the United States. Globally, companies have issued $13 trillion in bonds. Much of the debt is Chinese, and their companies will struggle to repay any of it given the lockdown and the breakdown in supply chains.
We have not even begun to see the full extent of the corporate bond market meltdown. One little discussed problem is that a large proportion of the debt is “junk”, i.e. lowly rated. An astonishing $3.6 trillion in bonds are rated “BBB”, which is only one rating above junk. These borderline bonds account for 54% of investment-grade corporate bonds, up from 30% in 2008. When recessions happen, these will be downgraded and fall into junk category. Many funds that cannot own junk bonds will become forced sellers. We will see an absolute carnage of forced selling when the downgrades happen. Again, the illusion of safety and liquidity will be exposed by the coronavirus.
The average family is encouraged to save money for a rainy day, in case they are fired, or they face hardship. Saving some money is considered prudent. It’s quite different for business. Companies pocket the profits in the good years and ask Uncle Sam to bail them out in the bad years. Heads shareholders win, tails the taxpayer loses.
Industry can’t be blamed for not expecting an act of God or force majeure, but in the past 30 years we have seen two Gulf Wars, 9/11, SARS, MERS, Swine Flu, the Great Financial Crisis, etc. Saving for a rainy day should only be expected in cyclically sensitive industries.
But rather than do that, companies have been engaging in a rather more reckless strategy: borrowing to buyback shares. This may boost their Return on Equity (ROE), but it is not remotely prudent and makes their companies highly vulnerable. Borrowing to prop up their own shares means they have less on hand when hard times come.
According to Barons, “Stock buybacks within the S&P 500 index totaled an estimated $729 billion in 2019, down from a record $806 billion in 2018.”
And then along came coronavirus.
Of those industries that are now seeking a bailout, none has saved for a rainy day. Boeing, the poster boy of financial engineering and little real engineering, bought back over $100 billion worth of stock over the past few years. Today it is asking the government for a backstop to its borrowing.
According to Bloomberg, since 2010, the big US airlines have spent 96% of their free cash flow on stock buybacks. Today, they’re asking US taxpayers for $25 billion.
Airline CEOs have been handsomely paid while not saving for a rainy day. Delta Airline’s CEO Ed Bastian made the most, earning nearly $15 million in total compensation. American CEO Doug Parker $12 million, while United CEO Oscar Munoz earned total compensation last year of $10.5 million.
Corporate buyback culture is financial engineering not value creation
The cruise liners were little different. Over the past decade, Carnival Cruises paid $9.2 billion dollars in dividends to its billionaire owners and bought back $6.7 billion of shares. Royal Caribbean, which is a smaller company, paid out $2.7 billion in dividends and $1.6 billion in buybacks. And the smallest cruise liner Norwegian Cruise Line spent $1.3 billion on share buybacks.
For years, the cruise lines have triumphally proclaimed massive dividends and buybacks. For example, Carnival proudly announced in 2018. “In just three years, we have doubled our quarterly dividend and invested $3.5 billion in Carnival stock.”
Cruise lines have no real claim to any bailout. They pay no taxes due to a legal loophole, and all their vessels fly the flags of Liberia, Panama and the Marshall Islands. Furthermore, their owners tend to be billionaires with more than enough financial wherewithal to recapitalise their own businesses. Their shareholders are not among the 1%. They’re among the 0.01% of richest people in the world. In the worst-case scenario, the US has a highly efficient bankruptcy process. Bondholders of today become shareholders of tomorrow, and the companies can have a fresh start. Bondholders would only be more than happy to own the equity of these companies.
Banks, too, will inevitably be asking for bailouts before this is over. Banks have among the most aggressive stock buyback programs of any industry, with some repurchasing a staggering 10% of their outstanding shares annually. The eight biggest banks have announced they will suspend their share buybacks for the next two quarters due to the COVID-19 pandemic on the global economy. In 2019, the top eight banks bought back $108 billion of their own stock.
If any good can come of the current crisis, perhaps it is exposing the irresponsibility of share buybacks and lack of prudence of most companies.
Monetary policy was one of the mechanisms employed in response to the last crisis, in the hope its effects would trickle down to the unwashed masses. Central banks bought vast amounts of treasuries and mortgage bonds to tighten financial spreads for banks and borrowers, but none of it went directly to households. It was all intermediated by the financial system and those who had access to capital.
The absurdity of the policy was perfectly illustrated recently in Europe. The European Central Bank has been busy buying bonds, and recently it bought bonds from LVMH, the luxury conglomerate owned by the world’s richest man Bernard Jean Étienne Arnault. The bonds had a negative yield, meaning that the ECB was paying LVMH to borrow. LVMH used the ECBs money to buy Tiffany.
If rates are now so low that billionaires are being paid to borrow, monetary policy has reached the limits of its usefulness.
Investors own stocks because their bond portfolios have acted like a hedge. Whenever stocks have fallen, bonds have gone up. In every downturn since the 1980s, central banks have cut rates, but most government bonds now have close to zero yields.
Extremely low interest rates and high valuations mean that any small change in interest rates will make portfolios much more volatile. If interest rates were to rise even slightly, they would vaporise many bond and stock portfolios. The margin of safety in bonds and stocks has diminished rapidly as rates have approached zero.
The world is now upside down. Many investors now buy stocks for current income and buy bonds to trade given how volatile they have become. Things cannot hold.
What do high frequency market making, share buybacks and high corporate debt have in common? They are supposedly tools to make trading, growth and returns on capital more efficient and cheaper, yet they have made the system more fragile and less resilient. Perhaps returns on capital and cheapness of market orders and ETFs are less important than stability and anti-fragility, i.e. designing systems that are robust in the face of stress.
We have seen the fragility in supply chains in the recent crisis.When the coronavirus struck in China, suddenly companies everywhere found out that outsourcing all their manufacturing and even medicines and face masks to China might be a problem.
Manufacturing has become less robust, more fragile, even if the returns on capital are better for those companies that outsource everything to China in pursuit of share buybacks.
The lessons of history are instructive. Although planting a single, genetically uniform crop might be more efficient and increase yields in the short run, low genetic diversity increases the risk of losing it all if a new pest is introduced or rainfall levels drop.
Have we been played by China?
The Irish Potato Famine is one such cautionary tale of the danger of monocultures, or only growing one crop. The potato first arrived in Ireland in 1588, and by the 1800s, the Irish had used it to solve the problem of feeding a growing population. They planted the “lumper” potato variety. All of these potatoes were genetically identical to one another, and it was vulnerable to the pathogen Phytophthora infestans. Because Ireland was so dependent on the potato, one in eight Irish people died of starvation in three years during the Irish potato famine of the 1840s.
The lessons from nature are dire. In the 1920s, the Gros Michel banana was almost wiped out by a fungus known as Fusarium cubense, and banana shortages became a growing problem. The widespread planting of a single corn variety contributed to the loss of over a billion dollars worth of corn in 1970, when a fungus hit the US crop. In the 1980s, dependence upon a single type of grapevine root forced California grape growers to replant approximately two million acres of vines when the pest phylloxera attacked.
Today, China is manufacturing’s monoculture.
Against this dangerous backdrop of volatility and uncertainty, the coronavirus will now achieve the impossible. For the past few years, two ideas have floated around on the political fringes of the Left, but they have been dead on arrival. No one has seriously thought they might become government policy. Today, the Left and Right in the United States and Europe are embracing them.
Andrew Yang, a former tech executive from New York, ran a quixotic, obscure presidential campaign in the United States based on the idea that every citizen should receive a Universal Basic Income (UBI). He advocated a “Freedom Dividend”. This would be a form of universal basic income that would provide a monthly stipend of $1,000 for all Americans between the ages of 18 and 64.
Today, Trump, Pelosi, Romney and others are fully backing Yang’s idea. Respected think tanks such Brookings and Chatham House have advocated UBI. But once it is implemented, there will be no going back. Handouts will start small and grow.
The other big idea has come from Stephanie Kelton, who advised Bernie Sanders and advocates for Modern Monetary Theory (MMT). Kelton argues that in any country with its own currency, budget deficits don’t matter unless they cause inflation. The government can pay for what it needs by simply printing more money — no reason to borrow by issuing bonds. Helicopter money.
Could free cash fix the economy?
Her ideas were widely criticised across the Left and Right, ranging from Paul Krugman to Warren Buffett to Federal Reserve Chairman Jay Powell.
Yet today, the two ideas have come together. There are no atheists in foxholes. Even libertarians on Twitter are now calling for government intervention. Investors and politicians of all stripes are calling for UBI financed by MMT money issuing.
This is an epochal turning point, a great reset. The coronavirus is the grain of sand that will cause the avalanche.
For once the taboo of printing money to pay citizens is broken, we can never go back. Governments will spend money with few constraints, aided by central banks. It’s a strategy that has not worked well in emerging markets, and it did not work well in the 1970s — which has conveniently been forgotten.
Undoubtedly, the government must compensate citizens from mandatory curfews and quarantines. The short-term impacts of the lockdowns must be mitigated, but temporary policies must not become permanent political expedients.
That’s why the danger is not today or even a year from now, it’s five to ten years away, when the crisis has past, along with the reason for UBI and monetary easing. What politican will be disciplined enough to stop spending? What central banker will raise rates when it is unpopular to do so?
Today we are reaping the whirlwind of the last financial crisis. Rather than pursue lower leverage, less debt and more robust institutions and more responsible corporate behaviour, investors and companies instead learned that they would be bailed out in a crisis.
Central banks became enamored of their own success as fire fighters, and they have busily been trying to put out fires by
- encouraging reckless behaviour,
- prizing low volatility above a robust financial system,
- viewing “risk management” as preferring no financial corrections ever.
They should accept that sometimes putting out every single fire creates greater conflagrations. They should be humbler about the extent and limits of their power.
It looks like they’re about to learn the hard way.
The Next Coronavirus Financial Crisis: Record Piles of Risky Corporate Debt
A fast-growing market in junk-rated leveraged loans is showing severe strains, a sign of a looming credit crunch that could stifle future economic growth
Serious strains are starting to appear in the $1.2 trillion market for loans to high-risk companies, which have borrowed record sums in recent years as investors chased bigger yields.
The market, which survived the 2008 financial crisis, has become overstretched since then, say regulators and economists, who worry that it is now so big and risky its problems could amplify any economic damage caused by the coronavirus crisis.
“What I’ve always worried about is that the existence of overleveraged corporations will exacerbate a downturn that occurs for any reason,” said former Fed Chairwoman Janet Yellen in an interview.
Years of low interest rates and easy credit have allowed companies across the board to borrow big, building a record $10 trillion mountain of debt. Lenders expect the vast majority of that money to be repaid on time.
The epicenter of risk involves a subset of that total: $1.2 trillion in leveraged loans, junk-rated debt secured by corporate assets much like mortgages are backed by homes. The market has exploded, ballooning by almost 50%—or $400 billion—since the start of 2015, as investors desperate for the high interest payments these loans provided threw cash at borrowers.
Private-equity firms fueled a lot of the growth, borrowing billions at a time to buy brand names including Dell Technologies and Staples Inc. Smaller but relatively stable public companies like car supplier American Axle & Manufacturing Holdings and electrical supply maker Atkore International Group Inc. also took out leveraged loans to fund share buybacks and acquisitions.
The banks that make such loans rarely hold on to them now because of regulations passed after 2008. Instead they sell the debt directly to money managers or repackage it into complex securities that are marketed to investors around the world.
SHARE YOUR THOUGHTS
Should the government rescue investors who made leveraged loans to high-risk companies? Join the conversation below.
When prices of the loans drop, or they fall into default, the losses hit pensions, insurers, and scores of mutual funds and hedge funds, some of which react by selling out, exacerbating market swings.
In addition, investors become less willing to buy new loans and the banks that arrange such deals stop making new ones. That can be compounded by sharp losses in the complex securities Wall Street repackaged many of the loans into, causing credit markets to seize up and leave already indebted companies without access to fresh cash. The consequences could cascade: A wave of defaults and bankruptcies, forcing job cuts and amplifying the economic slowdown.
The impact will likely be long and drawn-out. Most loans don’t start coming due until 2022 and the hardest-hit sector—energy—is a small component of the market. Still, loan prices can fall sharply well before companies run out of cash, hurting investors who own the debt. And as business dries up for some companies, they may not be able to stay current on their existing loans.
Leveraged loans suffered their worst run since the financial crisis this month when a widely tracked index lost about 16% of its value. Prices for loans to 24 Hour Fitness Worldwide, which operates a chain of gyms, fell to about 44 cents on the dollar this week from 80 cents in February, according to analytics firm AdvantageData Inc. Prices of loans to airlines such as United Airlines Holdings Inc. and American Airlines Group Inc. declined about 10% in the first two weeks of March, more than any full-month loss since October 2008, according to S&P Dow Jones Indices.
Repackaging loans into bundles called “collateralized loan obligations” became popular in the 2000s, alongside similar techniques employed to market mortgage-backed bonds. Unlike mortgage bonds, very few CLOs defaulted in the 2008 financial crisis. That record and their high yields have made CLOs popular in recent years, but they are susceptible to violent price swings and have been one of the worst-performing debt investments this month.
Loan investors remain hopeful that the virus will subside and that its aftershocks will be brief. But with the amount of loans outstanding about twice as large as in 2008, according to data from S&P Global, a recession will likely trigger a larger wave of defaults and heavier losses on their debt than the dot-com bubble or the financial crisis, analysts say.
Companies that borrow in the junk loan market now are far weaker financially than those in that era. Borrowers with loans Moody’s Investors Service rated at the lowest rungs of the junk-debt ladder—B3 or lower—made up 38% of the market in July compared with 22% in 2008.
“Investors will probably be surprised by the extent of their losses on loans compared with their historical losses,” said Oleg Melentyev, a strategist at Bank of America Corp. He calculates that about 29% of outstanding leveraged loans will likely default cumulatively in the next credit downturn, compared with an average of about 20% by junk-rated companies during the 2007 to 2009 period. Worse yet, investors will likely recover less money: about half of their original investment, compared with 58% back then.
The storm is rocking even well-established leveraged-loan borrowers like hotel chain Hilton Worldwide Holdings Inc. The company took out a $2.6 billion loan in June to refinance debt left over from when Blackstone Group bought it over a decade ago, according to data from LevFin Insights.
Prices for the loan, stable at 100 cents on the dollar in late February, have now fallen to about 83 cents on the dollar, according to data from IHS Markit. The company has borrowed more in recent days on a $1.75 billion revolving loan—basically a line of credit—to build cash as tourism and travel plummet. Prices of the revolver have fallen to around 79 cents.
Other companies won’t have the same access to cash. “The real risk is in those incremental borrowers, the borrowers who need access to capital that could dry up,” said Frank Ossino, senior loan portfolio manager at Newfleet Asset Management, which holds about $2 billion of leveraged loans in the $10 billion of investments it manages.
Cracks appeared in the market last week as businesses sent workers home, travel slowed, sports leagues halted play and predictions about the virus’s economic impact grew increasingly dire.
Moody’s downgraded Cirque du Soleil Inc. on Wednesday to a credit rating “in, or very near, default” after the company, which employs 4,000 people, suspended its shows in Las Vegas. Prices of about $700 million in loans the circus operator mostly borrowed for its purchase by private-equity firms in 2015 fell to 68 cents on the dollar from around 94 at the start of the month, according to data from IHS Markit. Officials for the company couldn’t immediately be reached for comment.
CLOs are highly susceptible because they use borrowed money to buy leveraged loans, boosting the yield, and the risk, of the investments. CLO managers issue bonds to buy bundles of leveraged loans, then use cash flow from the loans to pay interest and principal on the CLO bonds, pocketing the difference.
When downgrades and defaults mount, CLO managers stop making payments on their most junior bonds, prices plummet and the market for new CLOs shuts down. Lower-quality CLO securities were the worst performers this month out of 29 types of debt measured by Citigroup Inc. analysts, losing 22% through March 13.
“CLO formation has come to a grinding halt,” said Alex Jackson, chief investment officer for Nassau Corporate Credit, which manages six CLOs and had planned to launch more this year. “It does feel like the market accelerated into a panic over the course of the week.”Pain TradeLeveraged loan prices are plummeting,punishing investors who piled into the debt inrecent yearsS&P Global Leveraged Loan IndexSource: S&P Dow Jones IndicesNote: Data as of March 182016’17’18’19’2017501800185019001950200020502100215022002250Aug. 12, 2018×2120.52
Loan markets seized up briefly the last time stocks tumbled in December 2018, but the declines are much sharper now and many fear a more prolonged disruption. During the last financial crisis, issuance of new leveraged loans slowed to a trickle for about a year starting in August 2008, according to data from S&P Global Market Intelligence.
Also worrying, it became increasingly difficult last week to trade existing loans of large companies normally viewed as comparatively safe bets. The gap between what sellers were asking and what buyers wanted to pay for Dell loans widened to 2 percentage points last week from about a half-point normally. On March 9, too few banks were making markets in the $5.3 billion loan of fast-food chain Restaurant Brands International, which owns Burger King, to accurately price the debt, according to IHS Markit.
If trading dries up, investors and analysts hope the Fed can intervene to avoid a credit crunch. The central bank on Sunday slashed interest rates to near zero and said it would buy $700 billion in Treasurys and mortgage-backed securities to help ease stress in the financial markets.
On Tuesday, the Fed announced plans to start making loans to American companies in a bid to unclog the $1.1 trillion market for short-term IOUs called commercial paper, which companies use to finance day-to-day business operations such as payroll expense.
Eric Rosengren, president of the Federal Reserve Bank of Boston, said earlier this month that without a stronger response from Congress and the White House to combat any downturn, the Fed would need Congress to authorize new tools to spur growth, such as allowing the central bank to purchase corporate bonds and other private-sector assets.
A high level of corporate debt “is one of the negative outcomes of having low interest rates for a long time,” he said. “We’ll see how much of a problem that is for unemployment.”
Worries over the risk in the leveraged loan market have been overstated, said Lee Shaiman, head of the Loan Syndications and Trading Association trade group. The biggest industries in the market, like business services and technology, are less affected by the virus than others, he said. And lower interest rates have cut debt expenses for most borrowers significantly in the past month. Energy companies, among the worst hit in the March turmoil, comprise only 3% of the loan market, according to data from S&P Dow Jones Indices.
But low-rated companies also borrowed more against their assets than ever before, while granting fewer lender protections, or covenants. And there are signs of weakness in some technology firms, which make up about 15% of the loan market. Loans of Coral Gables, Fla.-based data center operator Cyxtera Technologies fell about 14% this month to 72 cents on the dollar, according to IHS Markit.
Some losses will hit investors in mutual funds, which now own about 10% of outstanding leveraged loans, down from around 17% in 2018 at the recent peak of the market’s popularity, according to research by Barclays PLC. About 65% of the loans are now owned by CLOs.
CLOs have become popular with institutional investors like Canada’s government pension plan and began to show signs of weakness in November when prices of some of their securities swung wildly. The recent selloff has been far worse and newly forming CLOs, which are still purchasing loans from banks, could also get caught in the market freeze.
Some CLO managers who are struggling to sell bonds to investors have begun liquidating the loans they had been accumulating in warehouses, fund managers said. Loans in such warehouses amounted to $10 to $12 billion in early March, according to research by Wells Fargo Securities.
Raoul Pal’s Thesis: The “Doom Loop”
Raoul Pal is a former hedge fund manager who retired at age 36 but remains actively involved in the world of macroeconomics and finance. In recent years, he started a finance news and content service called Real Vision.
In a video posted on YouTube on August 14th, Pal discusses his case for a recession in the next year or so as well as a very alarming scenario he calls the “doom loop.” It’s a fascinating and frightening thesis, and I find it persuasive. Here’s the line of reasoning:
(1) The Fed lowers interest rates to stimulate the economy through increased lending. How else are lower interest rates supposed to stimulate anything besides through more lending, i.e. more debt?
(2) As a result, all sorts of market and government actors increase their debt loads. Corporations, especially, took advantage of falling rates to refinance and take on more debt.
(3) Some of this debt buildup has been for acquisitions or mega-mergers, but much of it was taken on simply for share buybacks. See, for instance, this chart showing the way in which debt issuance and share buybacks became tightly correlated right around the time that the Fed Funds rate bottomed near zero. (See my article addressing this subject here.)
Source: Hussman Funds
Debt-funded buybacks have served as a convenient way for corporate executives to lift earnings per share, thus meeting guidance more regularly and reaching the targets for their performance bonuses more often. (I wrote about this subject here.) What’s more, an SEC study found that insider selling tended to coincide with the announcements or implementation of buybacks.
(4) Indeed, if you look at the performance of U.S. stocks versus any other country or world region’s stocks, you’ll notice a stark difference. U.S. stocks have soared ahead of the competition. It turns out that this is largely because of buybacks, as corporations themselves have been the biggest net buyers of corporate stock since the Great Recession:
Source: Avondale Partners
Notice that institutions (including pension funds) have been net sellers of U.S. equities since the recession. This likely means that pensions have been forced to sell many of their assets to fund benefit payouts but have sold other assets such as Treasuries at a faster rate than equities.
(5) Who is buying all this debt being issued to fund buybacks? The answer, in large part, is pensions. Mainly corporate pensions:
Writes Mark Johnson: “This uptick in bond buying has caused corporate pension funds to play a more influential role in the bond market, since pension managers tend to hold bonds for the long term. As more and more companies adopt the strategy of buying more bonds, pension demand could total $150 billion a year. It is estimated that corporate pension funds buy more than 50 percent of new long-term bonds, up from an estimated 25 percent a few years ago.”
So corporate pensions are buying more and more bonds. Which bonds? Specifically, corporate bonds: “Pension plans… like to use corporate bonds to hedge liabilities.” Corporate bonds offer the highest yields. Of course, pensions are only allowed to own investment grade corporate debt, but if they opt for longer duration or lower rated bonds they can get a higher yield. In the previous twelve months, BBB-rated corporate bonds have yielded as high as 4.83%, certainly better than the highest yield offered by the 20-year Treasury bill in the last twelve months — 3.27%.
BBB-rated corporate debt has grown to be roughly half of all corporate debt outstanding. That’s one (small, for some companies) step above junk status.
(6) During a recession, much of this investment grade debt (Pal guesstimates 10-20%) will be downgraded. But remember: pensions cannot own junk bonds. If BBB-rated debt on their books gets downgraded, they will be forced to sell it, even at a loss. If multiple downgrades happen quickly in succession, the supply of newly labeled junk bonds will overwhelm demand from other market buyers of those debt instruments. This could lead to a fire sale scenario, in which the prices of junk bonds plunge as pensions dump huge supplies into an unsuspecting market.
(7) Not only would pensions have to accept a fraction of their cost basis for these former investment grade bonds, they would also see their primary revenue stream — tax revenue — slacken during a recession. Tax receipts, after all, are as cyclical as the business cycle. When individuals and businesses aren’t making as much money, there is less available to be taxed. This would diminish demand for corporate bonds, which would cause corporate bond yields to spike.
(8) All of this chaos in the credit markets will make it very difficult for corporations to issue debt at anything other than high rates. This will cause the costs of new debt to soar high enough for buybacks to become prohibitively expensive. Moreover, cash flows will dry up, as they do in every recession, and thus every potential source of funds to use for buybacks will disappear.
(9) If the previous points play out, the biggest net buyer of U.S. equities over the last ten years will no longer be a buyer. “The largest buyer will have left the room,” as Pal says. In fact, publicly traded corporations may actually be net issuers of shares during the next recession as they were in 2008-2009.
In the words of Jesse Colombo, “If the stock market performed as poorly as it did in 2018 with record amounts of buybacks to prop it up, just imagine how much worse it would be if buybacks were to slow down significantly or grind to a halt?”
I don’t see how the preceding chain of events playing out as described would not ultimately result in a very nasty stock market crash. Whether it’s a relatively quick crash like in 2008-2009 or a bit more drawn out like from 2001-2003 is unknown. Either way, I see the above scenario as plausible. Disturbingly so.
Since I’m an income-oriented investor, my preferred method of hedging against this possible crash scenario is to hold ample cash and ultra-short term bond funds. That way, if this scenario does play out, I will be prepared to buy assets at fire sale prices with yields higher than I might ever see again in my lifetime.
Raoul Pal’s thesis is fascinating, but it could be wrong. What I’m much more certain of is that the Fed bears the majority of the blame for the underfunding of pensions and thus for putting us into a situation in which Pal’s thesis would even be possible.