Ten years ago, Lehman Brothers collapsed in a pile of overextended debt that could not be sustained by a weakening housing market, stock market, and many other bubbles. It would later be called the end of the “housing bubble” as a general panic ensued over the asset most commonly held by the general public.
But the issue at hand was, more generally, a debt crisis which fueled an unsustainable rise in asset prices in many areas. Banks were caught with more liabilities than assets as loans that should never have been made defaulted.
Today, banks are more wary, especially of consumers. But corporations have been racking up debt to a level that many feel is unsustainable.
Business cycles are very much a feature of industrialized nations, but the underlying reason is hard to understand. In general, an economy overextends itself in good times which it believes will go on forever. That is simple human nature. Where it becomes problematic is when excessive debt is taken on during the good times which cannot be maintained in bad. Rather than build resilience into the systems, debt often makes capital cycles more brittle and accentuates what should otherwise be a normal fluctuation in economic activity.
Business cycles are better known as Debt Cycles, as noted by Irving Fisher.
This received a lot of attention ten years ago, but where banks have been forced by new regulations to be more wary of the stability of capital markets as a whole and how they are affected, corporations have not. Borrowing against their valuation, rather than their cash flow, corporations have been on an ever increasing binge of borrowing more and more money.
Corporations have two sources of capital available to them – equity, or shares of the company, and debt. The stock market supposedly exists for the purpose of making shares of companies liquid for the purpose of raising capital. We all know that it also serves a more nefarious role in setting the “value” of a company. Between this and judgment of executives based largely on rising stock prices and stocks are increasingly divorced from their real purpose.
There are many reasons to choose debt over equity in good times, when it is available. Debt is less complicated and does not change the ownership of the company. But when debt is used largely for the purpose of keeping the stock price as high as possible, the net result can only be called another bubble.
Today’s stock prices are defined by this level of debt. That makes them unsustainable. This is a global phenomenon, not just a US one.
When considering debt levels and determining whether they are acceptable, there are two main considerations. Debt can be borrowed primarily against value, like a mortgage on a house, or it can be borrowed against cash flow, more like a credit card. Both are essential to well structured debt, in that there is an asset which backs the loan and the ability to repay it with interest is clear. Maintaining the balance is essential.
Corporations did indeed have a large cash flow even before the last depression clearly ended. Running very efficiently, quite “lean & mean,” the corporate cash engine was awesome. But it was defined, as noted here, but companies’ lack of interest in investing in the future and maintaining an excessively lean structure long into the recovery.
When borrowing did start to become significant, around 2014, the purpose was not expansion of the company itself. Much of the borrowing that has taken place against the cash flow was used to improve stock prices, creating the longest and most impressive run in stock history. It has not been put to good use. And as time has gone on, borrowing has been more and more against value rather than cash, creating a high level of debt to cash ratio today.
Borrowing against value largely for the purpose of increasing perceived value is pretty much the definition of a debt fueled bubble – a Ponzi scam with debt.
In a truly open market with proper incentives this would not be a problem. But the need to increase the value of equities by any means necessary is a major feature of debt cycles as we have come to know them. And they are a hallmark of business cycles, at least short term ones, which create havoc for working people and investors alike.
Is corporate debt too high? As companies have been gearing up for a growing economy, their cash on hand is not quite the same as it was at the exit of the worst of the last downturn. Investment in their own businesses have created a much more normal situation in terms of cashflow, and that is good. But the debt taken on to make everything look good has made things much worse where it counts.
Corporate debt is at an all-time high, in real value as well as a ratio to cash on hand. This is a measure of a new bubble not in banks but in the corporate world, and it is driven by a completely out of whack incentive system. When the bubble bursts, it will cause terrible problems – and all of this is completely avoidable.
Perhaps not avoidable? Seems like the rain has already left the station.
You are right, it probably has. One thing I cut out due to length, and may revisit again, is that this is a much more serious problem in a time of rising interest rates. But the Fed appears to be protecting the stock market by raising rates very slowly – despite obvious inflation well over their 2% target. If that situation corrected itself and the Fed Funds Rate was up about 5% like it should be, a collapse would be totally unavoidable. So yes, by all rights you are spot on.
Not just big corporations. I am seeing a lot more debt in small companies too. Businesses are borrowing to expand & sometimes to get themselves established. It is a dangerous trend.
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Very nice. I really like your blog.