Shannon McConaghy of Horseman Capital paints a dour picture of the Japanese banking system. He reveals the accounting tricks that have allowed these banks to survive in a predominantly negative-interest-rate world, and discusses why credit costs are finally rising. Shannon warns of a potential meltdown that could have far-reaching ramifications, in this conversation with Real Vision’s Roger Hirst. Filmed on July 11, 2019 in London.
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A decade after the subprime bubble burst, a new one seems to be taking its place in the market for corporate collateralized loan obligations. A world economy geared toward increasing the supply of ﬁnancial assets has hooked market participants and policymakers alike into a global game of Whac-A-Mole... Historically, there has been a tight positive relationship between high-yield US corporate debt instruments and high-yield EM sovereigns. In effect, high-yield US corporate debt is the emerging market that exists within the US economy (let’s call it USEM debt). In the course of this year, however, their paths have diverged (see Figure 1). Notably, US corporate yields have failed to rise in tandem with their EM counterparts... In what is still a low-interest-rate environment globally, the perpetual search for yield has found a comparatively new and attractive source in the guise of collateralized loan obligations (CLOs) within the USEM world. According to the Securities Industry and Financial Markets Association, new issues of “conventional” high-yield corporate bonds peaked in 2017 and are off significantly this year (about 35% through November). New issuance activity has shifted to the CLO market, where the amounts outstanding have soared, hitting new peaks almost daily... These CLOs share many similarities with the mortgage-backed securities that set the stage for the subprime crisis a decade ago. During that boom, banks bundled together loans and shed risk from their balance sheets. Over time, this fueled a surge in low-quality lending, as banks did not have to live with the consequences... Furthermore, not only are the newer issues coming from a lower-quality borrower, the covenants on these instruments – provisions designed to ensure compliance with their terms and thus minimize default risk – have also become lax. Covenant-lite issues are on the rise and now account for about 80% of the outstanding volume... As was the case during the heyday of mortgage-backed securities, there is great investor demand for this debt, reminiscent of the “capital inflow problem” or the “bonanza” phase of the capital flow cycle. A recurring pattern across time and place is that the seeds of financial crises are sown during good times (when bad loans are made). These are good times, as the US economy is at or near full employment... The record shows that capital-inflow surges often end badly. Any number of factors can shift the cycle from boom to bust. In the case of corporates, the odds of default rise with
- mounting debt levels,
- erosion in the value of collateral (for example, oil prices in the case of the US shale industry), and
- falling equity prices.
All three sources of default risk are now salient, and, lacking credible guarantees, the CLO market (like many others) is vulnerable to runs, because the main players are lightly regulated shadow banking institutions.
.. A decade after the subprime bubble burst, a new one seems to be taking its place – a phenomenon aptly characterized by Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas as “Financial ‘Whac-a-Mole.’
.. Like the synchronous boom in residential housing prior to 2007 across several advanced markets, CLOs have also gained in popularity in Europe. Higher investor appetite for European CLOs has predictably led to a surge in issuance(up almost 40% in 2018). Japanese banks, desperately seeking higher yields, have swelled the ranks of buyers. The networks for financial contagion, should things turn ugly, are already in place.
It was a story that seemed to reinforce stereotypes of President Donald Trump: On a visit to Japan, he was handed a box of food for a ritual feeding of carp, and after doling out a few spoons’ worth, he got impatient and dumped the rest of the box all at once.
Initial reports of the food dump — like this early video from CNN — suggested that Trump acted on his own. This pushed the late-night Twitterverse and blogosphere into a tizzy. The website Jezebel posted a story headlined, “Big Stupid Baby Dumps Load Of Fish Food On Japanese Koi Pond.”
A jab at Reagan?
Donald Trump once spent nearly $100,000 to place a full-page advertisement criticizing U.S. foreign policy in the New York Times, the Washington Post, and the Boston Globe.
“There’s nothing wrong with America’s Foreign Defense Policy that a little backbone can’t cure,” the ad’s headline blares. Below, the reader finds “an open letter from Donald J. Trump” — addressed “To The American People” — “on why America should stop paying to defend countries that can afford to defend themselves.”
.. “For decades, Japan and other nations have been taking advantage of the United States,” the letter declares. “The saga continues unabated as we defend the Persian Gulf, an area of only marginal significance to the United States for its oil supplies, but one upon which Japan and others are almost totally dependent.”
“Why are these nations not paying the United States for the human lives and billions of dollars we are losing to protect their interests?” the ad continues.
“The world is laughing at America’s politicians as we protect ships we don’t own, carrying oil we don’t need, destined for allies who won’t help.”
.. Trump writes that Americans could “help our farmers, our sick, our homeless by taking from some of the greatest profit machines ever created — machines created and nurtured by us.”
“‘Tax’ these wealthy nations, not America,” suggests the tycoon. “End our huge deficits, reduce our taxes, and let America’s economy grow unencumbered by the cost of defending those who can easily afford to pay us for the defense of their freedom.”
“Let’s not let our great country be laughed at any more,” Trump’s letter concludes.
.. At the time the ad ran, there was speculation that Trump might oppose George H.W. Bush for the Republican nomination for president. The same day the ads ran, an article elsewhere in the Times reported that the developer had scheduled a trip to New Hampshire.