Enumerating coronavirus’ threats to the financial system

In yesterday’s newsletter I claimed that we are now in a financial crisis. That’s because, for me, yesterday was the first day during the present market turmoil that felt like the Great Financial Crisis. And sure enough, the Dow Jones Industrial Average dropped 13%, the most since the crash in 1987.

But the stock market isn’t the locus of financial crises. That’s just what the media seems to focus on. It’s actually the credit markets where the real trouble lies. And they’re larger and more important than equity markets. So today, I want to begin to identify areas I think regulators should be looking to shore up to prevent this crisis from becoming more severe.

I think there is still time to prevent a severe financial crisis. And my hope is that regulators move in to help identify and financially aid fundamentally sound companies that face temporary liquidity problems. Of course, we have to prepare for the eventuality that they don’t do so.

Small and medium-sized business

Before I get into firms that deal in our financial markets to gain credit, let me say a few words about small and medium-sized businesses. Arguably, they are going to be hit the hardest by this crisis. That’s simply because they are on the front lines of the lockdown and quarantine response approach, and because small businesses have fewer outlets for credit in crisis.

They are also so numerous that it makes it difficult to provide them the kind of crisis liquidity designed to differentiate between insolvent and poorly managed businesses and fundamentally sound ones going through a rough patch. Governments are simply not going to hand out ‘free money’ to small businesses, whereas they will ‘bail out’ large businesses like airlines, hotel chains and cruise lines. That’s the reality, whether we like it or not. So, for me, this is where the recession will be felt most acutely – via the mass bankruptcies of small and medium-sized businesses.

Just yesterday, both in Maryland, where I live, and in Washington DC, which is four blocks down the road from my house, governments shut down restaurants, bars, cinemas and gyms to prevent the spread of coronavirus. They should do. This is how we want responsible governments to act.

Nevertheless, in the Maryland announcement, there was nothing about financial assistance or relief for small businesses. There was a section labelled “Relief for Residents and Families”. And that relief included a moratorium on evictions, prohibition of utility shutoffs and expansion of available school meals. Again – all good. Protecting individuals and families from deprivation in a time of crisis is essential. But, there was nothing for small business. Many will fail. And the longer this crisis continues, the more small businesses will fail – and the more people employed by those businesses will lose their jobs.

This alone is a financial crisis.

Commercial paper

But, when you look at financial markets, there are credit problems there too. One market people outside the finance community aren’t talking about is the commercial paper market. Commercial paper is basically an unsecured loan. It’s a short-term debt instrument issued by a company to finance accounts receivable, inventories and the like. It’s geared toward meeting a company’s short-term liabilities.

And these debt instruments are tradable in a very liquid financial market. At it’s peak in 2008, we saw $2.2 trillion of paper outstanding. We still have $1.1 trillion today in the market. And the fact that they are short-term liabilities makes them safer. Investors aren’t taking a risk of holding debt for 5, 10 or 30 years, just several months. That’s doable. It’s low risk.

But what if there’s a total lockdown and businesses across the country are closed? Then, suddenly, what looked like a low risk asset for you the investor becomes a potentially toxic loan that you want to get rid of. The problem is no one wants to buy your asset. And so, with no buyers and lots of sellers, not only does liquidity dry up for existing loans in this market, new issuance dries up too.

That’s where we are right now.

Many financial analysts have expected the Fed to do something about this. In fact, Reuters reported that Bank of America expected the Fed to announce something this past weekend. They didn’t. And so, the market continues to be a locus of financial disruption. Companies are now drawing on credit lines with banks, putting them on the hook for debts previously managed through financial markets and concentrating more risk in our financial system at these banks. It’s a perfect example of policy makers being reactive and not proactive.

High Yield

Up until recently, the high yield bond market was doing relatively well given that it is the public market sector of greatest risk for bonds. This is where more highly leveraged and cashflow poor companies borrow directly from investors. And asset managers have been asking for less and less compensation for the risk associated with loaning these high risk companies money. That’s because investors are desperate for yield in a low-interest rate world.

All of this has changed overnight. During last Thursday’s rout of equities, the major high yield exchange-traded funds (ETFs) traded down to their lowest level since February 2016, when the shale oil bust was roiling the junk bond market. That caused the Markit high-yield credit-default swap index to hit its highest level since November 2011. And the VanEck Vectors High Yield Municipal Index (HYD) fell 15.6%, the worst day since Black Monday in 1987.

Now, the high yield market is toxic. And, what’s more is that there is the reasonable fear that a cascade of lower credit but investment grade rated companies could fall into junk bond territory due to the coronavirus recession. More than a quarter trillion dollars of bonds are trading like junk right now. In total, $868 billion of investment-grade debt is rated BBB-, the lowest notch on the investment grade ladder.

I’ve been warning of this for some time. In January, I wrote about “BBB fallen angels and fake ETF liquidity“, saying:

So my view here is that we have a disaster waiting for a trigger. And the disaster is a selling wave of high yield bonds and bond ETFs. Ostensibly, to the degree this is merely a liquidity problem, this could present a buying opportunity for investors. But, to the degree the trigger is a downgrade to fallen angel status caused by a recession, you have the makings of a rout in high yield that could lead to refinancing risk, especially in the CCC space.

Personally, I think when the music stops, there will be a lot of defaults at the lower end of the credit spectrum. And the dynamics of fallen angels and high yield ETFs will only exacerbate the fundamental issues by heightening the loss of liquidity.

In my view, regulators need to fix the bond ETF liquidity mismatch issue before investors get hurt. Right now, it’s a question of when, not if.

Regulators didn’t fix the problem though. So, now we just have to see how bad this gets.

For example, in the energy space, investment grade rated Occidental Petroleum is one of the largest publicly traded American oil companies. They slashed the dividend a week ago from 79 cents a share to 11 cents. The company also said it will cut capital spending to between $3.5 billion and $3.7 billion from $5.2 billion to $5.4 billion. More cost reductions are expected, including layoffs.  A year ago, they were rated A3 by Moody’s but were under review for downgrade. Now, they could become a fallen angel, whose bonds are junk-rated.

One last word. Part of the problem is what I have been warning about – ‘fake liquidity’. You can see the reference to this in the January article up above regarding high yield ETFs. As I put it in earlier that piece:

high yield bond funds like HYG give investors the false sense of security that they can sell on demand, even though the underlying high yield investment universe is relatively illiquid. The reality is that bonds are much less liquid than stocks. Long-term investors often buy and hold to maturity. And single name companies release a multiplicity of bond issues, whereas they generally have only one publicly-traded stock issue. That further decreases liquidity. For bond ETFs that’s a big problem when there is heavy selling.

My View

Cutting it short here, I would sum up by saying that many of these problems were readily apparent to anyone to see. But regulators ignored them. And small business’ problem during the coronavirus recession, while unanticipated, is now also being ignored.

It’s going to get much worse. And the longer officials delay, the worse it will get. Eventually some of these markets will seize up so much that we will be back to 2008 and systemic risk. That’s the situation we want to avoid. But, without some fixes, that’s where this is headed.