Wednesday, October 8, 2008

the spectre of debt maturities

A spectre is haunting the markets -- the spectre of maturing debt.
All the powers of the finance have entered in a holy alliance to exorcise this spectre: Fed and Treasury, ECB and BOE, Liberal Democrats and Conservative Republicans. Where is the liquidity package that has not already been extended by its opponents in power? Where is the repurchase agreement that has not tried to hurl back the branding reproach of a frozen interbank market, against the more advanced stages of asset-price declines, as well as its reactionary writedowns? Two things result from this fact:

1-Maturing debt has been acknowledged as something that comes due.

2-It is high time that corporate bond investors should openly, in the face of the whole world, refuse to buy new issues. They have long been jammed with every forced renegotiation (a la Charter Communications), insulted with every credit-rating-ruining LBO (sungard), and left out in the cold while activist shareholders take their money and rebuild capital structures in their own image (home depot, time warner).

this little imitation of the opening lines in Marx's Communist Manifesto is dedicated to the logjam developing in the primary market for corporate bonds. if left unsolved, it will turn into a catastrophe in 1-2 months. I spoke to several market insiders today. "it's all anyone talks about," said one. in the last 2 weeks, the corporate bond market as we know it has shut down. normally we would see $10-15bln of issuance per week this time of year. now the only companies that dare the market are AAA-rated suprantionals like the European Investment Bank, or utilities that pledge their physical assets as collateral. in other words, investors are willing to lend to only the highest quality issuers. banks and financials, with 100s of billions of debt coming due, are locked out of the market. they are now turning to the Fed as a true lender of last resort... but this can only last for so long.

most people have no idea how menacing this spectre is. for the last 30 years, they have simply taken the bond market for granted. companies borrow billions everyday, and most financial reporters and stock investors don't even think twice. well, now the time is coming to get worried.
one strategist at a major investment bank told me that if the deal flow doesn't revive by the end of the month, issuers will start attaching all kinds of incentives -- such as put features and stricter covenants -- to bonds to get them sold... and that would be in addition to selling them at rock-bottom prices. all of this will drive the value of existing debt lower and force them to take growing losses. that means buyers are now on strike... they fear lower prices, so they demand cheap prices on new deals, creating a self-fulfilling prophecy and a vicious cycle.

interestingly, the Fed is going to lend AIG about $38bln, and will accept AIG's holding of investment-grade corporate bonds as collateral. this is apparently some kind of emergency power to support AIG, but not the bond market itself. this is a single step in the necessary direction, which I discussed in the posting immediately before this one. basically, the government needs to buy straight corporate bonds to get issuance moving again and to take pressure off the beleagured banks. it's a needed step to precent the next closet full of shoes from droppping in the credit market.

I have been arguing that instead of buying toxic mortgage assets, henry paulson should announce broad price supports in the corporate and municipal bond market. he should simply declare "official levels" at which he will buy bonds. .. maybe something like this:

AAA debt is "worth" t+100bp
AA is "worth" t+150bp..
A is "worth" t+200bp
and all the way down the rating spectrum.

once this happens, other buyers will be confident and the money can flow again.

interestingly, this would give the taxpayer garranteed upside because the government borrows at the treasury rate (here denoted as "t".) imagine I say you can borrow at T, and lend it at t+2%. no matter what T is, you make money. it's simple "carry trade"... the only risk becomes default risk... while this is a cost, it's already something the government must worry about... if a company fails, tax revenue goes down and unemployment goes up.

right now, companies have been forced to draw down bank lines to pay off their maturing bonds. that is putting more pressure on the banks at the very same time they cannot lend, creating a huge logjam at our banks and overnight financing market.

US banks are already troubled and look increasingly insolvent. fixing them will take years. that means we need to find ways to reduce their importance in the economy. we must help companies roll over their massive looming maturies. this spectre of maturing debt is haunting the market but has not yet inflicted its real turmoil. in 2-3 months, it will. and, the damage is beyond anything people can grasp. when companies run into problems with bondholders, their shares quickly approach 0.

look at the chart below of RH Donnelley, a printing company that took on heavy debts to expand. things didn't work out very well and investors worry about its ability to service its debt over the next few years... that drove the stock from over 80 to less than 5 in less than a year. it's now under 2.

every stock that runs into debt problems looks the same ... just a straight line down to 0 as investors dump shares wholesale. after all, the bond investors have a contractual right to get their money back first. they own the company and the shareholders only have what's left afterwards ... the so-called "residual" rights. (it's like if you paid $200,000 for a house and put $40,000 down. if you sell it for $150,000, your $80,000 equity is now worth precisely $0...leverage works in both directions.) in fact, judging by the complete death of hope in recent trading days, I think this process is already starting.

I heard former Fed governor and princeton professor Alan Blinder just say something very worrying on charlie rose. speaking of the Fed:

"they are going to keep at it doing things until the crisis is over."

since when is flailing about hopelessly, casting off liquidity in every direction, a valid policy?


Blinder also observed that the fed's rate cuts are having little impact on the economy. I think he misses the point that the Fed's rates have been disconnected from the economy for years now. when the bubble was inflating, greenspan decried the "conundrum" ... he would raise interest rates and long-term rates would continue to fall.

now we cut rates, and borrowing costs continue to rise....

the Fed has lost control of the US economy. I think we might actually be seeing the death of monetarism... this is the belief system of milton friedman.. the idea that "inflation is always and everywhere a monetary phenomenon."

in economics, the words "always" and "everywhere" make me nervous. they smack of religious faith or revelation. I fear we need to go back and check some assumptions, and realize that some major cracks are appearing in the monetarist altar.

first, I think monetarism doesn't appreciate international capital flows. it views economies as little fiefdoms in which central banks rule as absolute authorities. it assumes that they have complete control over money supply, or liquidity. that's why liquidity INCREASED in the US economy in 2005-6, even as the fed was "tightening"... why? because foreigners were flooding our country with money as they recycled huncreds of billions of dollars they had from selling us barbie dolls, fresh salmon, pharmaceutical chemicals, and of course oil.

second, monetarism seems too focused on official banks. for the last 5-10 years we have allowed hedge funds and asset-backed issuers to create a shadow banking system. what good does it do to raise the Fed funds rate when they can borrow for free in yen and plow that money back into the US economy? the big story in the last 5-10 years is that financial markets have taken over much of banks' important role. policymakers should not confine their actions to the banking system. the bond market is more important to the economy now than ever before.

I fear we will cling to the same religious tenets of monetarism, trying to "inject liquidity" into the banks, when the real danger is now growing in the debt capital market. companies have real liabilities coming due. we need to address this looming spectre of maturing debt.. the longer we wait, the harder the solution will be and the greater the stock price declines. the government needs to buy corporate bonds soon, or we could face the collapse of many leveraged companies in the stock market.

I will end on one final medical anology... our economy has cancer... the banks are going insolvent. it's a long-term disease that can be treated. but now the cancer has caused nausea and the patient vomits... as he throws up, he inhales some of the vomitus back into his lungs and cannot breathe.

any doctor would immediately focus on clearing the airway ... he wouldn't just stick with the regular regimen of chemotherapy. our economy now is starting to choke on all this maturing debt. it's happening at the state, local and corporate levels. these entities employ tens of millions of people and pay trillions of dollars to workers and vendros . these guys ARE the economy. we cannot let them choke. we might be able to cure the cancer, but the patient needs to survive the next 5 minutes, or much more will be lost.


Mike RHD said...

Not sure how you can even imply that RH Donnelley is in "danger of bankruptcy." True, our company is carrying a large debt load, but our yearly free cash flow (around $500 million) enables us to easily fulfill all debt obligations. And we don't have any major debt maturities for a couple of years. I'd recommend your readers review Barron's take on RHD ( before jumping to the wrong conclusion about our business.

David said...

I appreciate the feedback from mike RHD and will amend my comments. I did not examine RH Donnelley carefully before writing that and was trying to make a broader point above leveraged companies. I apologize for generalizing about his company.