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Investors often focus on stock prices to take the temperature of an economy’s health. If share prices are high and rising, they feel upbeat. If price levels sink low, so does investor confidence. Still, as the 10th anniversary of the Great Recession of 2008 draws nearer, some experts are beginning to worry that a looming bubble in corporate debt poses a danger. “The … domestic debt market – at $41 trillion for the bond market alone – reveals more about our nation’s financial health,” wrote William D. Cohan, a former investment banker, in an op ed in The New York Times earlier this month.
Cohan, author of the recent book, Why Wall Street Matters, believes that the bond market is broadcasting a dangerous message. How serious is this risk? Could the puncturing of the corporate debt bubble spark another recession? What are the dangers of mispriced risk? Cohan joined Jyoti Thottam, opinion editor for business and economics at The New York Times, to speak about these questions and more on the Knowledge@Wharton show on Sirius XM channel 132. (Listen to the complete podcast at the top of this page.)
An edited transcript of the conversation follows.
Knowledge@Wharton: Why do you think it is important to talk about the corporate debt bubble, when everything we see reported about the markets and the economy is portrayed in positive terms?
William Cohan: When everything looks great, we tend to overlook all sorts of crumbs along the trails to trouble, thinking that everything will continue to be great. The stock market is great. The bond market is great. The economy is booming. The unemployment rate is low. Our President tweets about how great everything is. But if you look underneath the surface, you will see trouble brewing, especially in the bond market. There are a lot of hidden risks.
A lot of the past financial crises and recessions have started in the credit markets because they freeze up. Credit is the lifeblood of our economy and if companies can’t get it, if municipalities can’t get it, if individuals can’t get credit, then they can’t power the economy. People in the bond market think it is safe because there is an obligation on the other side to repay their money. That obligation is there. But people forget that it can be very risky as well. That is why I felt the need to remind them that it can be risky and to show them the crumbs that I am seeing on the pathway.
Knowledge@Wharton: Jyoti, why did you think this was such an important topic?
Jyoti Thottam: One of the things that we wanted to do was to be mindful of what happened in the last financial crisis. There was a sense that there were many warning signs, red flags waving, that people somehow missed. We are on the lookout for those kinds of signs.
Knowledge@Wharton: Given the cycle of issues that we see in the financial sector, could we be facing another significant economic downturn, maybe not today or next month, but in the next 12 or 18 months?
“People in the bond market think it is safe because there is an obligation on the other side to repay their money.”— William Cohan
Cohan: Financial crises are part of the human condition. It doesn’t take Wall Street to bring about financial crises; it is part of human nature. I think that America was founded in the midst of a financial crisis, because the federal government couldn’t pay back the debt that it took on to have the Revolutionary War.
As I walk through in Why Wall Street Matters, there’s been a financial crisis pretty much every 20 years in this country since it started. Some are more severe than others, and sometimes there are long periods where there is no financial crisis, especially after regulations tightened considerably after the Great Depression. It was quiescent in the financial markets until the mid-80s. But as a result of investment banks and banks going public and substituting other people’s money for partners’ capital, bankers and traders have been rewarded to take big risks with other people’s money. This has exacerbated financial crises in the last 40 years. They have been getting deeper and more severe.
Thottam: Ben Bernanke [former chairman of the Federal Reserve] was a student of depressions and recessions and what to do after that. He, and everyone else around him, came up with this somewhat novel policy, quantitative easing (QE), which in retrospect perhaps was the right thing to do. One of the things that I felt Bill did really well in his piece was to lay out that we had QE, at some point it had to be unwound, and after so many years of super low interest rates, what is the effect of that? We don’t know. We are going to see that right now.
Cohan: There are a lot of experts who worry about this. Jamie Dimon, the CEO of JP Morgan Chase, is worried about it. James Grant, who is the guru of the bond market at Grant’s Interest Rates Observer, writes about this repeatedly. Jeffrey Gundlach, who runs one of the biggest bond funds on the planet, has worried about this continuously and talked about it.
Knowledge@Wharton: How big a role would the corporate debt bubble play if we were to get into a recession in the next several years?
Cohan: It is hard to know. One never knows what the catalyst is going to be for the next financial crisis. We know that there have been catalysts in the past. But the truth is nobody rings a bell at the top of the market and says, “That’s it. It’s over. It’s been fun, guys. It’s all downhill from here.”
When I was a banker 27 years ago, the management of United Airlines (UAL) was trying to take it private in what was then one of the largest management buyouts of all time. They had got the commitment letter from Citibank to finance that deal. But suddenly Citibank went back to the management and said, we can’t finance this deal, the market is not there for this buyout. This was in 1991, four years after the stock market crash of 1987. It became a huge problem and shut down the credit markets for the next two or three years. The fact that the UAL buyout could not be financed in the market was the signal that the party was over, and that we were now heading into a severe credit crunch.
Anything could be a catalyst. Maybe Tesla trying to go private will be a catalyst for this market shutting down. And that is when real trouble happens. Because people who had nothing to do with it, with the excess, can’t get access to capital.
“[People] who are putting these deals together are getting paid. So until you change people’s incentives, things are not going to change. –Jyoti Thottam
Knowledge@Wharton: Why do you think the markets have an issue with mis-pricing risk at this point?
Cohan: This goes back to the experiment that Ben Bernanke, the Fed chairman, put in place after the financial crisis in 2008 for the next eight years — the quantitative easing program — which expanded the Fed’s balance sheet from around $900 billion to $4.5 trillion dollars. It was then buying up all kinds of debt securities, from safe treasuries to mortgage-backed securities that were on the balance sheets of these banks. As a result of the combination of wanting to keep short-term interest rates low, and then buying up all of these bonds in the market which forced their prices up, the yields were forced down because bond prices trade in inverse proportion to their yield. The yields of bonds were near zero. Investors, of course, don’t want low yields. They want to find debt instruments that pay them higher and higher yields. So they would bid up the price of other high yielding securities, drive down their yield, and the cycle just continued. You have this continuous eight-year period of mis-pricing risk. That is where I think we are now.
Thottam: It is still unclear if this is going to be bad just for individual companies. Once the pendulum swings the other way, will it be just a handful of individual companies that go bust without affecting the rest of the market? [It is the] same thing with individual countries that may have taken on too much dollar-denominated debt. Is it just those countries, or are they connected? It is very difficult to know at this stage.
Knowledge@Wharton: Quantitative easing helped the banks. But for a lot of smaller businesses, why didn’t it give them a bigger boost to be able to get loans, or for home buyers to get mortgages?
Cohan: Well, because the pendulum swings on the credit underwriting front. Banks go from seeming to have virtually no standards — if you breathe you can get a mortgage, if you breathe you can get a line of credit — to disaster striking, as happened in 2008. And then the credit pendulum swings back the other way. Only the most credit worthy companies, the single A, the double A, the triple A companies can get access to capital, or the private equity funds, or the hedge funds. They can get all of the capital they need. But individual home owners or people who want to buy a home, can’t get [loans]. Small and medium sized businesses which drive so much job creation in this country were basically choked off from the credit markets after the financial crisis. They may still not able to get the capital they need. Home owners may still not be able to get the mortgages to buy homes unless they put down some large percentage in equity.
So you’ve got lots of things going on underneath the surface at the same time. I think the biggest risk is the desire by investors around the world for higher and higher yields. This has forced them to mis-price the bonds that they are buying, the debt that they are buying, the loans that they are buying. They are not getting adequately compensated for the risks that they are taking. And they are willing to forgo all sorts of covenants and other protections.
“[Bankers] and traders have been rewarded to take big risks with other people’s money. This has exacerbated financial crises in the last 40 years.” –William Cohan
Knowledge@Wharton: Jyoti, you use the example in the piece that you did on Asurion [technology solutions company], and those covenant light loans, as you called them.
Thottam: That’s right. That was one of the things that really resonated with me. People remember what the mortgage market was like in 2006, 2007 and the loosening of credit standards in the mortgage market in 2008. You see a similar thing now in the corporate debt market.
Cohan: It is not just one isolated industry or a group of companies. This is happening throughout the corporate loan and bond market. A lot of these loans are made by the big banks, but then they are repackaged into securities, and that potential trouble is exported as investments all around the world. That is what happened with mortgage-backed securities in 2005, 2006 and 2007 leading up to the crisis. Something similar, I fear, is happening now. You can’t mis-price risk for eight years and expect no consequences.
Knowledge@Wharton: What about what we are seeing in Turkey right now?
Thottam: You can see it’s that chasing of yield that has been going on in the last few years. Investors are looking for higher yields, not just in the United States, but all around the world. Even if you didn’t have the political conflict between Turkey and the U.S., the underlying problems, the economic problems, were there.
Cohan: Bernanke’s idea of quantitative easing worked well to get our banks back to being healthy and our economy rolling again. And so, central bankers around the world copied what Bernanke did. It is not just mis-pricing of risk that has happened in this country, it has happened with debt securities all around the world.
Knowledge@Wharton: How similar are some of these elements that we are seeing now to what we saw pre-2008?
“It is still unclear if this is going to be bad just for individual companies … without affecting the rest of the market.” –Jyoti Thottam
Thottam: Some of them are similar. For example, the manner in which big pension funds are invested in some of these securities is similar to how they were exposed to mortgage-backed securities in 2008.
Cohan: The biggest investors in the bond markets are mutual funds and pension funds — firefighter pensions, police pensions, teacher pensions, ordinary Americans who probably don’t understand the risks of buying into these risky bonds. One example is the bonds of Toys R Us, which was the biggest toy retailer that KKR [the investment firm formerly known as Kohlberg Kravis Roberts] had taken private. They were trading at near par, nearly 100 cents on the dollar until KKR announced last year that the company was going to go bankrupt. The bonds have lost 95% of their value. That is money that is not coming back. It can’t be recovered.
Knowledge@Wharton: What do you think needs to be done at this point with some of these scenarios?
Thottam: As Bill points out, at the end of the day the people who are putting these deals together are getting paid. So until you change people’s incentives, things are not going to change. In some cases, companies are taking on debt, not to build a new factory or invest in new technology, but to pay fees to their private equity owners. That is not a very productive use of capital. That is something that we have to take a hard look at.
Cohan: Changing what you reward people on Wall Street to do requires great courage, which doesn’t seem to be in the offing. But credit committees exist in all of these firms, and they could definitely tighten up their credit standards.