Moody’s Warns about Credit Crunch, Unnerves with Parallels to 2008!
The US bond market has swollen to $40 trillion. Over $8 trillion are corporate bonds, up a mind-boggling 50% from when the Fed unleashed its zero-interest-rate policy and QE seven years ago.
So far this year, $1.34 trillion in new corporate bonds have been issued, up 6.8% from last year at this time, which had already been a record year, according to the Securities Industry and Financial Markets Association (SIFMA). Bond issuance in 2012, 2013, and 2014 set ever crazier records; 2015 is on track to set an even crazier one: close to $1.5 trillion.
That’s a lot of newly borrowed moolah. Much of it is being used to pay for dividends, stock buybacks, M&A, and other worthy financial engineering projects designed to inflate stock prices, though that strategy has turned into a sorry dud this year.
Junk bonds now make up $1.8 trillion of this pile of corporate debt, nearly double the $944 billion in junk bonds outstanding at the end of 2008 before the Fed saved the economy, so to speak.
But what happens when this flood of cheaply borrowed money begins to dry up as an ever larger percentage of that $1.8 trillion in junk bonds begins to default, while ever more high-grade bonds get downgraded to junk?
That’s the end of the credit cycle – and the beginning of financial nightmares. It’s the phase the bond market has already entered, according to a report by John Lonski, Chief Economist at Moody’s Capital Markets Research.
One metric that marks turning points in the credit cycle is the credit upgrade ratio. In Q2 this year, the ratio of ratings upgrades to total ratings revisions for junk bonds was still 49%. By Q3, this upgrade ratio had fallen to 39%, the worst level since Q2 2009 when it was 30%. Halfway into Q4, there have been 18 upgrades and 57 downgrades, a ratio of 24%, the worst since Q1 2009.
Among investment-grade bonds, the ratio is even more terrible: 1 upgrade and 11 downgrades. “A convincing negative trend may be emerging,” the report said gingerly.
To reduce quarter-to-quarter volatility in the metric, Lonski looks at the upgrade-ratio of two quarters combined. In Q3 and Q4 so far, the combined upgrade ratio is 35%, a hair better than the 34% from the two quarters ended September 2009. The ratio had bottomed out in the two quarters ended March 2009 at 13%.
But here’s the thing: the last two times when the upgrade ratio fell from above 40% to below 40% was in Q4 2007 (at 37%) as exploding debt was already putting cracks into the financial system, and in Q4 1998 (at 29%) as the dotcom bubble was approaching its final year.
“Both episodes constituted important turning points in the corporate credit cycle. Thereafter, not only did high-yield bond spreads remain relatively wide, but both projected and actual default rates trended higher,” the report pointed out – a hilarious understatement, given the fiascos that followed.
And these “projected and actual default rates” are already taking off. The Expected Default Frequency (EDF) of US and Canadian junk-rated companies, a metric of future defaults, hit 5.6%, the highest since the 6.4% of August 2009.
Moody’s unnerving parallels to 2008, 2009!
“Given the surge in the number of downgrades, plunging upgrades, and the likelihood of significantly more defaults,” the all-important spread between the yields of junk bonds to US Treasuries is likely to widen, especially given last quarter’s “decidedly subpar showings by business sales and operating profits.”
These dynamics in the bond markets are spooking banks – and bank regulators. They’re seeing them as a deterioration of credit quality. And so they tighten their lending standards, and they widen the rate spreads on business loans. Thus they make borrowed money scarcer and more expensive.
Banks have been pushing risky borrowers into issuing bonds and use the proceeds to pay down their credit lines. This is a way for banks to roll off risk to bondholders. But when companies have trouble issuing bonds at survivable yields, banks get worried about extending loans to them. In turn, when banks get spooked, bondholders panic.
These companies need new money to service their debts, and when the money spigot gets turned off, default rates and projected default rates rise, thus triggering even tighter lending standards….
The vicious circle of the credit crunch sets in.
“Typically, the downward spiral continues until the weak credits have been sufficiently culled and the business outlook improves,” Moody’s explains. Last two times this happened, it was mayhem.
It’s already happening. The Fed reported in its quarterly Senior Loan Officer Opinion Survey of October that banks have begun to tighten lending standards on commercial and industrial loans – the first tightening after three years of loosening lending standards, and after tightening throughout the Financial Crisis.
But the last two times when lending standards switched from loosening to tightening to a similar degree, according to Moody’s, was in, well, the infamous Q3 2007 and Q4 1998.
We know what came after both occasions. Only this time, the pile of debt is far larger, and the risks – thanks to the Fed’s ingenious policies that have encouraged all this – far greater.
Debt is the key in commercial real estate. Low interest rates make it happen. Banks are eager to lend. They repackage this debt into Commercial Mortgage Backed Securities and sell them to yield-desperate investors. It has performed miracles, once again. Read… Fed Trips over Eye-Popping Commercial Real Estate Bubble, Accidentally Looks, Sees “Early Signs” of “Search for Yield”
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.