The coronavirus epidemic has been accompanied by sharp declines in equity values. Share prices have slumped by about 20 per cent around the world since its severity became known.
That is clearly grim news for investors in quoted companies. But it is even more frightening for those pursuing highly leveraged strategies. That decline alone might have eaten through the slender equity cushion shielding their bets from insolvency. It is why a claque of heavily indebted companies in hard-hit sectors — such as airlines and airports — have been loudly imploring governments to bail them out.
Of course, not all companies are to blame for their predicament. Many smaller businesses simply have not built the balance-sheet reserves to endure a prolonged period of zero or limited income. Governments are right to have pursued policies to assist these businesses through cost subsidies and access to capital through guaranteed loan schemes.
But for others high leverage has been a conscious strategy aimed at magnifying returns. They are a major factor behind the extraordinary expansion in corporate borrowing over the past decade, when the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5tn last year, double its level in real terms in 2008, according to OECD data.
It is this population of heavily leveraged companies — especially lower-grade borrowers in the US and Europe — that threatens to magnify the severity of the crisis. Their fragility may lead to more insolvencies, idle assets and dispersals of skilled workforces than would otherwise have been the case.
High leverage makes returns more volatile — both on the upside and the downside. Normally the fear of loss should act as a self-regulating check on excessive borrowing. But monetary policy has in recent decades short-circuited this mechanism, with the authorities supporting markets when they plunged but failing to damp them down when they inflated bubbles. Excessive risk-taking consequently cascaded through the financial system, creating a web of incentives that encourage the bosses of enterprises to take on more debt.
None of this would come as much surprise to the American economist Hyman Minsky, who died in 1996. He noted how prudent financial arrangements can give way to what he called “Ponzi finance”, which is where borrowers are unable to service their debts or repay principal out of current income. Ponzi borrowers depend on refinancing against the collateral of rising asset prices to stay afloat.
Long before economists were hailing the era of the “great moderation” of low inflation and stable growth that preceded the financial crisis, Minsky argued that stability itself was destabilising because people responded to the good times by changing their risk-taking behaviour.
Just how Ponzi-like the markets have now become is revealed in some analysis from Matthew Mish, global credit strategist at UBS. This looks at how the riskiest borrowers — many backed by private equity — have massaged a measure known as ebitda — earnings before interest, tax, depreciation and amortisation — to appear more creditworthy and hence able to take out bigger loans.
Perhaps the most ludicrous example was when the US office-sharing company, WeWork, turned a $933m loss into $233m of what it termed “community-adjusted ebitda” (by basically excluding most of its core operating expenses). Such corruption has filtered through the ranks of lower-grade borrowers — especially those in the $1.3tn market for leveraged loans, much of it in the US.
Mr Mish estimates that in the context of a virus-induced recession lopping, say, 20-25 per cent off the ebitda of such borrowers, the actual fall could be of the order of 40 per cent, simply “due to the unmasking of aggressive accounting practices”. A balance sheet meltdown on this scale could lead to a surge of defaults and bankruptcies.
Yield-chasing investors may have accepted ebitda fictions in the good times, but are now less trusting. Spreads in the markets for leveraged and other high-yield loans have ballooned and issuance has sharply declined.
With economies in lockdown, much depends on the profile of the recession. The early discovery of a vaccine might permit a rebound. A longer lockdown would not just cause more financial damage, it might change consumer behaviour in ways that were detrimental to some established business models.
Minsky believed that crises were important in making people more cautious. So the Great Depression made the next generation of Americans more risk-averse, while New Deal reforms made the financial system much safer.
Since the 2008 crisis, change has been superficial. The too-big-to-fail banks have become even more humongous. Private equity, with its cavalier approach to limited liability, has expanded to absorb an ever greater slice of an increasingly leveraged corporate sector.
Whether this is yet a “Minsky moment” is not certain. But the bigger lesson is an old one: Trends that cannot go on forever, do not. When the virus has passed, we need to restore more respect for financial risk.