Some minor stabilization crept in at the end of Monday’s session but there’s no incentiv...
Debt, debt and shaky collateral: The global financial crisis isn't actually over
07/22/2013 11:17 pm EST
Right now I find myself asking many of the same questions about debt, risk, and collateral that investors were asking in the run up to the bankruptcy filing of Lehman Bros in September 2008.
The big question that I have at the moment is Where’s the collateral for all this debt—private, corporate, and governmental—that has been issued in efforts to prop up global growth? And what’s that collateral worth?
Like a brief survey of some recent high (or low) points? Please note that the examples are from pretty much everywhere.
On Thursday, July 19, the European Central Bank announced that it would accept lower rated assets—including asset-backed securities—as collateral from banks. The asset-backed securities would have to be simple, plain vanilla instruments, the bank said, and in exchange the EuroZone central bank would accept assets rated as low as A instead of the current AAA. Reminds me of the good old days when Wall Street added a thin dose of AAA credits to a bundle of risky subprime mortgages and called the whole thing an AAA credit.
Fitch Ratings and other credit analysts have warned that many of the wealth management products being sold to Chinese savers anxious to earn more on their deposits than the 3% that banks are allowed to pay are invested in loans backed by inadequate or shaky collateral. In the worst cases no one can identify exactly what collateral stands behind a loans.
Companies in Europe, Africa, and the Middle East with sub-investment grade credit- ratings—that is “junk” ratings—owe $114 billion that’s due in 2014. That’s up from $84 billion in 2013, according to Moody’s Investors Service. Half of that debt carries a negative outlook, up from 34% with negative ratings in 2012.
Credit outstanding to Brazilian consumers has climbed to 44% of disposable income from 18% over the last decade. The default rate on consumer borrowing did fall for the fourth straight month in April to the lowest level since November 2011—although I would note that at 7.5% the default rate in Brazil is still extraordinarily high. One explanation for the drop in default rates: Interest rates in Brazil fell to a historic low of 7.25% by April. Unfortunately, for Brazil’s consumers, the central bank raised rates in April in what looks like the beginning of a fight to reduce inflation that’s likely to last for the remainder of 2013.
The good news is that Japan’s budget for the fiscal year that started on April 1, 2013 will see the government raise a higher percentage of spending from tax revenue than in any time during the last four years. The bad news is that the government will still cover 46.3% of its spending from borrowing. The Organization for Economic Cooperation and Development estimates that Japan’s budget deficit for 2013 amounted to 10.3% of GDP. In comparison such countries as Spain and the United States that generate a fair amount of worry about the size of their deficits come in with estimated budget deficit to GDP ratios of “just” 6.9% and 5.4% for 2013. The CIA World Factbook estimated Japan’s accumulated government debt in 2012 at 214% of GDP, the highest ratio in the world.
Back in the U.S. of A, on May 20 Moody’s Investors Service warned of a rise in covenant-lite loans with fewer investor protections or covenants. The volume of these covenant-lite loans approached $80 billion in the first quarter of 2013. That’s close to the total for all of 2012, according to Thomson Reuters. Among new speculative grade corporate bonds rated B1 or below by Moody’s through April 2013, 35% received weak covenant quality ratings of 3.8 to 5.0 from Moody’s. In the same period a month ago, 29% of new issues had equivalently low scores.
I could go on and on. For example, there’s Russia’s recent decision to borrow money from its state pension funds to spend on expanding the Trans-Siberian Railroad, building an 800-kilometer high-speed rail line from Moscow to Kazan, and constructing a new ring road around Moscow. Or the EuroZone’s decision to leverage the credit ratings of member countries to sell debt to raise money for its bailout fund—a decision that showed its downside when Fitch Ratings simultaneously downgraded France to AA+ from AAA and dropped its rating on the European Financial Stability Facility to AA+ from AAA. Cutting the rating on the European rescue fund seemed only logical, Fitch said, because France is the second largest guarantor of the fund’s debt issues.
Why is all this important now?
As the recent bankruptcy filing by the city of Detroit serves to remind us, the ultimate collateral behind any debt is the borrower’s ability to pay.
Oh, yes, such issues as the specific collateral pledged to a debt, the actual value of that collateral, and the ease or difficulty in converting that collateral to cash are important—as U.S. banks have learned so thoroughly during the subprime mortgage crisis when houses used to secure mortgages turned out to be worth much less than banks had calculated and when selling foreclosed houses turned out to be amazingly difficult. (Turns out—surprise—that when you foreclose on so many houses, you depress the market price for all foreclosed houses—if you can manage to sell them at all.)
And this level of debt, the sinking quality of loans, and the questionable value of collateral will become huge issues if the national and global economies slow and the some borrowers become unable to pay.
Consider what happens in China as economic growth slows. Of course, the Chinese financial system isn’t especially transparent, but the best analysis we have says that the Chinese corporate sector is badly over-extended. The debt service ratio at Chinese companies was 30% of GDP in June, Societe Generale calculates. That’s a level, the bank notes, that is a typical threshold for a financial crisis. The official China Securities Journal agreed in a June front-page editorial. Total credit in China’s financial system could be as high as 221% of GDP, the journal said. That would be an eight-fold increase in a decade. Chinese companies are looking at $1 trillion in interest payments this year, the journal continued.
And all this comes as the Chinese economy continues to slow—decelerating from 7.7% growth in the first quarter to 7.5% growth in the second quarter—and as a slumping EuroZone economy plus sluggish growth in other parts of the global economy cuts Chinese exports. Local governments, which are reliant on real estate sales to raise much of their revenue, look like they’ve already hit a financial wall this year. China’s many unprofitable state-owned enterprises aren’t far behind.
I don't think this necessarily means another acute global financial crisis like that in 2008 that almost brought down the global economy--although I wouldn’t rule out another acute crisis—if we get unlucky. The likely origin of an acute crisis is the Chinese financial system but, because of the still largely insular nature of China’s financial system and the demonstrated willingness and capability of the national government to intervene in a financial crisis, I think going from a regional crisis to a global crisis would require a badly timed simultaneous breakdown in Europe and the United States. (See my post http://jubakpicks.com/tag/china-perfect-storm/ from July 15 for this scenario.)
Instead what I see right now is evidence that the financial crisis never really ended—despite the huge run in the U.S. stock market off the bottom and the recovery of the housing market. And that the effects of the crisis are still playing out across the global economy.
The structural problems of the global economy that contributed to the crisis in 2008 (and I’d argue in the earlier, smaller crises of 2000 and 1997) haven’t been “solved.” We’ve still got a massive imbalance of production and incomes across the globe as countries such as China and Germany have by policy suppressed domestic consumption. Countries such as the United States and Spain have created credit bubbles in their efforts to support consumption and “repeal” the business cycle. The world as a whole hasn’t prepared very well for the huge challenge of an aging global population and has, I’d argue, made the problems of that transition harder to address by using monetary policy and deceptive accounting to pretend the problem didn’t exist. (This isn’t a comprehensive list of the problems in the global economy—there are the still unsolved and long-standing problems in the global energy economy, for example. Add your own items to my list.)
In other words the absence of an acute attack of global crisis doesn’t mean the patient is healthy or even just free of disease. Because the effects and the causes of the global financial crisis are still with us, I think we’re likely to see a period when the global economy grows relatively slowly at a speed well below its potential limits—and where intermittent local outbreaks of the problems underlying the crisis result in heightened levels of volatility.
Elsewhere I’ve called this period of lower returns and higher volatility the new paranormal economy. If you’ve missed my initial descriptions of this period, my March 2, 2012 post is a good place to begin http://jubakpicks.com/ .
One of the comforting aspects of this view of the global economy and the global financial markets is that I think the odds are low that the global economy will suffer another nearly fatal event (as it did in 2008.) Call that event a heart attack.
But the bad news, the news that should keep you from getting very comfortable and should certainly prevent you from getting complacent is that while the patient looks likely to avoid a fatal event, the global economy is likely to keep us on edge with repeated visits to the emergency room and late night calls to the paramedics. The underlying health of the economy isn’t especially robust and the recovery looks lengthy and uneven.
Calling the timing on any of these less events is certainly difficult and I can’t pretend to a very accurate crystal ball when it comes to timing market moves. Right now, though, with the U.S. markets at an all time high, with growth in China slowing, with European economies caught in recession, with EuroZone leaders seemingly frozen into inactivity by Germany’s September elections, and with, finally, the U.S. facing a brutal budget and debt ceiling fight come September, I certainly see an awful lot of short-term risk for very little short-term reward.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any company mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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