Debt and Malinvestment

Readers may recall our recent article on Variant Perception's special report “Understanding Market Tops”. The report echoes an idea we have discussed on previous occasions as well, namely that the corporate debt market (or more generally, the market for low quality debt, whether it is corporate or state debt) represents the major Achilles heel of the current echo bubble era. One interesting characteristic of the financial asset bubble created by the world's central banks in the wake of the 2008 crisis and euro area crisis is that there seems to be no specific business sector in which bubble activities are concentrated.

In this respect, the current inflationary boom (weak as it is in terms of real economic activity) is different from e.g. the late 1990s mania, which was mainly focused on the technology sector, and within this sector specifically on capital goods producing companies. As an aside to this, the demise of the late 1990s boom provided us with empirical evidence that was perfectly in keeping with Austrian business cycle and capital theory: many of the companies that went bankrupt were investing in the production of capital goods that were temporally very far removed from the consumer goods stage of the capital structure. Examples for this were companies like communications satellite manufacturer Loral or undersea cable producer Global Crossing.

The current boom also differs in this respect from the real estate and mortgage credit bubble that expired in 2007/8, and the concomitant China/commodities bubble. In short, there were two distinct business sectors that could be identified as the focal points of that particular boom, namely real estate and commodities.

The Bernanke/Draghi/Kuroda echo bubble appears far more diffuse, but there are nevertheless a few areas that stand out. One is the explosion in government debt and activities associated with it. Government debt is basically 100% waste, as bureaucracies can only engage in a very rudimentary form of economic calculation by observing prices in the market economy. Essentially they have very little idea of the opportunity costs associated with their spending.

In most cases they are not even interested in whether their spending is economically sensible, because bureaucratic incentives regarding how funds are to be spent are entirely different from those prevailing in the market economy. For instance, a bureau usually must try to spend all the funding it gets in a fiscal year, so as not to create the impression that it will need less funding in the next financial year. Whether such spending actually serves consumer wants is not exactly at the top of the list of priorities. To name two specific areas in which massive state-financed malinvestment is currently underway, there is e.g. the explosion in US student debt, which is a symptom of malinvestment in human capital. Since reportedly a large number of college graduates end up as burger flippers these days, one must assume that a large portion of the funding in this area is wasted.

 

 

student-debt-as of Q4 2013-gTotal US student debt as of Q4 2013. Including forbearance agreements, about a quarter of this debt is probably delinquent by now (officially, it is only half as much, but the official number excludes forbearance) – click to enlarge.

 

TOTALGOV

Consumer loans (mainly student debt) owned by the federal government – click to enlarge.

 

Another area we want to pick out as an example are various government subsidies for 'green' energy projects, which have produced truly abject economic failures. Among those is e.g. the famed Solyndra bankruptcy, which is really just the tip of an iceberg. As reported here, federal 'alternative energy' subsidies reached $154 billion by late 2013, and have produced a string of corporate failures. In other words, the companies concerned were not even able to remain afloat with these subsidies. An excerpt from the article:

 

“In October, the Department of Energy announced $60 million in subsidies for solar energy research and development programs as part of the SunShot Initiative. The primary goals of the program are to reduce the cost of photovoltaic solar energy systems by 75 percent and to double the generation of clean energy in the U.S. over the next 25 years—goals that are probably unachievable.

These announcements come on the heels of the recent bankruptcy of the government-subsidized electric vehicle technology company ECOtality, which received $115 million in federal stimulus grants. Of course, that followed the multimillion dollar failures of solar energy companies Solyndra ($529 million) and Abound Solar ($70 million). With last week’s bankruptcy filing by government-backed hybrid car manufacturer Fisker Automotive, a failure which will cost taxpayers $139 million, the question must be asked: Why is the federal government funneling good taxpayer money to bad companies and failing technologies?

The answer may be that cronyism and influence often decide where these loans and subsidies go.”

 

(emphasis added)

Indeed, as this study published by Reason Magazine (pdf) shows, these federally funded 'green energy dreams' appear to be mainly driven by cronyism and political influence. Although the amounts involved are not as large as those expended on student loans, it is a good bet that far bigger losses are produced on a relative basis. 25% of the student loans outstanding are in danger of default. The value that can ultimately be salvaged from these energy subsidies is likely to represent a far smaller fraction of the money that is pumped in overall.

 

Federal-Electric-SubsidiesFederal energy subsidies by unit of production as of 2010 (note that 'solar' is completely off the chart and not reproduced to scale here), via the Institute for Energy Research, in its report on the 186% (!) increase in federal subsidies for alternative energy in 2011.

 

energysubsidiesA view of energy subsidies by billions of BTUs, via Forbes

 

The Likely Trigger for the Next Bust

When the euro area crisis raged, it appeared that unpayable government debt would become the trigger for the next major bust. Everybody knows of course that the debts amassed by governments will never be paid back. The functioning of government debt markets is entirely dependent on maintaining the illusion that that it can be paid back; market participants must basically be kept in a constant state of hallucination.

This has been achieved by convincing everybody that governments cannot go bankrupt as long as they have a central bank willing and able to print the money required to pay. In other words, the way in which the aforementioned illusion is now maintained is by the admission that the terms of the debt contracts will be violated if need be, by debasing the currencies in which the debt was issued. As Ludwig von Mises wrote on this in 1949:

 

“The financial history of the last century shows a steady increase in the amount of public indebtedness. Nobody believes that the states will eternally drag the burden of these interest payments. It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract.”

 

The fact is though that governments and their monetary authorities have for now succeeded in averting the danger of government default (with a few exceptions such as Greece) by convincing market participants that 'printing their way out of it' is a legitimate and doable ploy and that there is nothing to be afraid of as a result. Market participants in turn want to be lied to, because they don't want to contemplate the alternative, which involves great losses and pain. They have thus convinced themselves that they will be able to recognize in time when monetary debasement reaches the point at which it could endanger their investments in government debt. We wish them good luck.

This leaves corporate debt as the most likely trigger of the next bust, in spite of the fact that a lot of corporate debt must in principle be regarded as more sound than government debt. However, due to the massive monetary inflation that has been pursued by central banks in recent years, we also know that a lot of capital malinvestment must have taken place in the private sector. Unsound debt mirrors these unsound investments, and much of this unsound debt is likely to be found in the 'junk bond' universe.

In this context we have recently mentioned the following chart published by sentimentrader earlier this year. It shows the explosion in leveraged loan issuance.

 

Leveraged LoansIn late 2013 to early 2014, leveraged loan issuance went through the roof. In terms of the terminology mentioned in the title of this post, we call this one 'Sister Madness' – click to enlarge.

The latest monthly issue of EWI's 'Financial Forecast' provides us with a glimpse of the other two sisters, Lunacy and Insanity. The first chart was adapted from a recent Bianco Research report and is really a show-stopper. We thought that junk bond issuance was already in a state of total frenzy prior to seeing these most recent data points, but it seems that we underestimated the situation quite a bit. Meet Sister Lunacy:

 

Junk Lunacy

Global junk bond deal flow, via Elliott Wave International/Bianco Research – click to enlarge.

 

Lunacy is supplemented by insanity, in the form of the issuance of 'covenant lite' debt of various types. This is mainly low quality debt featuring a distinct and deliberate lack of creditor protections.

This market sub-sector includes such bubble innovations as 'payment in kind' toggle bonds, which give debt issuers the opportunity to pay interest to their creditors by issuing additional debt instead of paying cash. If the proliferation of such bonds isn't symptomatic of a giant Ponzi scheme, what is?

EWI presents Sister Insanity in the form of a recent chart published by S&P's Capital IQ Letter, which shows annual sales volumes of first-lien covenant lite loans. 'Covenant-lite loans' are a sub-sector of leveraged loans. By early December 2013, issuance of such loans exceeded the previous annual record achieved at the bubble peak in 2007 by about 150% in nominal dollar terms. The percentage figure indicates the percentage of new leveraged loan issuance that consists of 'covenant lite' debt. This percentage has almost tripled from the previous peak in 2007. Investors are evidently completely oblivious to risk these days.

 

Insanity

Covenant lite loans: another symptom of lending insanity – click to enlarge.

 

Incidentally, the EWI Financial Forecast also mentions that issuance of collateralized debt obligations is once again soaring, with $10.8 billion issued in March, the highest monthly total since 2007.

What can we conclude from this? It actually means that central banks have 'succeeded' beyond their wildest dreams. Investors have been driven into the riskiest investments imaginable by their zero interest policy and the associated pumping up of the money supply.

It also means that we know which area of the market to watch in order to get clues as to when the echo bubble might run into difficulties. Is there such a clue available at this time? Actually, yes – at the very least we can say that there are a few noteworthy warning signs in evidence. In spite of the fact that investors are seemingly completely oblivious to risk and the appetite for high yield debt is still enormous (as the deal flow chart above indicates), high yield bonds have not been able to keep up with the recent rally in treasury bonds and notes.

In short, at the margin, there are the first signs of a move away from risk.  This is demonstrated by the recent deterioration in the JNK-TLT and HYG-TLT ratios (JNK and HYG are ETFs holding junk bonds, TLT is an ETF holding treasury bonds with a maturity exceeding 20 years). In fact, this trend started already at the beginning of this year and is beginning to look rather ominous by now:

 

JNK-TLT

The JNK-TLT ratio and the HYG-TLT ratio: evidence of a move away from risk at the margin – click to enlarge.

 

It is no coincidence that this deterioration in the ratios of high yield debt and treasury ETFs mirrors the recent sharp decline in the ratio of the Russell 2000 to the S&P 500 index. Both are indicative of investors beginning to shy away from risk.

 

Conclusion:

As we always stress, 'QE tapering' is indeed a tightening of monetary policy. It follows from this that various bubble activities should slowly but surely come under pressure. The debt used in financing unsound investments is consequently going to reflect growing risk premiums and decline in value. Since many financial market players use a lot of leverage (a strategy that is especially pronounced in the debt markets), a financial accident of major proportions is eventually going to occur. Although we believe that the point of crisis is getting ever closer, we cannot forecast the timing with certainty. However, there are a few things we can state with great confidence already:

When it happens, everybody concerned, from fund managers to the monetary authorities, will tell us that 'no-one could have seen it coming'. The latter, as well as assorted politicians and pundits will insist that it happened because 'we don't have enough regulations' (a few mavericks will blame the Fed's policies, but their voices will be drowned out).

Another telephone book sized compendium of rules and regulations will be created as a result and yet another new bureaucracy will likely be born as well. All of this will cost untold billions in addition to the losses produced by the downturn. It will make us all less free, while making future financial market crashes more rather than less likely.

 

 
Charts by: Elliott Wave International / Bianco Research/S&P VCapital IQ, sentimentrader, stockcharts, Energy Research Institute, Forbes, LA Times, St Louis Fed
 
 

 

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2 Responses to “Meet the Three Sisters: Lunacy, Insanity and Utter Madness”

  • JE Stater:

    What to worry, added together, the three sisters equate to a yearly run-rate of only 3 trillion in new low-grade debt issuance. Aren’t we too fuddy-duddy?

  • No6:

    at least three companies pulled their leveraged loans in April, Bloomberg reported: that “insatiable” demand had suddenly evaporated.

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