Nobody knew what would trigger the next financial crisis, but just about everyone knew it would involve the record pile of corporate debt. And so it happened. Now the Fed fixed it…
By Wolf Richter. This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
Something spectacular happened in April, despite the gut-wrenching phenomenon that 30 million people lost their jobs in the United States: In late February and early March, credit markets were freezing up and corporate bonds, particularly junk bonds and the lowest rungs of investment-grade bonds, were in the process of imploding. But then in late March and in all of April, companies issued record amounts of bonds under blistering demand from once again yield-chasing institutional investors.
Corporate debt has already been at record high levels by any measure going into the year 2020, and the Fed has been warning about it repeatedly, including in its Financial Stability Reports, and people figured this corporate debt bubble would eventually implode and put the economy at risk, and it could cause another Financial Crisis because at the next downturn, credit could freeze up and these companies would run out of cash and wouldn’t be able to refinance their debts, and wouldn’t even be able to make interest payments. And defaults, debt restructurings, and bankruptcies would become the new growth industry.
Corporate leverage was gigantic. But no one cared. And then came February 20, when it began to unravel. And suddenly, people cared. By early March, junk bond issuance was freezing up. And it became clear that these overleveraged companies couldn’t refinance their debt, couldn’t borrow money to fund their losses, and would run out of cash soon, and would default.
Back in 2019, nobody knew what would trigger the next financial crisis, but just about everyone could see that it would involve this record pile of corporate debt.
And so it happened. But then the Fed decided to solve that problem of too much debt and too much leverage with even more debt and even more leverage.
On March 15, the Fed announced that it would mess around with every aspect of the financial markets, buying via its Special Purpose vehicles, or SPVs, whatever wasn’t nailed down, and it expanded those programs to ever more asset classes, including investment grade corporate bonds, fallen-angel junk bonds, corporate paper, commercial mortgage-backed securities, even junk bond ETFs. And all this was hyped in the media with great fanfare.
So the Fed plowed $2.3 trillion in seven weeks into Wall Street, buying mostly Treasury securities, government-guaranteed mortgage-backed securities, and smallish amounts of corporate paper, and a few other things, and hand $440 billion to foreign central banks, half of it to the Bank of Japan, via its central bank liquidity swaps.
But the Fed hasn’t yet bought a single corporate bond, neither investment-grade or junk-rated, and it hasn’t yet bought a single ETF.
Turns out, the Fed was just jawboning about buying corporate bonds and junk-bond ETFs. Every Thursday, since this whole S-H-I-T-show has started, I post an analysis of the Fed’s weekly balance sheet. And no – as of the Fed’s last balance sheet, the Fed still hasn’t bought a single corporate bond, not a single fallen-angel junk bond, not a single junk-bond ETF.
It was just jawboning – which is an official tool in the Fed’s tool box and goes by other terms, such as “forward guidance.”
This jawboning worked like a charm. It triggered a huge rally in stocks and bonds, and particularly in junk bonds and junk-bond ETFs. Banks and hedge funds and others were buying this stuff to front-run the Fed and then sell this stuff to the Fed at a higher price, and stuck-at-home retail investors with nothing else to do were trying to ride up this wave too.
And this rally in corporate bonds, particularly junk bonds, did something else: It re-started the chase for yield, and investors jostled for position to buy bonds offered by companies from Carnival Corporation, with its pariah cruise ships, to Boeing with its 737 MAX fiasco. And demand was so huge that these companies upped their bond offerings and sold a lot more bonds than they had imagined they could.
Boeing became the bond hero a couple of days ago. Boeing is rated triple-B minus, which means one notch above junk. If it is downgraded one notch into junk, it becomes a fallen angel. Not too long ago, it was begging for a $60-billion government bailout for itself and the industry because it had hollowed out its balance sheet by incinerating $43 billion in cash on buying back its own shares since 2012, and now it’s burning huge amounts of cash in its operations.
Well, last week, it approached the bond market, hoping to sell between $10 billion and $15 billion in bonds, with maturities as long as 40 years, according to what some people familiar with the matter told Bloomberg.
These bonds were offered to private investors – so this was not a public offering, which means that filing requirements were much less onerous, and the deal could be pulled off quickly.
The buyers were institutional investors, such as asset managers and insurance companies that usually buy investment-grade bonds, and also some hedge funds, and other investors that are usually focused on junk bonds, according to the sources.
And Boeing offered relatively high yields. A mad scramble ensued to get some of these bonds. Demand for these bonds was gigantic. Over $70 billion were offered to buy these bonds. So Boeing raised the bond sale to $25 billion.
Boeing had already fully drawn its term loan facility at the banks in March, which was over $15 billion, to have the cash ready at hand. This $15-plus-billion in cash together with the cash from the $25 billion bond sale will give Boeing $40 billion in cash to burn and still have some cash left over on its balance sheet.
But it also means that Boeing will have $40 billion in additional debt, and as it burns this cash, its negative net worth will balloon, and while it was fragile and over-leveraged before all this happened, hollowed out by its $43 billion in share-buybacks, it will be a LOT more fragile and a lot more overleveraged going forward.
It has been like this all month.
It was kicked off on April 1, when Carnival Corporation the operator of pariah cruise ships, offered $3 billion in bonds at an interest rate of 11.5%. There was huge demand, with investors offering to buy $17 billion of those bonds, so it upped the bond sale to $4 billion. And it also pulled off a stock sale to raise more cash.
In the week through April 2, issuance of investment-grade bonds surged at an all-time ever record of $111 billion, in just one week. This included the $19 billion in bonds from T-Mobile to fund the acquisition of Sprint.
That weekly record beat the prior all-time weekly record of $109 billion, which was set the week before.
In other words, since the Fed started jawboning the markets without ever buying a single bond, investors bought up everything with ravenous appetite, in part lured by the higher yields, and in part lured by the hope that they could sell it to the Fed for a profit.
Fed Chairman Jerome Powell proudly pointed out the success of the Fed’s jawboning in his press conference on April 29, when he said:
“Many companies that would’ve had to come to the Fed have now been able to finance themselves privately since we announced the initial term sheet on these facilities,” he said. “There’s a tremendous amount of financing going on, and that’s a good thing,” he said.
And that’s true, it’s a good thing that investors funded those bond sales, and not the government and taxpayers, and not the Fed.
What’s not a good thing is this: prior to the crisis, the record amount of corporate debt had made many companies super-fragile and in no position to weather the crisis. And then, when the whole thing threatened to implode, the Fed cut interest rates to zero and moved heaven and earth to enable and encourage these companies to load up on even more debt. See Boeing.
And here is the amazing thing that happened with corporate loans from banks. Commercial and industrial loans are tracked by bank regulators, such as the Federal Reserve. In terms of the total C&I loans outstanding, they had been essentially flat for about a year. At the end of February, there were $2.4 trillion of C&I loans outstanding.
But then companies such as Boeing and many others drew down their credit lines and stand-by term loans to get through the crisis and avoid having their access to cash cut off. From March 3 through the end of April, those C&I loans outstanding jumped from $2.4 trillion to $3.0 trillion. Over the span of eight weeks, they’d jumped by over $600 billion. In percentage terms, they’d jumped by 25% in just eight weeks.
How historic is this? C&I loans always jump during a crisis as companies draw down their credit lines. During big-bad Financial Crisis 1, during peak-panic following the Lehman bankruptcy, C&I loans jumped by 5.8%. This time, they jumped by 25%. This just never happened before in the data going back to 1973.
So now we have this crazy situation where the “next crisis” has arrived, and the next downturn is here, and it’s a bad one, and likely the worst one we’ve seen in our lifetimes. And the record amount of corporate debt, that everyone had warned about and that even the Fed had fretted about publicly, did what it was expected to do, it started blowing up, and the credit markets started freezing up.
And then the Fed came out with about $2.3 trillion of QE in a few weeks, cut its interest rates to zero, and added lots of jawboning about buying corporate bonds, and this has caused and enabled Corporate America to load up on even more debt than ever before.
And these companies will burn through the cash they raised from these debt sales because they’re now in deep trouble and losing money. And then the cash is gone, and what’s left over is the additional debt.
This record amount of new and additional debt is piled on top of the record amount of debt that was already weighing down these companies before the crisis, which already made these companies overleveraged and way too fragile going into the crisis, and that’s why they couldn’t handle the crisis.
And now these companies will be even more overleveraged and more fragile, in what will be a very rough economy for quite a while. And that record pile of corporate debt has become a lot more explosive and a much bigger risk in just a couple of months than it already was before. That’s where we’re at now. Nothing has been solved.
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