Coronavirus has shaken our relaxed attitude to financial risk
The coronavirus epidemic has been accompanied by a sharp drop in stock values. Stock prices have fallen around 20% globally since its severity was known.
This is clearly bad news for investors in listed companies. But it’s even scarier for those who pursue high leverage strategies. This drop alone could have eaten away at the thin cushion of capital protecting their bets from insolvency. That’s why a clique 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 small businesses simply have not built up their balance sheet reserves to support an extended period of no or limited income. Governments are right in pursuing policies to help these businesses through cost subsidies and access to capital through guaranteed loan programs.
But for others, high leverage has been a conscious strategy to boost returns. They are a major factor in the extraordinary expansion of corporate borrowing over the past decade, when the global stock of non-financial corporate bonds hit a record high of $ 13.5 billion last year, or double its level in real terms in 2008, according to OECD data.
It is this population of heavily indebted businesses – especially sub-prime borrowers in the United States and Europe – that threatens to amplify the severity of the crisis. Their fragility can lead to more insolvencies, unused assets and dispersal of skilled labor than would otherwise have been the case.
High leverage makes returns more volatile, both upward and downward. Normally, fear of loss should act as a self-regulating control over excessive borrowing. But monetary policy has bypassed this mechanism in recent decades, with authorities supporting markets when they plunge but not restraining them when they inflate bubbles. Excessive risk-taking has therefore spread through the financial system, creating a network of incentives that encourage business owners to take on more debt.
None of this would surprise the American economist so much Hyman Minsky, died in 1996. He noted how prudent financial arrangements can give way to what he called “Ponzi finance”, that is, where borrowers are unable to repay their debts or to repay the principal with their current income. Ponzi borrowers depend on refinancing against collateral for rising asset prices to stay afloat.
Long before economists hailed the era of “great moderation” of low inflation and stable growth that preceded the financial crisis, Minsky argued that stability itself was destabilizing because people reacted. at the right times by changing their risk-taking behavior.
An analysis by Matthew Mish, global credit strategist at UBS, reveals how similar the markets have become to those of Ponzi. This examines how the riskier borrowers – many of whom are backed by private capital – have applied a measure known as ebitda – earnings before interest, taxes, depreciation, and amortization – to appear more creditworthy and therefore able to take out larger loans.
Perhaps the most ridiculous example is that of the American office-sharing company, WeWork, which turned a loss of $ 933 million into $ 233 million of what it called “the adjusted ebitda in. community function ”(essentially excluding most of its basic operating expenses). Such corruption has filtered through the ranks of substandard borrowers – especially those in the $ 1.3 billion leveraged loan market, much of it in the United States.
Mr Mish estimates that in the context of a virus-induced recession reducing, say, 20-25% ebitda for these borrowers, the actual drop could be in the order of 40%, simply “because of the unveiling of aggressive actions. accounting practices ”. A balance sheet collapse of this magnitude could lead to an upsurge in defaults and bankruptcies.
Yield-seeking investors may have accepted ebitda fictions in good times, but are now less confident. Spreads in the leveraged and other high yield loan markets exploded and issues fell sharply.
With frozen economies, it all depends on the profile of the recession. The early discovery of a vaccine could allow a rebound. A longer foreclosure would not only cause more financial damage, it could change consumer behavior in ways that are detrimental to certain established business models.
Minsky believed that crises were important in making people more careful. So the Great Depression made the next generation of Americans more risk averse, while the New Deal reforms made the financial system much safer.
Since the 2008 crisis, the change has been superficial. Banks too big to fail have grown even bigger. Private equity, with its cavalier approach to limited liability, has expanded to absorb an ever larger share of an increasingly indebted corporate sector.
Whether this is still a “Minsky moment” is not certain. But the biggest lesson is an old one: Trends that can’t last forever, don’t. Once the virus has passed, we must restore more respect for financial risk.