Bare Talk named two vulnerabilities in the global economy last week. One was debt in developing nations, especially external debt. The second vulnerability was the rise in non-financial debt in the US. Last week, we examined the first, and, this week, we take up the second. Commercial borrowing and its securitization in the US have now assumed dangerous proportions, like mortgage loans and their securitization in 2008.
M&T Bank is a small but solid community bank in the US which had assets of $118.6 billion at the end of December 2017. It has banking offices in New York State, Maryland, New Jersey, Pennsylvania, Delaware, Connecticut, Virginia, West Virginia and the district of Columbia. In 35 years up to 2017, “investors in M&T stock enjoyed a more than 126-fold appreciation in M&T’s stock price, which equates to a 15% compounded annual growth rate.”
Rather unusually for such a profitable bank in a year in which US economic growth held steady and even went up a notch, its commercial and industrial loan (C&I loans) assets declined 4% in 2017. These merely reflected national trends. The median comparable loan growth rate for its peer banks was only 1% during the first three quarters of 2017, slower than the 3% growth rate in 2016. The rate of growth in C&I loans made by banks has gradually declined over the last three years , reaching a meagre 1.2% in 2017.
A growing share of C&I loans has migrated to capital markets—loans underwritten by investment banks and shadow banks such as asset managers sponsored by private equity and hedge funds. These bonds are not held by underwriters. They are sold onwards to insurance companies, public mutual funds, private loan funds and many other vehicles.
In the first three quarters of 2017, nearly 60% of the business credit of $412 billion raised was in the form of corporate bonds. Banks’ C&I loans were only $35 billion. The 25 largest domestic banks in the US that hold half of all C&I loans, nearly $2 trillion in total, extended only $5 billion of them. In addition, credit market excesses have accompanied this shift in the source of lending to capital markets. Savour the facts: (1) US corporations issued a record $1.6 trillion in bonds during 2017, with the volume of bonds issued by firms lacking an investment grade credit rating reaching a level more than double that prior to the financial crisis.
(2) The volume of new loans to companies with high levels of debt, or so-called leveraged lending, reached a new record of $1.4 trillion during 2017, also more than double the pre-crisis amount.
(3) “Covenant-lite” (looser credit standards, in simple English) loans comprised less than 5% of issuance as recently as 2007, prior to the financial crisis; this increased to 75% in 2017.
(4) The relaxation in standards that began with the largest companies has extended to borrowings by smaller firms. For example, 36% of syndicated loans to middle market firms in 2017 were considered “covenant-lite”, up from 15% just one year prior.
Worse, the problem of high debt in non-financial businesses is global. A recent report by Moody’s (Weekly Credit Outlook, 28 May 2018) notes: “About 60% of global non-financial companies are now rated speculative grade, with the highest proportion ever, over 40%, rated B1 or lower. Global speculative-grade companies have $3.7 trillion in rated debt outstanding, of which $2 trillion is in deep speculative grade with ratings of B1 or lower.”
For the first time in this cycle, in their financial stability assessment presented to the members who vote on monetary policy at the Federal Reserve, staff at the Federal Reserve have characterized the vulnerabilities associated with non-financial sector leverage as elevated. Pointing to the absence of wage pressures, these voting members are signalling to financial markets that they would respond with aggressive rate action only if the inflation rate was persistently above 2%. Interest rates that are too low for too long contribute to debt accumulation and financial instability. Policymakers are being hostile to this lesson from the crisis of 2008. After doggedly advising the Federal Reserve and the European Central Bank to keep interest rates at very low levels in 2015 and 2016, the International Monetary Fund sounded the alarm on excessive global debt in April 2018, as though it was an innocent bystander to the phenomenon. Boggles the mind.
Absence of wage pressures is a sign of unequal balance of power between capital and labour. Monetary policy compounds this by pussyfooting around raising rates, forcing workers to make up for lack of income gains through debt and allowing the rich to lever up their wealth through asset markets. According to the AFL-CIO Executive Paywatch, in 2017, CEO pay at S&P 500 Index companies increased 6.4% to a total of $13.94 million. In contrast, production and non-supervisory workers received a paltry 2.6% raise, earning on average just $38,613—a CEO-to-worker pay ratio of 361:1.
It is both easy and silly to blame populists for being what they are and for winning elections. The source of their success lies in the denial of the culpability of non-populist, unelected and unaccountable policymakers for the economic malaise that populists tap into. Here is hoping that it does not take another crisis for them to realize the follies of their ways —something that the crisis of 2008 has evidently failed to achieve.
V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Thegoldstandardsite.wordpress.com. Read Anantha’s Mint columns at www.livemint.com/baretalk
Comments are welcome at baretalk@livemint.com.