Wider Still and Wider, Thy Shining Bonds Increase

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by Sean Corrigan

Are wide credit spreads a direct result of the New Era? Well, perhaps. The default rate on speculative grade issuers rated by Moody’s jumped last year to a post-1991 high of 5.5%, with the bulk of them (99 out of 106 issuers and $23.5 out of $35.6 billion) being concentrated in the US.

For such a rate to exist when we have just experienced the fastest two-quarter growth in nominal GDP in the rate cycle is worrisome indeed. Nor is it something which has confined itself to the capital markets: the FDIC report for Q1’2000 also wears a concerned frown. Commercial and Industrial (C&I) loans have been growing strongly of late, trailing defaults in their wake. In a re-rerun of the early 80s, syndicated loan activity has been prevalent in this expansion, with just over a trillion dollars of originations last year. Of this, fully a third was in leveraged loans — high fee, high risk lending, irresistible to banks desperate to supplement shrinking net interest margins. Indeed, one private study shows that 80% of syndicated loan fee income resulted from leveraged loans last year

Such rapid loan growth has also been shown statistically to be significant for loss rates in the future and it is of note that the OCC has produced evidence that ‘banks are booking loans that are weak at their inception’. Fully 14% of adversely classified loans were made in the course of last year, while Moody’s points to the fact that in 50% of rated-bond defaults, the debt had been in existence less than three years, 20% for less than two. The classic symptom of a credit bubble is a continuing deterioration in the quality of that credit, even when its inflationary impact is seemingly delivering widespread prosperity.

The FDIC cites three main factors; global competition, loosened underwriting standards and increasing reliance on debt markets for corporate funding rather than internal cash flow. This latter is again a matter of concern in the face of after-tax corporate profits which are a record in absolute terms and in the 80th percentile as a proportion of GDP in the last 35 years.

Here we once again recall an Austrian school belief that credit is ultimately a consumer of capital, not a creator of it.

Two things have driven this increasing reliance on debt market growth from the demand side; the dictatorship of EPS and the fear of technological obsolescence. Corporates have spent $700 billion on repurchasing equity since the bubble began, something which has meant that only a little more E goes a lot further per S, boosting the stock price (and the stock options scheme) in the process. After all, the share price is obviously the only true test of management, not production or customer satisfaction or genuine, unpadded, unpooled, home-grown profits.

On the technological front, we are told to relax also; the New Era means boundless prosperity for all. Who could cavil at borrowing for capital expenditure on software and hardware when its benefits are so plain to see? Except that these are being depreciated so fast even in Old Era government statistics (where they give a misleading boost to both non-inflationary growth and productivity) that they make a firework look as long lived as the pyramids. How much physical (as opposed to intellectual) capital have we added here? In our own capacity as private consumers, we are well-used to the twin perils of forefront shopping — high entry prices and the risk of backing the wrong technology. As the man said, come out fighting and may the Betamax win.

On the supply side, the next link in the chain has been that ole New Era feelgood. Having started by bailing out Latam in 1994 and having failed to sterilize the impact of the tsunami of cheap Japanese money from 1995-98, the Fed has underwritten a credit creation process almost unheard of in peace time. Seduced by the siren of a lower rate of increase in traded goods’ prices, bereft of an intellectual anchor, basking in the vainglory of the plaudits heaped upon it, the Fed has — year in, year out — allowed double digit increases in the monetary aggregates, fuelling a consumer boom which is itself psychologically dependent on the WOW! Factor of the Net and of the Genome. That spending-beyond-income has helped corporate revenues and the new, democratic access to the stock market has enabled a logistically painless and psychically straightforward participation in the dynamic of generating paper wealth in a financial version of bootstrapping . Round and round and round she goes where she stops nobody knows.

Or do they? The stock market has also acted to punish the builders of real castles in favour of those whose turrets and battlements are now cluttering up the flightpaths of Silicon Valley. In times gone by, bright young people struck with a brainwave would post it in the company suggestions box: today they file it with the SEC. If credit, masquerading as capital, were not in such superabundance, would all these aspiring Edisons be twenty-something CEOs? Of course not, but the majority of these will soon burn out, singeing their investors’ fingers in the process as the raft of entrepreneurial error is revealed. The damage will not be restricted there, however. Old Era companies have wasted valuable managerial time and company cash on the futile search to look New. In addition to buybacks, in an increasing number of cases this has led to leveraged buy-outs — the ultimate example of credit being substituted for capital.

In the meantime, the ‘P/Es’ dividend has enabled the government to rake in enormous chunks of capital gains and begin to pay down debt. The mantle of fiscal prudence is a lot easier to assume when you are generating more commission than Schwab and Merrill out of the legions of daytraders too busy churning portfolios in the hope of finding the next Microsoft to worry about minimizing tax liabilities. Why build a casino in the desert to enhance revenues when you can wire one up to every parlour and den in the country?

So malinvestment is raising its head in too much credit being showered too cheaply on ill-thought out fledglings with thin potential. It is shunning established economic value-adders to smile upon speculative start-ups. It has banished the habit of thrift (never particularly well-rooted in the first place) from millions of households as they round-trip home equity loans and stock collateral borrowings against checkable mutual fund accounts and equity-linked CDs.

It has blown credit spreads up to dizzy heights, even while the Jazz Age is still in full swing, so much so that the cost of capital for productive America is now rising to levels where prospects will truly be impaired by a much more traditional method than B2B competition. Stripping the heart out of the intermediate production chain which is the true source of a nations’ wealth and which is over twice the size of consumption, will, of course, ultimately hit both the New Era companies which service these enterprises and those very consumers who earn their income in their employ.

Now, remember, Government stands ready to borrow again in the event of a downturn, as Larry Summers has told us several times, so don’t get too nostalgic about those dear old Treasuries — the Spotted Owl they are not. However, any such deterioration in their standing will be more likely to be felt not against leser credits, but in comparison to other government obligations in the wider world — especially if the Dollar gives way — where the New Era disease is serious but not yet critical.

For now, be aware that the new regime of yawning credit differences is very much an intrinsic part of the New Economy and be very careful about anyone at a model-based hedge fund who starts whispering to you about mean reversion.

April 18, 2000

Sean Corrigan writes from London on the financial markets, and edits the daily Capital Letter and the Website Capital Insight.

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