Is 2008 about to repeat?

Dear Readers,

I hope you know that we at IM Cincy are not the type of people that are full of doom and gloom. Nor do we ever intend to cause you stress or panic by our posts. But we are avid readers of The Economist, and we couldn't help but notice two articles in the May 5-11, 2018 publication of that newspaper that paint a less than rosy picture of our current economic situation. Together, these two articles made me wonder, are we about to repeat 2008?

Credit-default swaps (CDS) are being manipulated again.

The first article, Credit-default swaps: Where it's due, discussed how Blackstone, a private-equity firm, used a loan to Codere, a Spanish gaming firm, to profit from some credit-default swaps (CDS) that Blackstone held. You see, the CDS held by Blackstone were on Codere and Blackstone required that Codere miss a debt payment to trigger a technical default on the CDS. Codere agreed to the terms. Blackstone loaned it money. Codere defaulted on a single payment. Blackstone got paid $19 million. Was such action market manipulation? Maybe.

Blackstone recycled this tactic in 2017 when it purchased CDS on Hovnanian, an American construction firm. Again, Blackstone offered Hovnanian a cheap loan in return for a technical default, but Hovnanian was concerned about its financial reputation. So Blackstone outdid itself by having one of Hovnanian's subsidiaries purchases bonds issued by the parent company. Hovnanian then made payments on all its outstanding bonds except those owed to the subsidiary. A technical default occurred, and Blackstone pocketed $333 million.

Blackstone argues that is has played within the rules set by federal regulators. But one can't help but wonder what would happen to the CDS market if more buyers started acting like Blackstone. Then again, maybe the self-destruction of the CDS market is not dangerous. It would indeed simplify global finance until some ingenious financier creates a new scheme for selling complex derivative products to financial institutions.

Corporate debt is losing credibility. 

The second article, Buttonwood: Where will the next crisis occur? notes that "financial crises tend to involve one or more of three ingredients: excessive borrowing, concentrated debts and a mismatch between assets and liabilities." The article then suggests that the "genesis for the next crises" could be corporate debt. The article notes that over a third of global companies are highly indebted, which is higher than the levels seen before the 2008 crises, and the median credit rating of corporate debt continues to decline and is now at BBB-. In other words, the median corporate debt rating is almost junk. And yet, bond investors are not demanding higher yields for such lower quality debt (on government bonds).

The article also notes that the cost of CDS have fallen by 40% over the past two years, although bank models for assessing default risk remain at levels similar to two years ago. Thus, while the risk assessment by banks has remained stable, investors seem to be optimistic about the operating cash flows of corporate issuers.

Finally, the article notes that the higher appetite for risk of corporate bondholders comes at a time of tightening liquidity in the bond market, which is a result of fewer market makers

Does this mean we should panic?

The short answer: I have no idea. But we seem to have all the ingredients for a financial crisis, and more. Corporate issuers have borrowed excessively, along with most governments. Corporate debt is concentrated in a fewer number of public issuers, and fewer market makers are supporting that debt (as noted in the WSJ article: Investors' New Headache: It's Getting Harder to Buy or Sell When They Want). And if we use CDS as a proxy for default, assets and liabilities are decoupling. Add to the mix volatile equity markets, higher oil prices, and the willingness of financial players to manipulate the CDS and corporate debt market, and one could see the current bull market collapsing under a weight of excessive, cheap debt.

Worse, if we do enter a crisis, it will be at a time of intense political discord. But as Carmen Reinhart and Kenneth Rogoff noted in their book published in 2009, maybe This Time is Different.

 

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