How a Small-ish Stock Market Swoon Might Unleash the Next Credit Nightmare

“Weakest link” companies worst since October 2009.

The “weakest links,” according to S&P Global Ratings, are financially squeezed companies that S&P rates B- (neck-deep into junk), with “negative” rating outlooks or negative implications on CreditWatch. They’re uncanny predictors of corporate defaults. When the number of “weakest links” rises, the default rate will soon rise as well. The last three times it rose enough, a recession kicked in. The last two times were accompanied by fabulous fireworks in the markets.

In August, the number of “weakest link” companies rose to 251, the highest since October 2009, up from 140 two years ago, and heading toward the record of 300 in April 2009 when the financial world was coming unglued.

These weakest links have $359 billion in debt outstanding.

They serve as “potential default indicators” because they’re almost 10 times more likely  to default than run-of-the-mill junk-rated companies, according the S&P report, cited by Bloomberg. Blame oil and gas? The markets surely would like to. But only 62, or 25% of the weakest links, are oil and gas companies. The next largest sector: 34 financial institutions for a share of 14%.

Among the eight companies that were inducted to the elect group in August: Chesapeake Energy, Hornbeck Offshore Services, satellite operator Intelsat which is already holding a gun to bondholders’ heads to get them to undergo a bond exchange with haircut, which S&P called “a distressed restructuring and tantamount to default.”

And it includes Tesla, which is burning cash faster than anyone can keep up with, and which has been raising even more cash via a torrent of follow-on stock offerings and debt sales, all to maintain enough liquidity. More on that in a moment.

The S&P US default rate rose to 4.8% as of July. S&P expects it to rise to 5.6% in June 2017. That may be optimistic. The default rate was 1.4% in July 2014. As it began rising over the past two years, S&P consistently underestimated how far it would go. Last November it was 2.8%. In nine months, it has jumped 2 full percentage points.

The default rate for energy companies is 21.7%.

And yet, liquidity is once again sloshing knee-deep through the system, trying to find a place to go. This includes refugees from negative interest rates in Europe and Japan. In this environment, even teetering Chesapeake was able to swap debt for equity and raise new money to be burned in the near future.

It’s hard to default when you keep getting new money to service old debts. Junk-rated issuers, now a hot property for NIRP refugees, have been able to refinance their debts and raise money to cover operating losses.

In that vein, back to “weakest link” Tesla. S&P rates it B-. The next step down is CCC. On August 1, S&P warned that it might downgrade it further, following its $2.6 billion acquisition of another money-losing, cash-burning Elon Musk company, over-indebted SolarCity. S&P slapped a CreditWatch “negative” on Tesla, based on “significant risks related to the sustainability of the company’s capital structure following the proposed transaction.”

Together, Tesla and SolarCity had over $5 billion in long-term debt at the end of March, and the deal would cause a “meaningful increase in the combined entity’s debt leverage.”

With its lofty stock price – though it’s down 27% from its 52-week high – and its insane market capitalization, Tesla has the ability to raise money in the equity markets without breaking a sweat, as it has repeatedly done, including the $2 billion follow-on offering announced in May. For now, investors are more than willing to pay an arm and a leg for a company that, after 10 years of existence, has not yet figured out how to stop losing money, and that sells so few cars that its sales are not even a rounding error in the 74.4 million new vehicles to be sold globally this year.

As long as Tesla, Chesapeake, and other “weak links,” plus a host of companies that are not yet “weak links,” have access to the equity market for more money, they’re unlikely to plunge over the default cliff. Creditors know this. As long as the stock price is high enough, they’re willing to lend more money. So these companies even have access to the credit markets. And everything is hunky-dory.

“Markets are now relatively sanguine about default risk,” John Lonski, Chief Economist at Moody’s Capital Markets Research, wrote in his latest missive. Moody’s US default rate is already 5.5%, just about at S&P’s expectation for June 2017 (5.6%). If the default rate continues to rise and if markets become less “sanguine” about it – if they start once again to fret about defaults and losing their shirts – they can trigger a chain reaction that feeds on itself. It happens every time.

Investors will suddenly seek higher compensation for the risk of default by demanding higher interest rates, and yield spreads begin to widen. Thus borrowing money becomes more difficult and for some companies impossible. They’re facing a liquidity crisis.

Equity investors see this too, and being at the bottom of the capital totem pole, they’re worried about losing everything in a default and debt restructuring. So they’re massively bailing out, and shares crash.

Now creditors, including banks, see that the company cannot raise new money in the equity markets, and they’re tightening the noose, trying to protect what they can.

“Thus, a worsened default outlook diminishes liquidity by increasing the cost of both debt and equity capital,” Lonski writes. When liquidity dries up for a company that is burning cash like a wildfire, it’s soon over.

If enough companies go through this, there are consequences: after each of the last three “episodes” when Moody’s default rate reached 6.5%, it “continued its ascent,” Lonski writes:

After first reaching 6.5% in February 2009, April 2000, and February 1990, the default rate eventually crested at 14.7% in November 2009, 11.1% in January 2002, and 12.4% in June 1991. Coincidentally, a recession overlapped each of the default rate’s last three peaks.

In addition, the equity market suffered deep setbacks at some point during the 12 months prior to the peaking of the default rate.

And the last two of these “setbacks” turned into epic crashes.

Over-indebted cash-flow negative companies need high stock prices in order to put creditors at ease. And this in turn puts equity investors at ease. That’s what happened since the turmoil late last year and early this year. Once again, markets are “sanguine” about default risks. They practically don’t care.

But when shares begin to follow the pull of gravity as markets are becoming less “sanguine,” the entire chain comes unglued, liquidity dries up, default rates spike, and the noose tightens. The last three episodes were associated with a recession, the last two with market crashes. And rising “weak links,” a leading indicator, don’t project a sunny picture.

And what would the Fed do? Who says the Fed can’t have fun at our expense? Read… The 11 Bone-Chilling Things I Gleaned from Yellen’s Chart

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  29 comments for “How a Small-ish Stock Market Swoon Might Unleash the Next Credit Nightmare

  1. nick kelly says:

    I think the Hanjin collapse is a huge red flag in support of this theory.
    Not all the MSM is getting the crux of the matter. It’s not that a bunch of stuff is stranded and retailers etc. are anxious.
    All true and hopefully at least stuff in the pipeline will get through.

    The main take away is that neither the South Korean banks or government would kick the can further down the road. Hanjin was a player in South Korea’s rise to a world class exporter- exceeding China in quality. Do you see Chinese cars in our driveways?

    Hanjin was not one of these Twitter- type, social media fluff merchants- it worked for a living but has been crushed by the shipping overcapacity and price war. Its failure has caused huge physical problems for a huge number of people. Which third parties would be seriously inconvenienced if the typical internet ‘unicorn’ went bust?

    South Korea is an export based, real world, live or die economy that does not have the luxury of printing a reserve currency. Someone there has said: ‘that’s it’, no more extend and pretend.
    It may a kind of first, where an important national flag bearer with a long history and connections to government is allowed to fail. The failure of BHS department stores is big news in the UK, but who outside the UK had heard of it.
    Hanjin’s name is prominent on ships and containers here on BC’s west coast and around the world -but South Korea wouldn’t bail it out.
    The company’s failure is bad news for any overextended company that is counting on government support.
    Can I think of any Canadian companies in a similar position?
    Of course not.

    • WTFrogg says:

      Valid comment re : Hanjin. Kind of sad but that’s business.

      I wonder which of the Big Three automakers in Canada will need a government bailout/handout the next time the SHTF ?

      I guess it really is true : The Taxpayer has LOTS of money !!!

    • Wolf Richter says:

      Nick, excellent comment on Hanjin. I think you hit the nail on the head.

      • d says:

        In addition the Korean Govt would have discussed this with uncle Sam before letting Hanjin go. So and interesting win for china decision.

        The only sad, and very unfair thing about this is that it makes the chinese state shippers (Who are radically oversupplying and undercutting the market causing Hanjin’s problems) stronger.

    • nhz says:

      Hanjin forgot to open an EU office. I bet Draghi and Coeuré are salivating at the prospect of buying their debt (and their stock) ;-(

      And if this can’t happen to large companies in the regions of the world that are controlled by the money-changers (FED, ECB, BOJ, BOE etc.) does it mean that all those countries that are still independent are going to be annexed by simply buying up all their companies and other assets with dollars and euros printed from thin air? What a crooked game …

    • Vespa P200E says:

      I heard that Hanjin was in comatose for some time headed by Chairwoman who took over when her husband died – typical chaebol ways of working/corporate governance. She ran it to the ground and did a lot of hide the weenie and misled the Korean banks as she knew the Korean government will surely bail out the “national” carrier and 1 of the export engines. Nail on the coffin was her rather dumb and obvious insider trading few days before excrements hit the fan and the banks finally had enough of her lies and forced it into BK,

      That said there may be more dominos to fall in other shippers.

  2. Sound of the Suburbs says:

    The greatest question facing the world today is:

    “Which way is up?”

    40 years ago, most economists and almost everyone else believed the economy was demand driven and the system naturally trickled up.

    Now most economists and almost everyone else believes the economy is supply driven and the system naturally trickles down.

    Economics has been turned upside down in the last 40 years.

    For a supply side, trickle down world you need Neo-Keynesian stimulus where money is fed into the top of the economic pyramid the banks to be lent out, invested and trickle down.

    For a demand driven, trickle up world you need traditional Keynesian stimulus where money is fed into the bottom through infrastructure spending to create jobs and wages which will be spent into the economy and trickle up.

    The West has been doing Neo-Keynesian stimulus for the last eight years and asset prices have been maintained but little has trickled down to the real economy.

    China has been doing Keynesian stimulus for the last eight years and had been the engine of the global economy, until it realised this stimulus was costing too much and debt levels were getting out of hand.

    China never rebalanced its economy towards consumption and was hoping the Western consumer would have come back to life in the eight years it was doing Keynesian stimulus, unfortunately this didn’t happen as the West did the upside down, Neo-Keynesian stimulus.

    China itself believes in supply side, trickledown economics which has led to massive inequality and almost no welfare state. The vast majority of consumers are forced to save for a rainy day and wages are low subduing consumption. A few have accumulated most of the wealth from the boom and have been busy spending it abroad mainly in high end property.

    China engaged in Keynesian stimulus because of Japan’s experience in a 25 year balance sheet recession where only Keynesian stimulus was found to work. It did what was known to work in the last eight years, but still fundamentally believes in supply side, trickledown economics. It is not suffering from schizophrenia.

    The Central Banks are still in Neo-Keynesian stimulus mode and are willing to give money to anyone apart from consumers. Banks can have free money, companies can have free money, but the consumer must wait for it to trickledown to them and all the evidence suggests they will be waiting a long time.

    Other policymakers are beginning to notice the failure of neo-Keynesian stimulus as hardly anything had trickled down in the last eight years. They are now coming up with ideas like helicopter money, re-distribution through taxation and Keynesian (fiscal) stimulus.

    In an exact science like economics, we just need to determine “which way is up?”.

    • nhz says:

      Only economists think they practice an exact science; people with common sense can see they are preaching a religion. I’m not aware of any decent science field either where idiots like Krugman, the Bernank etc. etc. are worshipped like they were gods.

      • polecat says:

        Just throwin those smokin chicken bones on the Eccles Building floor…looking for a ‘positive sign’ ……

  3. Dave Mac says:

    The MSM simply adores Tesla, but Wall Street loves it even more.

    They’re making money building it up to nosebleed heights, then they’ll make even more tearing it down…eventually.

  4. MC says:

    Recently CNBC broke the story that even the almighty US equity world is slowly drying up. Right now there are roughly 3,300 common stocks traded in the US. The last time numbers stood so low, the Soviet Union still existed and Ronald Reagan was still the US President: it was 1986.
    By comparison at the height of the dotcom bubble the number of common stock traded in the US touched 6,500 for a brief moment in 1999 before collapsing spectacularly: throughout the whole fiasco leading up to the Lehman Crash, the number of these traded common stocks stayed remarkably stable at around 4,500 before beginning the still ongoing collapse. The equity strategist CNBC interviewed blamed in equal measure “the lack of IPO activity” and “M&A and buybacks”. Sounds about right to me.

    This is all part of a present phenomenon which I somehow doubt was in the blueprints for an increasingly financialized world: the number of assets you can buy, at least on Western markets, is drying up.
    As soon as the ECB will start following into the BOJ’s footprints and outright buy REIT’s and equities there will be even less to buy.
    hence it’s no small wonder that complete basket cases such as Chesapeake Energy and Tesla can still very easily rise money despite having proven time and time again to be money pits. This is the reason why Uber has been able to burn through cash at a pace unseen since the Dotcom bubble with no apparent ill consequence.
    Plainly put the menu is shrinking daily, unless one wants to enter the uncharted waters of “emerging markets”, which at the moment are merely driven by NIRP refugees while fundamentals do not merely fail to improve but become even more worrisome by the month. The 1998 Asian Crisis will look like a Sunday school picnic once reality catches up with those who have driven “emerging” stock markets back into the stratosphere: values are so nosebleed high even a measly 10% drop in a week, not even close to a bear, will be enough to wipe out billions in Western wealth.

    • nhz says:

      what happens if the central banks buy up and bid up everything (stocks, bonds, mortgages, commodities) and as a result all trading stops? Or if there are no other buyers left at the central bank driven price, so in fact it is all worthless?

      Instant hyperinflation?

      • ThroxxOfVron says:

        Then the Bankers will own everything.
        All having been purchased with what is in effect counterfeit currency.

      • MC says:

        Interesting rhetorical question.
        Already now we are already well into law of diminishing returns territory. By this I mean that, yes, financial assets can still climb higher, but if before it cost 3 to drive up one index 1%, now it costs 5. Soon it will cost 7. In two years it may cost 15 or even 25.

        Yes, I hear all the time central banks have unlimited resources, they can “print” as much money as they want to drive up the price of any asset simply by bidding for it, but Japan has taught us things work differently. The Bank of Japan has embarked in one of the largest asset buying sprees in history and the Nikkei 225 refuses to budge. Housing prices outside the prime markets of Tokyo and Osaka are still declining. Even the much awaited “thrashing” of the yen, which according to Abenomics prophets should bring about a new Golden Age, is just not working.
        This is not for lack of trying, nor for lack of sweeping powers granted to the BOJ president, Haruchiko “Kamikaze” Kuroda.
        Given how rice paper thin Kuroda’s majority among the BOJ board of directors has become, I suspect things will get very interesting very soon.

    • OutLookingIn says:

      The US economy has transformed from a system of value creation, to one of value extraction. This approach has contributed to employment instability and income inequality.

      The number of common stocks traded on major US exchanges are the lowest since 1984 according to the University of Chicago, Center for Research in Security Prices.

      August has ended with the fourth narrowest trading range since 1928 with the range smaller only in 1958, 1964, and 1965.

      • polecat says:

        “value extraction” ……..

        If you meant ‘unicorns’ for value …. then I would agree ……

        Skittles as far as the eye can see !

        • MC says:

          I think he meant “extraction” as in “pulling teeth” or “sueezing beets for blood”. An apt metaphor.

    • ru82 says:

      Good analysis. Beside there being less companies to invest in many companies have reduced the number share that can be purchased via stock buybacks.

      No wonder the stock market is rising faster than GDP growth. More demand than supply?

      • MC says:

        Thank you.

        When Mr Richter speaks about “NIRP refugees”, he’s nailing it perfectly.
        Us investors are being driven to the point we simply close our eyes and scoop up anything we hope we’ll be able to resell for a profit down the road or which will give any discernible yield or dividend.

        One only needs to look at Apple.
        Last month AAPL took off like a Vostok rocket on its launch pad. What has Cupertino done? Announced some revolutionary new technology? Announced the hiring of some financial wizard as their CFO? Came up with the next Pokemon GO? No. In fact the last month has been an unmitigated disaster for Apple: there’s been a serious security/privacy issue, a massive lawsuit in the EU and now Apple has confirmed it expects the upcoming iPhone 7 to sell less than its predecessor.
        Analysts have even suggested Tim Cook is considering the unthinkable, meaning slashing margins,and savagely so on some markets. While the move would make a whole lot of sense because Apple has such ridiculously high margins it can well afford to do so to regain an edge over Chinese and Korean competitors, Apple shareholders have come to expect ridiculously inflated dividends year after year from here to eternity.
        In such a situation AAPL should have been hit on the head with a brick but it’s not happening. People are effectively betting that the two largest State-backed AAPL shareholders, the Banque Nationale Suisse and the Norwegian State Pension Fund, will do “whatever it takes” to drive up AAPL, just like they did earlier this year… before AAPL took that breathtaking plunge…

  5. Dusty says:

    I’ve been thinking any significant correction would unleash a credit event, but if so why did we get through the early 2016 correction or even the Brexit-reaction correction?
    I’m also still looking for a logical answer to the fact the market is up when other data shows that money going into the market is negative. (futures?)

    • Captain KurtZ says:

      That’s true. We can’t afford even the smallest downtick because the hedge-fund hotels (FANG + Cheaspeake and Tesla) are the only place these geniuses have put their money.

      Just like in 2000. The water is rising. Everyone jumped into just four stocks, then it all blew up.

      Hanjin is a real crisis. A real company with JIT implications. Credit is drying up, the lifeblood of these over-levered corporations who aren’t doing anything but have been buying back their stocks.

      This will not end well. Its clearly the beginning of the……..

  6. Bellinghouse says:

    Morningstar has VWO (Vanguard Emerging Markets) at a p/e of 13, price/book of 1.5, price/sales of 1.2 and price/cash flow at around 5. Yes I get that Tesla’s metrics are in the stratosphere, but I have a hard time understanding how a broad basket of emerging market stocks could be called “nosebleed.”

    • Vespa P200E says:

      EM is rife with accounting shenanigans so to believe in the reported PE, etc. takes some guts or naivete,

  7. ML says:

    Here in UK, Carlco plc announed that the diividend the company had announced in June would in fact not be paid in October because the co does not have enough reserves to meet its pension fund deficit.

    Pf deficits as an issue have been simmering for years but the next to zero interest rates are aggravating the situation.

  8. J P Frogbottom says:

    A credit re-set about to unfold? Good! Markets need to be self-cleaning, as is the stock market where insolvent companies re-organize if they can, or fold and go bust.
    Yes, a lot of speculative oil energy stuff on the edge, as are some marginal retailers, marginal manufacturers, transporters, and shall we include inadequately funded public pensions?
    A LOT of stuff can be rationalized, that didn’t quite go bust in 2008. Better late than never. That by itself should drive up interest rates, and right now perhaps the biggest credit risk out there is us -WE the People- with 19.5Trillion in debt. Lending HAS RISK – get paid appropriately for that risk or, do not lend!

    We used to be a good country. What happened to us? Can’t we get paid adequately for lending to the U.S.?

  9. Ryan says:

    Here Richter, it looks like we have “Voodoo Economics” on steroids. We have low interest rates and low taxes. But we do not have any demand.

    I like to hang out in Downtown Palo Alto. Everyone there is having a grand old time.

  10. Copernicus says:

    Banks, in these low interest rate times, are only too aware of self inflicted ‘collateral damage’. They will not send assets to market that will impair collateral on other holdings if they can help it. It cheaper to avoid collateral damage than it engage in it.

  11. Julian the Apostate says:

    Gosh Toto I guess we’re not in Kansas anymore…

Comments are closed.