Unsound Credit And Risk Assets – How Serious Is The Situation?

We also cannot judge off the cuff whether it is is possible that the potential losses might already be so large as to imperil bank capital adequacy, but this strikes us as unlikely for the time being, at least for the largest banks. It could well be true for a number of small to mid-sized banks though. That banks may have been urged to go easy on struggling energy producers certainly does sound credible.

In principle the banking system should be more insulated against the kind of problems it experienced in 2008, as massive excess reserves have reduced the dependence of banks on interbank markets and have greatly lowered the probability that big withdrawals by depositors will cause trouble (as compared to the pre-crisis era, a far larger proportion of extant deposit money consists of covered money substitutes these days).

Readers may want to review a few of our previous articles on corporate debt. Most recently we have focused on the fact that it would be a mistake to blithely assume that credit stress in the commodities sector will remain “contained” (see “Junk Bonds Under Pressure” from mid November and “Getting Run Over on 3rd Avenue” from mid December). However, more important may be the background information we discussed in a 2014 article entitled “A Dangerous Boom in Unsound Corporate Debt” (with hindsight it has turned out the the junk bond market had peaked out just a few days earlier).

The article sheds some light on the huge expansion in low grade corporate debt up to that point in time. More and more credit has been granted to increasingly less creditworthy borrowers, combined with covenants offering less and less protection to creditors. This suggests that bond investors rather than banks will actually suffer the greatest damage – not least as new regulations have caused banks to vastly reduce their proprietary bond trading activities. As a result there are no longer any big market makers that can ensure a certain degree of market liquidity, which is obviously a big problem for investors who are forced to sell.

With respect to banks, one must keep in mind though that they still have a lot of indirect exposure junk bonds as well, through their funding of leveraged bond investors, who have inter alia been buyers of assorted structured products (for details on the resurgence in such products and the leverage involved, see “Embracing Leverage Again”). The main purpose of such structures is to let low-rated debt masquerade as something better than it is, by means of creating tranches of different seniority based on assumptions of the overall size of likely credit losses in the event of a downturn. Similar assumptions went spectacularly wrong in mortgage backed CMOs in 2008. Leverage used in bond investments is often especially high and has a tendency to increase as yields go lower, because it becomes increasingly difficult to obtain decent returns without it. This means that the greatest amount of risk is likely to have been amassed at precisely the worst possible point in time.

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Gary Anderson 5 years ago Contributor's comment

So bank funded investors have been fooled into thinking that the junkiest bonds are not so junky? Wow, that story played before. Amazing that the Fed probably thought all this structured finance was good risk. I wonder if they had their hand in the mispricing of this risk too, just like the subprime bonds back in 2008?