Reckless Endangerment: Why The Next Fed Induced Crisis Will Be Worse Than The Last

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Includes: DIA, IWM, QQQ, SPY
by: Weighing Machine

Summary

0% interest rates are leading to dangerous lending practices at banks.

The surge in the S&P 500 over the past 6 years have emboldened investors while share prices are at all-time highs.

A banking and stock market crisis is likely to have a longer impact than we saw during 2008-09 as the credibility of the Fed will be much lower.

Investors must exercise extreme caution when allocating capital.

While perusing the SA headlines yesterday, I read that private equity is near a deal to purchase Petsmart (NASDAQ:PETM) in an $8 billion transaction. The summary noted that transaction will have debt of 6.25x Net Debt to EBITDA and that this had dissuaded several banks from participating (though evidently Citi is eager to 'keep dancing'). They were dissuaded not because of concern over the soundness (or lack thereof) of putting a huge debt load on a company already saddled with significant operating lease obligations. The banks feared incurring the wrath of the Federal Reserve, which has given banks guidelines suggesting lending no more than 6x EBITDA.

Banks needing to be told not to lend at this level (factoring in the operating leases, I estimate this is the equivalent of 8.5x EV/EBITDA) is terrifying. The Fed has a cozy relationship with banks but has recently been trying to pull back the reigns as banks make increasingly risky loans (without raising interest rates of course). Why are banks so risk blind? In part it is because with Federalized interest rates at 0, net interest margins are compressed inducing banks to take riskier lending in an effort to improve their profitability (never mind their risk profile). Beyond this, credit analysts at banks are back to doing blue-sky forecasting whereby economic disruptions are ignored and businesses are assumed to steadily increase revenue, profits and cashflow forever. This again is the Fed's fault.

In attempting to eliminate the business cycle through interest rate manipulation, the Fed has blinded the private sector (admittedly banks aren't really private sector animals but I digress) from seeing risk. Having bailed out the banks, investment banks and private equity funds with a series of interventions from 2007 onward, banks assume (rightfully?) that the Fed will do whatever it can to prevent the slightest bit of economic discomfort. This pushes banks further and further out on the risk spectrum. This causes Too-big-to-Fail institutions to grow bigger and more likely to fail (in the absence of intervention).

However this is just one example of risk blindness in the markets. Over the past year I have received countless calls from average savers looking to 'do something with my money because I'm getting nothing at the banks'. By punishing savers with mandated sub 1% interest rates, the Fed has pushed normally risk averse people into the stock market. Pushing some into the market puts upward pressure on the market, inducing others to get a sip from the punchbowl. History and common sense dictate that the market is riskier at higher levels however behavioral finance and realized results by mutual fund investors (while the S&P 500 has increased 9% on average since 1980, the average mutual fund investor has earned a 2% return as they tend to buy high and sell low) indicates that people perceive the market as being less risky the higher it goes.

This disconnect is likely to create very ugly consequences for the economy at large and the average American. Unsophisticated investors are plowing money into the market at all-time highs in search of earning a low-risk return. Banks are making increasingly risky loans in order to improve profitability in the 0 interest rate environment. While this is likely to continue for awhile (I have no ability to call the top of anything), it is not difficult to see that this can only end badly. Particularly troublesome is that many of the people being drawn into the stock market are nearing retirement age. Should the stock market take a big hit (as we saw in 2008-09) many would be unable to fund their retirements.

The intersection of another banking and stock market crisis is likely to have far-reaching consequences. While the government/Fed was able to 'fix' the economy with scotch tape during the last crisis, the government's credibility is likely to be severely hampered. As such, it is unlikely we will see a hockey stick recovery (in the stock market).

What advice would I offer up to investors? In a market where risk aversion is a rarity, investors must be even more risk averse than usual.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.