Cheap Cash Virus
Black Monday has been triggered by the events that were shaped months before.
The JP Morgan managers every afternoon leave their temporary headquarters in Midtown Manhattan for a lunch in “Casino” bar only three blocks away. “Bull”, “bear” and “crisis” are jokingly named the vegetarian dishes in which top-earners usually delight. But last Monday “Casino” was nearly empty during the lunch hours.
The Dow Jones Industrial Average closed the day with a loss of around 2,000 points Monday, part of a global market rout that saw spiralling sell-offs in the energy sector amid the biggest drop for crude oil since the Gulf War in 1991.
The blue-chip Dow saw its biggest points drop ever, down 7.8 per cent, with the S&P 500 and the Nasdaq down by 7.6 per cent and 7.2 per cent respectively for one of the worst days since the financial crisis.
The fall preceded collapse on the markers from Tokyo to London. The Hang Seng stopped below 25,00 points. The German DAX lost 7.8 per cent. Saudi Arabia index Tadawul lost 9 per cent. The United Kingdom FTSE was down by 9.5 per cent.
Banks policies upset investors
The theory invented by the visibly shocked media pundits focused on coronavirus. The investors did not trust in the government policies, they claimed.
But the recently deceased General Electric manager Jack Welch and investor himself once stated that today’s market reactions were prompted by the events that happened two years ago. Mr Welch tried to explain that investors, unlike politicians, pursue long-term strategies. This is not always true but it explains the sell-off during the last Black Monday.
The pessimism of the investors caused not an oil price fall neither bearish tendency on the markets. Banks policies upset them. When banks or other financial institutions including insurance firms or hedge funds are short of cash they lend it to each other overnight in exchange for collateral like US debt or bonds of other strong economies. This is a so-called “repo” market. It usually is thriving throughout the year and becomes tighter in the last quarter when money is in short supply. These months are particularly difficult for business because banks are tightening credit policies or increasing borrowing cost.
In 2017 Federal Reserve bought trillions of dollars of US government debt to prop up the economy after the financial crisis. It began unwinding that intervention two years ago, taking one of the biggest buyers of Treasuries out of the market.
New buyers had to step in to replace the Fed. These were often banks using their own cash or other investors withdrawing cash from banks to fund the purchases. In both cases, the result was to reduce the cash reserves banks held and therefore to reduce the amount available for overnight lending.
Some buyers used the repo market to fund their purchases, increasing demand just as supply was coming down.
Outstanding stock of non-financial corporate bonds reached an all-time high
In January 2018 The Trump administration lowered the corporate tax rate, which meant lower tax income for the US government and a bigger budget deficit. The US Treasury funded that by selling more debt, which the banks and other investors bought. Once again, since cash was going to buy government bonds, there was less available to lend in overnight markets. By extension, the business started to feel another wave of credit crunch.
The first signs of pressure began to emerge in June 2018 in another short-term lending market. The fed funds rate — which reflects unsecured borrowing between banks, unlike repo where borrowing is secured using collateral — was drifting towards the top of the range set by the Federal Reserve. That worried central bankers, since fed funds is the rate they target to guide the US economy. They could not afford to lose control of it.
Fast forward to 2019 Federal Reserves through the combination of lowering interest rates and other monetary policies pumped almost half a trillion dollars into the financial system over the end of the last year.
A comparison of today’s circumstances with the period before the financial crisis is instructive. As well as a big post-crisis increase in government debt, an important difference now is that the debt focus in the private sector is not on property and mortgage lending, but on loans to the corporate sector. A recent OECD report says that at the end of December 2019 the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5tn, double the level in real terms against December 2008.
Current market volatility exacerbated by banks
Much of the debt is concentrated in old economy sectors where many companies are less cash generative than Big Tech. Debt servicing is thus more burdensome.The shift to corporate indebtedness is in one sense less risky for the financial system than the earlier surge in subprime mortgage borrowing because banks, which by their nature are fragile because they borrow short and lend long, are not as heavily exposed to corporate debt as investors, such as insurance companies, pension funds, mutual funds and exchange traded funds.
The OECD report notes that compared with previous credit cycles today’s stock of corporate bonds has lower overall credit quality, longer maturities, inferior covenant protection — bondholder rights such as restrictions on future borrowing or dividend payments — and higher payback requirements.
Current market volatility is further exacerbated by banks’ withdrawal from market-making activities in response to tougher capital adequacy requirements since the crisis.
Corporate debt of poor quality will be trigger of next recession
Nearly $1.3tn global market are loans arranged by syndicates of banks to companies that are heavily indebted or have weak credit ratings. Such loans are called leveraged because the ratio of the borrower’s debt to assets or earnings is well above industry norms. New issuance in this sector hit a record $788bn in 2017, higher than the peak of $762bn before the crisis. The US accounted for $564bn of that total.
This financing enables buy backs. Executives are interested in this financial engineering which raises earnings per share and secures for them high bonuses. But this practice systematically weakens balance sheets of the firms putting them at risk of default. Cheap borrowing cost can eventually destroy real economy.
Otmar Issing, former chief economist of the European Central Bank, says prolonged low central bank interest rates also have wider consequences because they lead to a serious misallocation of capital. This helps keep unproductive “zombie” banks and companies — those that cannot meet interest payments from earnings — alive.
The IMF’s latest global financial stability report amplifies this point with a simulation showing that a recession half as severe as 2009 would result in companies with $19tn of outstanding debt having insufficient profits to service that debt.
This huge accumulation of the corporate debt of increasingly poor quality is likely to exacerbate next recession. "It's going to be very volatile but around, unfortunately, a downward trend for now," the chief economic advisor at Allianz Mr Mohammed El-Arian commented on the market fall.
Last Monday the investors sent another warning to the political elites.