Looking For The Next One; Part 2, Finding Risk Rather Easily

Includes: DIA, QQQ, SPY
by: Alhambra Investment Partners

By Jeffrey P. Snider

Part 1 is here, Orderly or Not (short version: not).

Also noted yesterday, the Fed sees no risks of bubble trouble because they are looking at it all from the 2008 perspective. That is completely wrong-headed; if there is a "next one" it will have nothing to do with subprime mortgages, or even mortgages and real estate. By March 2007, the conventional estimate is that there were $1.3 trillion in subprime mortgages outstanding, all of which caused inordinate decay in liquidity and pricing through wholesale mechanisms that turned out to be disastrously self-feeding and often contradictory (as an example, tranche pricing through correlation trading where correlation estimates were based on CDS prices derived from liquidity in hedging demand which traced back to tranche pricing). Everyone seems to simply assume that the subprime problem ended in 2008, if only by crash.

That is true but only of mortgages. Deleveraging is myth as debt has still expanded, and greatly, just not in the same exact places. There are certainly auto and student loans that have exploded exponentially, especially in subprime categories, but if there is another credit bubble now, the third, it is undoubtedly corporate debt. The FOMC looks at corporate credit spreads being narrow and yields being low as a measure of its own success with QE, but that largely misses the real risks in such a condition - junk bonds are not meant to yield 5% or 6% because there is absolutely no cushion to that price!

A junk bond that yields 12%, as it had historically, offers some interest cushion to the pricing in principle - that was the whole point of junk bonds to begin with, the basic financial factor of risk/reward to be gainfully compensated by recognizing and pricing much higher credit risk. Thus, if a junk bond issuer were to start trending toward negative factors it wouldn't necessarily offer a disruptive circumstance as prices typically were not exaggerated until the very end closer to default. A junk bond issued at 5.5% offers absolutely no cushion, and worse, the entire predicate position of junk bonds at 5.5% is endless liquidity which artificially caps default rates at historical lows, self-feeding the upward trend in prices (if the weakest companies can get financing easily, they don't default where they may have before but that does nothing to change their business circumstance especially in a weak economy). In other words, the fact of the corporate debt bubble is that it will, in the end, push defaults together into a single event rather than allow them to be interspersed more organically. Worse, the more that artificial impediment to creative destruction seeps the less of a rebalance there is in pricing.

What good will a 5.5% yield be if defaults not only tick higher but do so in what looks like the snowball effect? That means the potential for selling is far, far higher under those circumstances than would ordinarily be the case where the Fed had not so intruded. Combine that with lack of liquidity systemically and the potential for disorder is enhanced beyond comprehension at this moment. Last month, Charter Communications floated three bond series of BB- junk, all priced with yields under 6%; May 2023 maturities with a worst yield of 5.125%; May 2025's with a worst yield of 5.375%; and, May 2027's with a worst yield of 5.875%. There isn't even much "protection" or cushion in those prices if a recovery did actually show up and interest rates normalized, let alone systemic defaults finding general illiquidity.

The problem seems to be, not unlike the 2003-07 period, lack of visibility. It seems as if there is vague awareness more generally about a junk bond problem but that it is taken as a minor affair; the vast majority of the deluge in corporate debt in this "cycle" has been investment grade. But that was also true of the housing finance debacle - $6 or $7 trillion in mortgages (depending on the source) overall but "only" $1.3 trillion in subprime. As I tabulated last week, corporate debt issuance (gross) was around $4.2 trillion in the QE3 period (defined as 2012-14) while junk gross was "only" $975 billion of that.

Admittedly, this is a bit of mixed comparison, as gross issuance can often replace matured or outstanding debt or bonds, but I am just using the past three full calendar years on the corporate side. In some ways, that doesn't even matter because these are all bonds that must be held somewhere by someone now (in other words, it is possible that a company may have issued a junk bond in 2012 and then floated a cheaper one in 2014 to retire the previous issue, meaning that there is some double counting in using gross issuance figures cumulatively, but given the short window here and the almost exponential increase in overall gross outstanding that is likely a limited occurrence).

Some might view that as entirely manageable, especially as being only three-quarters the size of subprime mortgages in 2007. The overall credit market has swung far higher, meaning proportions dedicated to the riskiest sector is actually smaller, and junk bonds are traded much more lively and openly; subprimes and their related structures were highly illiquid and thus pricing was limited to narrow gauges.

But that is not the extent of the corporate "subprime" problem, however, and it goes far greater to illiquidity and hidden regimes. In fact, leveraged loans may be the single largest problem in the corporate bubble universe under adverse conditions, even factoring any "gate" problems that will undoubtedly show up as corporate bond funds look to sell junk bonds if redemptions come in too hot. Leveraged loans are syndicated junk loans that are dispersed through the banking and financial system in almost exactly the same manner as MBS pieces were in the last bubble - and there is no real liquidity in them in which to offer robust and broad systemic pricing should it all go wrong.

I wish this were a small problem, but the fact is that leveraged loan gross in the QE3 period actually far, far outpaces even junk bonds - some $1.6 trillion!

And that's not the fullest extent, either. We can add corporate debt CLO's too, as even though not all are junk or of the leveraged loan type, they are essentially structured products with very low liquidity and open pricing just as dispersed throughout the financial system. That brings the total corporate bond bubble potential basis up to some $2.8 trillion!

Not only is that an immense total, even if gross, it has taken place in a manner totally unknown to financial history. We have no real idea how corporate bond prices will perform with bond funds and leveraged loan "products" scattered so far and wide, inside and outside of the banking system, and with a decaying eurodollar system to try to hold it all together. If there is another financial crisis, it will indeed look nothing like 2008 in its consistency, but the patterns are all already arranged.

All of this has taken place upon a foundation of illusion far too similar to the housing bubble - that economic growth would be sustained and robust, and that liquidity would be just as unfailing and dependable. That is the commonality among all asset bubbles, which the Yellen Doctrine asserts is unproblematic even where great financial imbalances are endemic; as they are assuredly now. That is a dangerous acceptance all its own, but for the Yellen Doctrine to survive, the flimsy bubble basis must as well. The herd is absolutely enormous and it will not take but a few to peel off toward the "sell" side to move prices into the snowball/stampede. The only reason that hasn't happened yet is that the vast majority simply still don't want to believe in any downside, especially one where the Fed got it all wrong; easy money is too much fun.

How does all this maintain itself if and when economic growth tends toward the worst case and liquidity is steadily revealed as beyond sickly already?

I don't have the answers to that, obviously, but imagination being what it is this is not a pretty scenario. As stated at the outset, I wouldn't even begin to venture a guess as the likelihood of it all going wrong other than to say it is much more realistic than is being talked about or even considered right now, and that a worst case at this point is really and truly a worst case. All the pieces are already in position, missing now only a spark. Maybe the Fed has more magic in its arsenal, but the eurodollar realities actually reveal that it never really did in the first place. There is now at least twice the leverage and still none of the financial cushion.