Inflated bond ratings were one cause of the financial crisis and it looks as if we haven’t learned from that experience. Here we are ten years later and we’re heading down that path once again. People are concerned right now about an imminent recession for just cause.
So how did we circle back?
This May, Federal Reserve Chairman Jerome Powell said, “Fifteen years ago, everyone was talking about whether households were borrowing too much,” … “Today everyone is talking about whether businesses are borrowing too much.”
He warns, there’s a “moderate” risk that “near record levels” of business debt will spill over into the broader U.S. economy and spark another financial crisis. “Business debt has clearly reached a level that should give businesses and investors reason to pause and reflect.”
Recent lending has been “concentrated in the riskiest segments,” Mr. Powell said. Specifically, he pointed to collateralized loan obligations (CLOs) — actively managed securitization vehicles that buy up riskier assets like leveraged loans — as a key source of funding for riskier business borrowing, given they hold 62% of outstanding leveraged loans. “Regulators, investors, and market participants around the world would benefit greatly from more information on who is bearing the ultimate risk associated with CLOs,” Powell said.
Debt has hit new highs due in part to “aggressive underwriting” using financial vehicles that sell different pieces of debt to different investors, often outside the banking sector.
This time around the issue is corporate debt, not individual mortgage-related debt. Two fast-growing structured-bond sectors are commercial mortgage-backed securities, or CMBS, and collateralized loan obligations, or CLOs. CMBS fund deals for hotels, shopping malls and the like. CLOs are backed by corporate loans to risky borrowers, typically to fund buyouts.
S&P and its competitors are giving increasingly optimistic ratings as they fight for market share. A Wall Street Journal examination found that since 2012 the six main ratings firms “have changed some criteria for judging the riskiness of bonds in ways that were followed by jumps in market share, at least temporarily.”
These firms compete with one another to rate the debt of borrowers, who pay for the ratings and have an incentive to pick rosier ones.
The Wall Street Journal analyzed about 30,000 ratings within a $3 trillion database of structured securities issued between 2008 and 2019. Using Finsight.com data, they looked at a direct comparison of grades issued by, S&P, Moody’s Corp. and Fitch Ratings, and three smaller firms that have challenged them since the financial crisis, DBRS Inc., Kroll Bond Rating Agency Inc. and Morningstar Inc.
One of the key regulatory remedies, that of promoting competition, isn’t working. It appears the smaller firms, DBRS Inc., Kroll Bond Rating Agency Inc. and Morningstar Inc rate bonds higher than the major firms on the same bonds. When one firm called a security junk, another rated it Triple-A – super safe.
After the financial crisis, ratings firms were criticized for taking lucrative fees and giving high grades to risky securities that caused big losses for investors. “The victims are the investors,” says Marshall Glick, a portfolio manager at investment firm Alliance Bernstein LP, who in 2015 complained about inflated ratings to the Securities and Exchange Commission, asking the agency to make it harder for issuers to cherry-pick the best ones.
Unfortunately, this advice has not been listened to. Bond issuers that buy ratings shop around to get the best deal. The rating agencies compete for a company’s business for rating their debt securities, with the net effect that the business will go to the rating agency which gives the highest credit ratings. The bottom line – companies pay for higher ratings, and investors rely on the risk ratings for credit quality, with many of the risk ratings no longer representing the true credit risk of the security.
Mr. Powell acknowledged similarities between the recent spike in business debt and the lending boom that preceded the global financial crisis. Debt has surged to historic highs and outpaced growth in borrowers’ incomes, lenders have loosened their underwriting standards, and much of the borrowing is financed outside the banking system.
According to Mr. Powell …Views about the risks from rising corporate borrowing “range from ‘This is a return to the subprime-mortgage crisis’ to ‘Nothing to worry about here,’” said Mr. Powell. “At the moment, the truth is likely somewhere in the middle.”
Mr. Powell continues, If the economic and financial conditions deteriorated, overly indebted companies could face significant strains, forcing more layoffs and cutbacks in investment, which could make any downturn more painful… “Investors, financial institutions and regulators need to focus on this risk today, while times are good…” the financial system today “appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages.”
Lest we forget, the Federal Reserve had a significant role in dropping interest rates, and thus setting the stage for the financial crisis. In turn, this caused investors to seek debt instruments that paid a higher rate of return, which then led to the explosion of the mortgage-backed securities market. To meet the ever-increasing demand financial companies and their securitizers became very aggressive in making and purchasing mortgages with lesser credit quality.
Recently I wrote about Robert S. Kaplan, President of the Federal Reserve Bank of Dallas, talking about corporate debt as a potential amplifier in a slowdown. What struck me was his warning about the domestic corporate debt market, which he said, “…reveals more about our nation’s financial health.”
And right now, the debt market is broadcasting a dangerous message: Investors, desperate for debt instruments that pay high interest, have been overpaying for riskier and riskier obligations. University endowments, pension funds, mutual funds and hedge funds have been pouring money into the bond market with little concern that bonds can be every bit as dangerous to own as stocks.”
The tax cuts essentially allowed for large corporations to use that money to buy (back) stock And debt is also increasingly used to fund record stock buybacks, with Mr. Kaplan noting, “It is estimated that a substantial portion of the increase in nonfinancial corporate debt was used to fund share buybacks, dividends and merger activity.[12] This trend has been accompanied by more relaxed bond and loan covenants,[13] which have had the effect of reducing protections for investors,” something I have sounded the alarm about as well.
Mr. Powell emphasized that America isn’t as vulnerable to shocks anymore. “The financial system today appears strong enough to handle potential business-sector losses, which was manifestly not the case a decade ago with subprime mortgages,” he said.
The Federal Reserve is also monitoring the issue closely, holding banks to strict risk-management standards, and using stress tests to ensure their resilience to shocks, he added.
However, let’s be a little skeptical. For some time, many experts, including William (Bill) D. Cohan, a former investment banker and author of several books, including Why Wall Street Matters, have been warning us about the dangers of the corporate debt bubble. Since the financial crisis, “investors have been paying higher prices for the debt of riskier companies and not getting properly compensated for that risk… investors assume that the good times will never end.”
Lest we forget, the Federal Reserve had a significant role in dropping interest rates, and thus setting the stage for the financial crisis. In turn, this caused investors to seek debt instruments that paid a higher rate of return, which then led to the explosion of the mortgage-backed securities market. To meet the ever-increasing demand financial companies and their securitizers became very aggressive in making and purchasing mortgages with lesser credit quality.
And the Fed is abetting this again with its low interest rates!
According to President Trump, “I don’t think we’re having a recession. We’re doing tremendously well. Our consumers are rich. I gave a tremendous tax cut, and they’re loaded up with money.” The President fumed at Mr. Powell for having a “horrendous lack of vision” and suggested the central bank had held the economy back.
However while some economists have cautioned against assumptions about a looming recession but have stressed that the risks are real, Mark Zandi, the chief economist at Moody’s Analytics says, “There’s a thin line between an expanding economy and a recession,” noting a downturn can be triggered if consumer confidence falters. “We’re pretty close to that tipping point.”
Richard Bowen is widely known as the Citigroup whistleblower. As Business Chief Underwriter for Citigroup during the housing bubble financial crisis meltdown, he repeatedly warned Citi executive management and the board about fraudulent behavior within the organization. The company certified poor mortgages as quality mortgages and sold them to Fannie Mae, Freddie Mac and other investors.
