CURRENT POLICIES IN WASHINGTON AND ELSEWHERE WILL LIKELY LEAD TO ONE OF THE MOST DEVASTATING RECESSIONS/DEPRESSIONS IN HISTORY - By W. Sherman Rogers

An article my professor W. Sherman Rogers wrote about the risk of the next economic recession or depression that I thought was worth sharing with others.

CURRENT POLICIES IN WASHINGTON AND ELSEWHERE WILL LIKELY LEAD TO ONE OF THE MOST DEVASTATING RECESSIONS/DEPRESSIONS IN HISTORY

THE SEEDS FOR WHAT COULD BE THE GREATEST FINANCIAL CRISIS EVER ARE BEING SOWED RIGHT NOW (7-4-18)

By

Professor W. Sherman Rogers

This is a friendly warning to all my friends. You may want to begin reducing the balances on your credit cards and other debt obligations immediately. The giant global credit bubble will pop. It’s hard to say WHEN it will happen or what will cause it to happen. Perhaps it will be oil prices topping $100 a barrel or some other event. Trying to figure out what will cause it to happen is a fool’s errand. Pretending it won’t happen is folly. See generally, Steven Pearlstein, The Buyback Economy and the Next Big Bubble, Washington Post, June 10, 2018, sec. G1.

THE BIG PROBLEM THAT WILL EVENTUALLY MATERIALIZE:

THE GLOBAL DEBT PROBLEM

The global economy is now awash in debt — not just (1) CORPORATE DEBT but also (2) record amounts of GOVERNMENT DEBT, (3) HOUSEHOLD DEBT and (4) INVESTOR DEBT — at a time when interest rates are rising from historically low levels.

GOVERNMENT DEBT

Here in the United States, as a result of a misguided and irresponsible tax cut, the federal budget deficit is expected to top $1 trillion a year in 2019, on top of the $20 trillion of outstanding debt, crowding out other borrowing and putting upward pressure on interest rates. The Congressional Budget Office projects that interest payments on the federal debt will grow from $316 billion this year to $915 billion by 2028. Not only does the new debt need to be financed, but trillions of dollars in old debt will also need to be refinanced when it comes due.

HOUSEHOLD DEBT

And then there is household debt. After the last financial crisis, American consumers made a concerted effort to save more, borrow less and pay off credit card and auto loan debt. But memories are short, and a decade later, mortgage debt, credit card debt, student loan debt, and car loan debt are all, once again, at record levels and growing briskly. Among the 38 percent of households with credit card debt, the average balance is nearly $11,000, according to ValuePenguin, based on data from the Federal Reserve. The Consumer Financial Protection Bureau recently reported that, among subprime borrowers, credit card debt is up 26 percent in just the past two years.

INVESTOR DEBT

There is also the debt that investors large and small take on to buy stocks, bonds, derivatives and other securities. That’s also at an all-time high.

CORPORATE DEBT

Investment bankers estimate that corporations will spend $1.2 trillion in buying back their company’s stock in 2018. This exceeds the Gross Domestic Product (GDP) of all but 15 nations in the world.

At least 1/3 of the corporate buybacks are being paid for by corporations going into debt and borrowing money— by selling junk bonds to the public—to finance the buybacks “despite record corporate profits and cash flow”.

In 2008, there were $2.8 trillion in outstanding bonds. Today, there are $5.3 trillion in outstanding [corporate] bonds.

In recent years, a greater part of corporate borrowing has come in the form of bank loans that are quickly packaged into securities known as CLOs (collateralized loan obligations) which are sliced and diced into and sold off to sophisticated investors just as home loans were during the mortgage bubble in 2008.

“And as happened with the late-cycle home mortgages in 2007 and 2008, analysts are noticing a marked decline in the quality of loans in the CLO packages, with three-quarters of them now without the standard covenants designed to reduce the chance of default.” [PLEASE READ CHAPTER 11 OF MY BOOK—

WINNERS AND LOSERS IN THE AMERICAN CAPITALISTIC ECONOMY: A PRIMER AT PP. 411-430]

As a result of this borrowing, more than a third of the largest global companies are now classified as “highly leveraged”—i.e., they have at least $5.00 of debt for every $1.00 earnings—WHICH MAKES THEM VULNERABLE TO ANY DOWNTURN IN PROFITS OR INCREASE IN INTEREST RATES.

In the past, most corporate loans were made and held by banks, while corporate bonds were held by pension funds, insurance companies and mutual funds that held them to maturity, keeping bond prices stable.

But with the rise of Bond ETFs—Exchanged Traded Funds composed of bonds that have made it easier for individual investors to participate in the corporate bond market—some market analysts and observers have begun to worry about what would happen if, in response to a sudden spike in interest rates or defaults, large numbers of individual investors rushed to sell at a time when nobody is interested in buying, sending ETF prices into a tailspin.

As Stephen Blumenthal of CMG Capital sees it, this is the “mother of all credit bubbles.” And with the Federal Reserve and central banks now bringing the supply and cost of credit back to normal levels, and with demand for credit continuing to soar, heavily indebted businesses, governments and households will soon be hit with big increases in interest payments. As interest payments begin to crowd out spending on other things, the economy will slow.

We’ve seen this self-reinforcing downward cycle before, and it invariably leads to market sell-offs, loan defaults, bankruptcies, layoffs and, quite likely, recession.

Although banks are in better shape than in 2008 to withstand the increase in default rates and the decline in the market price of their financial assets, they are hardly immune.

“Banks will reap what they have sowed in having created all this debt,” said James Millstein, an expert in corporate and government debt who oversaw the restructuring of insurance giant AIG for the treasury during the 2008 financial crisis. “Banks are still the most highly leveraged financial institutions in the economy. They remain vulnerable to a recession-driven increase in delinquencies and defaults in their corporate, real estate and household loan books.”

It’s hard to say what will cause this giant credit bubble to finally pop. A Turkish lira crisis. Oil prices topping $100 a barrel. A default on a large BBB bond. A rush to the exits by panicked ETF investors. Trying to figure out which is a fool’s errand. Pretending it won’t happen is folly.