Anxious Krugman: "The Bond Market Warning Us of Turbulence Ahead"(was Re: NY Times: clueless on Argentina)
Henry C.K. Liu
hliu at SPAMmindspring.com
Fri Nov 24 18:24:49 MST 2000
Krugman is on target that the US ecnomy is heading for a credit crisis. This is
particularly true for the communication sector.
US investors looking for guidance are starting to heed recent distress signals in
the bond market - a storm for the United States capital markets that may be tougher
to recover from than the debacle in the
autumn of 1998. Then, a crisis was precipitated by the demise of one giant hedge
fund, Long-Term Capital Management, while HK had to make a massive incursion into
the equity market. But after the Federal Reserve Board lowered interest rates,
recovery came swiftly to the US stock market and the US economy was relatively
unscathed. This time around, the turbulence will be set off by many troubled
companies buckling under the weight of excessive debt lent to them at the height of
New Economy euphoria.
As worried investors continue to shun corporate bonds as they turn away from risk,
companies will find it impossible to further raise the capital that leads to new job
creation and continued economic growth.
And since much of the economic growth in this nation over the past few years came
from the big money spent by companies that had raised cash in the anything-goes bond
market, the economy could slow quite sharply as the money spigots go dry.
Greenspan's soft landing is turning into a hard one, and what is worse, the attemp
to engineer a soft ending has used up the entire runway. As more and more companies
go under, their woes could turn a soft economic landing into a crash. And the
longest American expansion on record could come abruptly to an ugly end. Even if
Greenspan can manage a soft landing, corporate fixed expenses have built up during
this nine-year period of prosperity and will be hard to roll back, so that a minor
shortfall in revenues will cause a major shortfall in profits.
The bond market's condition has implications for interest rate policy as well.
Before the Fed can cut rates, it must weigh the decline in credit quality against
the need to get the market moving again.
The corporate debt market has grown enormously in recent years, expanding to
accommodate the burgeoning capital needs of hundreds of companies. Although most
investors focus on the stock market, the corporate bond market dwarfs it in size. So
far this year, companies have raised only $146 billion from new stock issues,
compared with $935 billion in the corporate bond market. The peak of corporate
issuance came in 1998 when $1.2 trillion worth of bonds came to market, up from $433
billion raised in 1995.
Just last Tuesday, ICG Communications, a telecommunications and internet service
provider in Englewood, Colo., filed for bankruptcy.
Its stock had traded as high as $39 last March, with $2.2 billion in long-term bonds
on its balance sheet before the bankruptcy. On May 17, GST Telecommunications, a
Vancouver voice and data services
provider, declared bankruptcy. Although Time Warner bought its assets, it paid only
70 percent of the book value of the company's plant, property and equipment. That
left just 50 cents on the dollar for
Bond investors appetite for risk has shrunk markedly. The total amount of money
raised in high-yield bonds this year will probably be around half the $99.7 billion
raised in 1999. In October, only seven
high-yield bond issues came to market, raising a total of $1.63 billion. In October
1999, 17 high-yield bond issues raised $3.3 billion from investors. Such bonds now
yield 13.34 percent, up from the 10.3 percent demanded by investors in September
1998, when Long-Term Capital Management was sinking and the capital markets stood
still. And high-yield bonds are trading at yields that are almost 9 percentage
points higher than comparable Treasury securities.
Today's high yields and high spreads suggest that investors realize that many
companies issuing high-yield debt confront much greater risks than they faced two
years ago. That is because in the crisis of
1998, even though one big participant was teetering, the overall balance sheets of
most issuers remained healthy. Then, the underlying credit fundamentals of
high-yield companies were better than they are
now. A recent report on heavy debt among telecommunications companies argues that
the market's current problems are tied to declining credit quality of underlying
issuers that have continued to add leverage in the face of falling growth rates.
Last year, 89 companies with debt that was rated defaulted on $24.2 billion in
securities; so far this year, 85 companies have defaulted on almost $24.7 billion of
debt. In 1991, when the country was in a
recession, 65 companies defaulted on $19.8 billion of debt. Adding to the unease
over the higher default figures of today, companies are defaulting on their bonds
more quickly than they have historically.
84 of the 152 bonds that defaulted this year were issued in 1997 and 1998. That's 55
percent, which is very significant. For most of the 1990's, high-yield issuers have
defaulted in four years on average,
not the two to three years that is becoming common. What these companies are running
into is an unaccommodating market just when they need to refinance. Between 1991
and 1997, lenders holding unsecured debt those that stand well back in the
creditors' line got back on average 40 cents on the dollar invested.
But, in the past three years, unsecured lenders have received 23 percent less on
average, or 31 cents on the dollar, because defaulters are so overextended. Credit
ratings of once high-quality corporations
seems to have collpapsed overnight. Investors fear that the woes of such blue chips
may signal a looming recession.
The high-yield bond market, where companies of questionable credit strength go for
money to fund their operations, has grown from $213 billion 10 years ago to $508
billion today far beyond the growth of
the economy. Naturally, as the market ballooned, so did the risks.
Besides the dot coms, an economic backbone sector like telecommunications, most of
the money needed for expansion has been raised in the high-yield bond market.
Telecommunications bonds made up an astonishing 18.6 percent of the market on Sept.
30. The next industry group, cable television, had just 8.63 percent. The telecom
area is venture capital masquerading as high-yield with only future earnings to
point to. Now, those earnings are in doubt.
Capital spending by telecom companies has never been done before in an unregulated,
free-market environment. This is significant because regulated industries can bank
on guaranteed income from consumers that can be used to pay interest on the debt
amassed to build the projects.
But given the intense price competition in telecommunications, lucrative cash flows
from customers are no sure thing.
That makes many of these bonds precarious indeed.
The precipitous decline of technology stocks in recent months is also contributing
to the high-yield bond market's woes. That is because investors who were willing to
lend to speculative companies took some
comfort in their holdings as long as these companies' stocks and overall market
value were riding high. Many of these companies have continued to add debt at a
consistent pace, but their market values have stopped growing or are growing at a
slower pace. As a result, the market leverage of the companies has grown rapidly and
so has their probability of default.
Other indebtedness that is not easily identified is growing at many corporations.
These less visible forms of debt include so-called vendor financing, increasingly
popular at technology companies, and
syndicated lending by banks to new companies. Last month, Lucent warned investors
that it was increasing its expenses to cover bad debts from its customer financing.
The news sent Lucent's stock
reeling, and it dropped 32 percent in a single day.
Syndicated lending by banks is also largely hidden from investors' views. FDIC
found classified credits, loans that are defined as substandard, doubtful or lost,
increased by almost 70 percent this year over 1999. As the high-yield market has
grown in recent years, the number of brokerage firms and banks willing to trade the
securities has declined. Some of the decline stems from mergers in the financial
services industry, but even the firms that still stand ready to facilitate their
customers' purchases and bond sales have sharply reduced the amount of money they
are willing to offer for this business. Since 1998, the capital that firms were
willing to commit to make secondary markets in high-yield bonds has been slashed by
at least 50 percent.
Unlike 1990 when financial institutions held most of under water securities; today,
the risks in the market are more widely spread among financial institutions,
insurance companies, sophisticated investors like those who put money in hedge funds
and individual buyers of high-yielding mutual funds.
Even if Mr. Greenspan cuts interest rates in coming months, it may not help this
situation. The cost of debt capital for high-yield telecom companies is 15.6
percent; if the Fed eases by 200 basis points, it
wouldn't substantially lower their costs. Furthermore, since the huge growth in
capital spending that has fueled economic growth in the United States was largely
funded by high- yield bonds, when the market freezes, it cuts off access to capital.
When a big growth engine stalls, the economy could get hit hard.
In the past four years, debt at a group of seven high-grade telecommunications
companies, including AT&T, Verizon and SBC, exploded from $93 billion, to $210
billion, an annualized rate of almost 23 percent. At lesser-quality telecom and
media services companies, like Global Crossing, Nextel Communications and PSI Net,
high-yield corporate debt and convertible bond issuance ballooned to $275 billion, a
compounded annual rate of 60 percent, in the period.
To put this binge into perspective, the entire value of high-yield debt issued
between 1983 and 1990, the heyday of junk-bonds, was $160 billion.
These companies' capital structures now are simply too indebted for their cash flows
to cover interest payments. The investment thesis for many of these firms was that,
as they were nimbler and faster than the incumbents, they would quickly raise
capital, build out networks with the latest technologies and then sell the completed
networks to the large investment-grade telecom companies which needed the new
Now, however, even the big companies are strapped for cash and are not in a buying
This puts immense pressure on the speculative companies whose debt levels exceed the
value of the plant and equipment they have sunk in their networks. For example, PSI
Net has $4.6 billion in debt and
preferred stock, more than double its $2 billion in net plant and equipment. Its
interest expense and preferred stock dividends for the past 12 months totaled $400
million, compared to revenues of $1.04
billion. The company's net operating cash flow was a negative $241 million in the
past 12 months.
PSI Net's stock reflects these difficult economics; it has crashed from $60.94 a
share last March to $1.63. The company's bonds are fetching less than 40 cents on
But other speculative companies' stocks are still trading at fairly fancy premiums,
even though their debts exceed the value of their hard assets. This suggests that
those companies are bound to feel further pain.
As to Bush Economic Team:
Lawrence Lindsey, a former volunteer for George McGovern, the 1972 Democratic
now holds a position within the George W. Bush campaign that is likely to make him
Assistant to the
President for Economic Policy.
Lindsey, having turned conserative, now argues the supplyside line that the current
philosophical structure of the leading nations of the world has been designed to
battle past challenges,
most notably the Cold War. He asserts that nations can effectively confront new
economic and financial
crises only by unleashing the power of democratic capitalism to establish innovative
arrangements, i.e. be a submissive colony of the US global system. He proposes what
many in the Thrid
World have identified as neo-imperialism and neo-colonialism as a natural law
disguised in the form of
neo-liberalism, just as the British economists since Amith did with classical
economics theory during the
British Empire. Lindsey was a member of the board of governors of the Federal
Reserve System from
1991 to 1997, a policy advisor to President Bush, and a member of President Reagan's
Economic Advisers. Lindsey's new book, Economic Puppetmasters: Lessons from the
Halls of Power,
focuses on the constraints that neo-liberal economics places on modern
Lindsey claims that decision-makers may never be the masters of the systems over
which they hold sway, no matter how much they delude themselves and the public into
believing that they are. More
typically, they are the systems servants, constrained by the prejudices of
existing theory, by the information flow that has developed in the bureaucracies
they oversee, and by the constraints that other decision-making forces impose on
them. Thus one of its principal lessons is how a knowledge of these constraints--an
understanding of the neo-liberal economics of the modern world--is an extremely
important tool of government today. Even powerful leaders are very tightly
constrained by institutions and history, that strings are being pulled elsewhere by
the "unseen hands" of the market system, and that the high politicans spend most of
their time frantically trying to pretend that they are leading the parade. In
other words, nations and their governments might as well surrender to US finacial
hegemony, which is the product of natural laws of neo-liberal economics.
John Taylor might soon be appointed to the Fed Board of Governors. His is the author
of The Taylor
Rule: if inflation is one percentage point above the Fed's gaol, rates should rise
by 1.5 percentage points.
And if an economy's total output id one percentage point below its full capacity,
fall by half a percentage point. Governor Laurence H. Meyer is an supporter of the
It is a not-widely-known fact that there are currently two vacancies on the Board.
Senator Phil Gramm
blocked approval of two appointees by Clinton in order to allow appointments by his
fellow Texan, young
Bush. Taylor has been an adviser to Bush. Robert Novak claims in today's
Washington Post that
Greenspan is secretly for Gore and that Bush will undermine him in revenge for his
perceived tanking of
Bush sr. in 1992 with tight monetary policy. Also, Larry Lindsey is a
supply-sider. Might be some
interesting things coming up soon....
Henry C.K. Liu
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