Dangerous Debt Bomb? A Little Premature

Milton Ezrati

Chief Economist

Most everyone these days wants to be the person to call the next collapse.  The desire is seemingly so powerful that newsletters and the media across the spectrum have of late filled with warnings of impending recession and threats of a 2008-like financial crash.  Ex-Federal Reserve (Fed) chair people Alan Greenspan and Janet Yellen have even got into the act. Of course those calling for recession are correct after a fashion. One will arrive, though not as immediately as they suggest.

On the financial side of things, the fear de jour seems to have centered on corporate debt.  In ominous tones, newsletters and articles tell us that debt has gone too far. They offer in evidence statistics about how the U.S. bond market has doubled in size over the last ten years and that leveraged loans have done as much in just the last six years. They link such seemly scary figures to descriptions of how high valuation ratios have become, especially the prices paid for buyouts.  The picture of financial collapse seems to paint itself before the reader’s eyes even without an explicit statement from the writers or speakers.

No one could deny that valuation ratios are high.  That explains why the stock market shows such fragility in the face of any scrap of adverse economic news.  On this basis alone, it should be clear that the great rally is near its end, though not necessarily at an end. On the financial excesses, however, a little perspective might help.

For one, a “doubling” in ten years amounts to an expansion of 7% a year. That is faster than the economy, to be sure, but not faster than earnings growth on average during this time. The picture sounds even less ominous when set against historic patterns. According to the Fed, non-financial business debt more than doubled in the 1980s, grew only slightly slower in the 1990s, by 75%, and about doubled again during the first decade of this century. As it is, non-financial business borrowing has actually begun to slow, growing during the last three years at a 6.1% annual rate, considerably slower than the 7.0% annual rate needed to sustain the earlier pace. The doubling of leverage loans in six years does carry more worrisome meaning. It amounts to about a 12% a year annual pace of expansion, but still not the sort of thing that constitutes a threat to the banks or the financial system.

Even if overall debt growth had exceeded historical rates, it should hardly surprise or seem dangerous. During most of this recent ten-year stretch, the Fed has kept rates and yields inordinately low. Any business manager worth half of his or her pay package could see an opportunity that would not likely recur for a long time to come. It simply made good sense to lock in debt on such attractive terms even if the borrowing firm had no immediate use for the funds. It even paid if for a time the firm invested the borrowed funds at lower rates than it had to pay.  On the leverage loans, the banks embraced these because the past crisis had created so much regulatory scrutiny elsewhere and rates were so low on so many other sorts of loans.  Even this is not necessarily as ominous as it sounds.  What matters is how the borrowed funds were used, and on this score, things look reasonably well balanced.

It seems that much of the bond borrowing went to pay down other debts. This would fit well with the notion that business borrowed to lock in low yields while it could.  They issued bonds to retire older, higher-yielding obligations, bonds issued years before, perhaps, as well as bank loans and trade credit. So even as bond issues expanded at about 6.1% annual rate during the past three years, the overall liabilities of non-financial business grew at only a 2.1% annual rate. Accordingly, non-financial business’ net worth, the Fed statistics show, increased at a 3.3% annual rate. Business also used the cheap borrowing to extend easy trade terms to others.  According to the Fed, trade receivables during the last three years expanded at more than a 5.0% annual rate.

It is also apparent that a sizable portion of the money flow from new bond issues went into stock repurchases.  The Fed reports that in just the last three years, corporate equities on the books of non-financial corporate business have increased almost 6.0% a year.  Of course, not all of this reflects stock repurchases.  Nothing prevents one corporation from buying stock in another, even when it plans no takeover. And price appreciation over this time has also had its effect.

Most of the skepticism centers on share repurchases and how the high prices firms paid for acquisitions distorted important financial ratios. Fed tracking, however, raises doubts on this score as well.  According to those authoritative figures, debt-to-equity ratios on non-financial corporate balance sheets have actually improved over the last three years, despite the share repurchases, falling from just under 35% in mid-2016 to just over 30% in this year’s third quarter, the most recent period for which data are available. Debt to net worth has risen but only marginally from 37.1% in 2016 to 37.9% at the close of the third quarter.  Equity to net worth has, unsurprisingly, soared, rising from 106.3% in mid-2016 to 123.8% at the close of this year’s third quarter.

The sky may indeed be falling and perhaps only a select group of very clever commentators can identify the bits as they crash to the earth.  That is possible.  But the full array of figures available paint a different picture. They suggest that business finances today present no threat to system stability. In time, as future economic growth gradually exhausts the room left to sustain it, the business community will no doubt succumb to balance sheet temptations. These will throw matters out of balance and could precipitate systematic financial trouble. That would be a typical cyclical pattern.  But as of the closing weeks of 2018, few signs of such behavior have emerged, suggesting that the economy and its financial markets face no such problems imminently.

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