HAVE WE ALREADY DROPPED IT?
Insight from Our Chief Risk Officer X
I have been asked to provide words of wisdom on the current state of debt and leverage in the world… It’s a difficult task, since the prevailing wisdom from the vast majority of the world’s elite economists and politicians over the last 30 years has been that debt and leverage are misunderstood when viewed through the old New England/Scottish lens of “less is more”… and that spending and leverage are all supportable by potential future growth. In fact, any that questioned this logic were dismissed… and frequently chastised.
Well, I am here to say that the worm is turning… because even the silliest prognosticator of future growth is now forced to confront the awe-inspiring growth in global debt over the past 18 years.
Remember that in 2000, the U.S. government actually ran a budget surplus… And that while corporate debt was on the rise, people were still grounded in the memories of what had occurred in the late ’80s and early ’90s when the price was paid for the excesses of the previous decade. A frequently heard phrase from real estate investors, emerging market participants, corporate lenders, investment bankers, and investors was… “Please god, let there be another bubble and I promise that I will not piss it all away this time.”
How have we done? Let’s review…
Since 2000, according to the folks at McKinsey & Company management consultants, global debt (household, non-financial corporates, and government) has increased from $64 TRILLION to $169 TRILLION. Through all of history, until Y2K, we managed to “only” accumulate $64 TRILLION… And in the last 20 years, we have added over $100 TRILLION…
Global household debt has increased from $18 TRILLION to $43 TRILLION, corporate debt from $25 TRILLION to $66 TRILLION, and government debt from $21 TRILLION to $60 TRILLION. Keep in mind, this is all in TRILLIONS of dollars!
The good news is that global GDP also accelerated broadly, driven by astounding growth in China, India, and Brazil… Remember BRIC?… The world’s leading emerging economies, namely Brazil, Russia, India, and China?… (And now, alas, pretty much reduced to the ICs, pronounced “ick.”) The bad news is that while plenty of debt growth was aligned with GDP growth in these markets, the rate of growth in debt in developed markets far outstripped the relatively pedestrian GDP growth from Europe and the U.S… With the U.S. – the home of the global reserve currency – leading the pack by a margin akin to Secretariat’s in the Belmont Stakes!
While the growth in U.S. government debt and entitlements has profound implications on the value of the dollar and its status as the global reserve currency, I believe that these challenges will likely not emerge over the shorter term… Rather, they are more likely to impact 5 to 15 years from now.
Of real short-term concern is the U.S. non-financial corporate-debt situation, which now stands at 45% of GDP (a record, post-WWII high) at a time when our GDP is at a record high and is growing nicely with a 3% (sustainable?) trend. But what will this look like as GDP slips in a recession?
In 2000, the Barclays bank’s index of total investment-grade bonds was a little under $1 trillion… with BBB and A-grade outstandings each at about $350 billion. Today, by the same measures, total outstanding debt has risen to over $3.5 trillion with BBB issuance over $1.8 trillion – an increase of $1.2 trillion since just 2007.
While that is scary enough in itself, what makes these record-high debt levels even more troubling is that the debt is attached to companies with materially more leverage than we have ever seen. The median rating for public corporate-bond issuers today is BB… 15 years ago it was BBB… and 28 years ago, when we had our last real corporate-debt meltdown, it was BBB+/A-. So the relative and absolute levels of investment-grade debt are extremely high and the relative quality of the issuers is substantially diminished. What could be worse?
Sadly, there is worse… The average leverage as measured by debt-to-earnings metrics has also risen. BBB debt in 1990 was on average 2x the EBITDA. Today, that is 3.2x… a record-high level for times when earnings are strong. Single A leverage by the same metric has risen from 1.5x to 2.9x. In essence, risk has substantially increased within the ratings, before any signs of a recession, and before factoring the aforementioned astounding growth in nominal terms.
These ultra-high debt levels in investment-grade bonds have created an environment with substantially more susceptibility to disruption… and deep implications for our economy in the next recession. In essence, a forest full of dried piles of tinder (and not the dating app kind) waiting for a spark. Where is that spark likely to come from?
The world of non-investment-grade corporates (high-yield and leveraged loans).
Strangely, unlike 1989, it will not be led by high-yield bonds, as to date that is the one area of the public bond markets where issuer leverage and issuance have not risen. Instead, it will be led by the levered-loan phenomenon… A gift from the Basel 1 banking regulation of 1988, which effectively created a shadow-banking system by pushing assets off of bank balance sheets.
The levered-loan market effectively began in the late 1990s, as investors were searching for yield through structured-credit instruments, and banks were actively discouraged by regulators from holding riskier paper on their balance sheets.
From those modest beginnings, levered-loan outstandings now approach $1.5 trillion and exceed the level of high-yield bonds outstanding. More concerning is that the average leverage in the underlying senior secured loans has risen from a little over 2x cash flow to 4x cash flow since 2000. Further, the total debt in these borrowers has risen from 3.7x to 5x… with much of the remaining debt in many cases being mortgages or advances against working capital, which is effectively senior to the first lien loans that we are discussing.
The secular concerns of this leverage are exacerbated by the way that this remarkable growth in the magnitude and availability of highly levered loans/credit has driven up the valuations of the underlying companies to over 10x cash flow on average (up from 8x in 2010). Again, heightened valuations, just like heightened leverage, are adding to that pile of tinder… and to the potential size and severity of an economic downturn.
The final piece to the puzzle in the world of levered loans is that while one typically thinks of a loan as a banking activity, these are not. In fact, the leverage in these borrowings frequently exceeds what the regulators would allow. Instead, 95% of these loans are owned by institutional investors, including many foreign institutions, who are drawn to the idea of floating rate assets with no duration risk and relatively high yields. In fact, more than half of these loans are in the form of collateralized loan obligations (CLOs)… a structured credit “solution” to the quandary that most investors are uncomfortable with – the level of risk in the underlying loans. This allows them to derive comfort from their investment-grade investment in these structures, supported by a sliver of capital that can be eroded instantly should valuations or leverage multiples decline… an almost certain future outcome.
Why does this matter? These investors can decide to withdraw from the market just as quickly as they decided to engage… and the underlying loans mature in three- to five-year increments. So the level of institutional demand that has to exist, just to support the rollover of existing loans, approaches $400 billion by 2021. In effect we have a large pool of institutional investors who must continue to participate… or the underlying refinancing of the corporations will not keep pace with loan maturities, driving heretofore unseen levels of defaults for companies.
In short, it is hard to see how this ends well.
It is likely we will soon have another chapter added to the novel of regulators and politicians pointing their fingers at financial institutions and allocating blame. And while plenty of blame should be placed at the foot of private-equity investors and loan underwriters, the root of the problem originates with regulatory rules written in 1988 and added to over the ensuing years… regulatory rules that drove the levered-lending business outside of the regulatory purview, creating the very real possibility that the “run on the banks” scenario will once again rear its ugly head. Although this time, the banks will be safe as the institutional investors withdraw from the market… leading to decreased valuations… leading to private-equity underperformance… leading to more investors withdrawing.
Happy Thanksgiving to all!