Stress In The Financial System

Summary

• With the exception of US bank balance sheets, the financial system is all that much more robust than it was at the outset of the financial crisis, in our view.
• Problems center mostly on the quality and quantity of outstanding corporate debt.
• Stress signs are already emerging, and we know from a decade ago that once things get sufficiently bad, they can feed upon themselves.
• It's a little early for panic, though, but keep in mind there are parts of the rest of the world where things look worse and contagion is another risk.

We think the US financial system still suffers from the same structural weaknesses as it did in 2008. These weaknesses are:

• Perverse incentives (investors making bets with other people's money avoiding negative consequences when these bets go wrong, central banks forced to interventions increasing moral hazard, etc.).
• Excessive leverage.
• Excessive complexity (Frankenstein derivatives that hide risk).

This is not a serious problems in good times, but things are taking a distinct turn for the worse, opening the prospects of serious financial stress emerging.

It is perhaps a little early to start predicting Minsky moments, where these stresses turn into self-feeding mechanisms (credit crunch, forced liquidations, freezing markets, falling asset prices leading to more forced liquidations, etc.) as US banks, for instance, are more robust than at the outset of the previous crisis. But we warn against getting too comfortable.

Where is the risk?

Well, for starters there is a whole lot of debt out there:

• World debt
• US corporate debt (quantity and quality)
• Leveraged loans

The markets are in a funk because of the economic consequences of the worldwide coronavirus outbreak and the botched response in many countries, among which the US, where there are still no sufficient amounts of test available two months into the crisis, although at least the availability is now increasing.

With increased testing come increased cases, as the virus has been spreading for weeks undetected and nobody really knows how widespread it is in the US.

Economic effects will follow this (we have argued a couple of weeks ago that a recession is likely); the question which will be addressed in this article is whether the economic and financial market impact will expose frailties in the financial system that could potentially morph into something more nasty.

We know from 2008 that the financial system, rife with debt and leverage and lightly regulated opaque financial instruments that tend to obscure risk, can be rather frail and is liable to sudden freezes and self-reinforcing feedback loops.

Indicators are beginning to show mounting stress in the financial system. On the day the Labor Department published very good job numbers with unemployment sinking to 3.6%, at the same time the US 10-year yield sunk 20% and reached an unprecedented low of 0.7% and the VIX shot up to 50.

The job numbers are of course entirely backwards looking, while the picture going forward isn't looking so bright and is distinctly out of focus.

Debt

Debt has, by-and-large, kept on growing since the financial crisis.

We are not so much worried about sovereign debt (apart from countries that borrow little in their own currency, like Argentina and Turkey, or countries that have no control over their own currency, like Italy).

While household debt in the US is high (there are notorious problems with credit card debt, student loans, car loans, and the like), the most dangerous part is corporate debt:

While high, this necessarily isn't a problem. What is a problem is that credit quality leaves a lot to be desired; here is the OECD summing it up (The Telegraph):

"The OECD report notes that compared with previous credit cycles today’s stock of corporate bonds has lower overall credit quality, longer maturities, inferior covenant protection — bondholder rights such as restrictions on future borrowing or dividend payments — and higher payback requirements."

Many corporations will see their cash flow dwindle as a result of the economic consequences of the outbreak. This problem can become especially acute for companies whose:

• bonds are hovering just above junk status and they already have problems with interest payments out of cash flow; and
• debt levels far exceed those of their assets (leveraged lending).

The US corporate bond market stands at roughly $10T, which is five times the size it was two decades ago with half the market at BBB rating or less.

A third, or $3.4T, of US corporate debt has a rating just above junk (BBB-), much of which could be downgraded in case of a significant economic downturn, which will trigger a wave of selling and refinancing prospects becoming quite unsure. From The Telegraph:

"...the Bank for International Settlements warns that the proportion of “zombie” companies with insufficient earnings to cover debt payments has risen to 12pc. Negative interest rates in Europe have put off the day of reckoning for these “walking dead” but once revenues start to evaporate the end is nigh."

There might a credit crunch, which is sort of ironic in the face of record low interest rates. There are several further uncomfortable data points, here is El-Erian:

"First, according to the Federal Reserve Bank of New York, net leverage — the ratio between a company’s net debt and its earnings before interest, tax, depreciation and amortisation — is roughly equal for triple B rated bonds and high-yield debt. Investment-grade bonds, excluding triple A rated debt, have even higher net leverage than high-yield."

Speaking about leverage, most of the $2.4T leveraged loan market is being packaged into CLOs (collateralized loan obligations), but these have little protection for creditors (banks and investors), leaving the latter exposed when things go wrong.

Overleveraged sectors are healthcare and media, European cars and, of course, the US shale sector which has just got the rug pulled out from underneath it by the triple whammy of demand destruction, a botched OPEC supply deal and a resulting Saudi Arabia flooding the market.

US banks have higher capital ratios than before the financial crisis and are expected to be able to weather quite a bit of storm, but the shadow banking sector (financial institutions like hedge funds, private equity, fintech firms and asset managers) which borrows short and lends long and has much less cover to deal with withdrawals, busts, and/or drying up of funding.

This shadow bank system is more pervasive than one might think. For instance, non-banks now originate over half of all new mortgages, this was just 10% in 2007, the height of the subprime crisis.

The plight of institutional investors (insurance companies and pension funds) in the super-low interest rate environment has been difficult to say the least. In our native the Netherlands, which has some of the biggest pension funds in the world, these were already struggling before the outbreak of the coronavirus, but they're hardly alone, from the NYT:

"European insurance companies were big buyers of bonds issued by countries like Germany or Switzerland that have impeccable credit histories. But when the return on those super-safe bonds dwindled over the past decade, and then turned negative, insurers and other investors began buying riskier assets like corporate bonds rated BBB, or just above the level considered junk. A lot of money is at stake. Insurance companies in Europe collectively have assets of 11 trillion euros, or $12 trillion. Recently regulators have become especially concerned that insurers have been loading up on a kind of investment known as collateralized loan obligations, or C.L.O.s for short."

And with bond yields tumbling in the US, this is now spreading there as well and the CLO holdings is hardly reassuring.

While US banks seem to have adequate capital buffers, the rapidly falling bond yields make banks less profitable, which could lead to less, rather than increased lending. This hasn't happened so far, not even in Europe, where rates have been lower for longer (PIMCO):

"This squeeze in bank margins across Europe means that their contribution to return on assets (ROA) has diminished. In aggregate, Eurozone bank ROA has held up so far, thanks to capital gains and improved credit quality – which have benefitted from negative rates and other unconventional monetary policy measures."

But, as they add, these are not sustainable sources of profitability, and can only temporarily mitigate the structural downtrend in profits coming from lower profit margins.

More specifically, credit quality is already deteriorating and there is only so much that bond yields can fall (producing the capital gains). In fact, below we will see that the yield on many corporate bonds is already rising, leading to capital losses.

Signs of stress

• Rising risk premiums: interest on high-yield debt is rising
• Corporate debt fund withdrawals
• Stress indicator rising

On the first, the rise in risk premiums on high yield debt is still moderate in historical perspective, but the recent spike is quite notable, especially with the background of falling sovereign yield:

This rise in yield is more marked in sectors, like cars, industrials and energy, that are more affected by the coronavirus outbreak, according to ING Bank:

Another bad sign is the $12B of withdrawals from investment funds specializing in corporate debt, which was the biggest withdrawal in a decade, from Bloomberg:

"High-grade bond funds saw $4.8 billion of outflows in the week ended March 4, according to Refinitiv Lipper. Junk-bond funds had $5.1 billion withdrawn, while leveraged loan investors pulled $2.29 billion during the period."

Another negative sign is that the FRA/OIS spread (a money-market indicator that measures the difference in rates between forward-rate agreements and overnight index swaps), which functions as an important benchmark for measuring stress in the interbank market, has (Bloomberg our emphasis):

"...soared to the highest level since the funding upheaval seen back in September. At one point on Friday it widened to as much as 51 basis points, double its level from last week... “We are on high alert for any spill-over not just into funding today but credit markets,” NatWest strategists led by John Briggs wrote in a note to clients. “We are concerned that there are skeletons out there in closets we may not be aware of that come out in times like this, particularly leverage from the shadow banking system.”"

Yea, skeletons, they have a habit of appearing when the credit tide recedes. To illustrate, we noticed the graph in the article from Heisenberg:

And while we write this in the weekend, on Sunday night, things are taking a significant turn for the worse as a consequence of the price war breaking out in the oil market.

Sovereign debt

Sovereign debt is already high in many corners of the world but so are interest rates. Things will almost surely deteriorate as economies slow down and public spending rises to combat the spread of the coronavirus.

Many countries can handle this, indeed, they would be wise to increase public spending further in order to soften the blow of the economic impact and remove key constraints that might hinder the fight of the spread of the virus.

For instance, people should not face adverse financial effects from testing or self-quarantining if they feel symptoms; if they don't test and/or continue to go to work, they could add to the spread of the virus.

Public funds would be well spent to remove these possible negative financial effects from self-quarantining and testing and one could also think of supporting companies (even whole sectors) where the economic impact is especially large.

However, there are also countries which are clearly not well placed to deal with the public finance impact. Over the weekend, Lebanon (28 recorded cases of the virus at the moment of writing) has defaulted on its debt for the first time with the economy already in free-fall.

Turkey is dealing with the war in Syria and a large refugee stream (for which it gets billions of EU money), but its debt and public finance situation are shaky to say the least. While it hasn't yet recorded a single case of the virus, this isn't likely to stay that way, given what is happening in the area.

While South America has seen relatively few cases of the coronavirus, Argentina has already contracted 9 confirmed cases in just the last couple of days.

It's in sensitive debt-restructuring talks with both private creditors and the IMF and its economic prospects are hardly improving from the slowdown in the world economy, let alone what would happen if a domestic outbreak would become more serious.

With zero room for additional public spending and inflation running at 50%, already the margin for error, which is already very slim, is reducing by the week.

While defaults in Lebanon, and possible defaults of Turkey and/or Argentina have limited effects on a world scale, the same cannot be said of Italy, which already suffers from a serious outbreak of the coronavirus (with 5,883 confirmed cases by Sunday March 8).

Much of the north of Italy is now on lock-down, although that measure was badly botched as word of its implementation got out earlier and lots of people escaped to the south before it went into effect.

The economy was already shrinking the last quarter of last year and that decline is accelerating now. At the same time, public spending is increasing and tax receipts falling.

Italian debt is already at 130%+ of GDP and the crucial difference to countries like the US or Japan is that Italy can't print its own euros. On the other hand, if the coronavirus situation lasts only a couple of months, this will cause a recession, but that can be a brief one. But all bets are off here, nobody knows how long this is going to last.

So implications are not necessarily dramatic. As long as the crisis is contained within six months to a year, it will give a one-off fillip higher to Italian debt/GDP levels. The problem is, though, even in the best of times Italy has not been able to grow sufficiently in order to dent debt/GDP during the good times. This isn't something that can last.

Should an Italian debt crisis become an acute prospect, the ECB will be forced into buying Italian bonds with the familiar poker game surrounding, imposing structural reforms in Italy.

Conclusion

We think the US financial system still suffers from the same structural weaknesses as it did in 2008. While US banks are better able to withstand shocks to their balance sheets, other parts of the financial system aren't so robust.

There are a number of signs that stress is increasing, and we know that these things can easily feed on themselves through a credit crunch, forced liquidations, freezing markets and confidence evaporating. In other parts of the world, things are worse.

Invariably, the deadly cocktail of corporate debt, excessive leverage and too clever by half financial derivatives have made the financial system frail. At this stage, we're less worried about sovereign debt but here too there are trouble spots in countries with high foreign currency debt.

As we argued before, now is not the time for heroics, cash is king.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[SCF12]

a bear cycle in a secular bull market. debt services obligations can be a serious focus.

we'll make money. it's more fun to be long, but we can short things just as easily, and the speed of money making is normally driven when fear peaks.

[murat_ozdmr]

"First, according to the Federal Reserve Bank of New York, net leverage — the ratio between a company’s net debt and its earnings before interest, tax, depreciation and amortisation — is roughly equal for triple B rated bonds and high-yield debt. Investment-grade bonds, excluding triple A rated debt, have even higher net leverage than high-yield." Does that say Net Debt/Ebitda=1 for triple B bonds?

[thumb.ai]

Thank you, quite different information presented from what I am seeing elsewhere.

[Shareholders Unite]

That never hurts..

[Little, Einstein]

Beautiful article

[Shareholders Unite]

Thanks, my pleasure Albert.

[rod handler]

To quote Iron Maiden:

Run to the hills
Run for your life