Principle #3: A Cause of Busts 

Entrepreneurial error on the part of both commercial banks and borrowers accelerates the tendency noted in Part I for the quality of credit to fall during a credit-financed boom. And clusters of such errors may set the stage for a reversal of the credit-financed boom. Spurred by the confidence induced by the boom, banks may lend excessive amounts on overly-generous terms to less-than-creditworthy borrowers and less-than-sound projects. Also prompted by the boom, businesses often misjudge the opportunity costs of borrowing, overestimate the benefits of leverage and assume more debt than they might under less euphoric conditions. As banks approach the limits of their ability to expand their supply of credit, and entrepreneurial errors by banks and businesses begin to appear, banks’ willingness to accommodate borrowers recedes and over-burdened borrowers begin to bid against one another for suddenly-less-than-plentiful credit. Under these conditions – and irrespective of the actions of the central bank – the artificially low rate of interest which triggered the boom and depressed savings gives way to smaller loans, higher real rates of interest and less generous terms of repayment, i.e., a ‘credit crunch.’ At these times marginal creditors and uncollectible debt are liquidated through foreclosure or bankruptcy. Also, asset values – hitherto inflated by debt-induced confidence – often fall, sometimes precipitously.

Debt-induced entrepreneurial error also assumes a second and closely-related form: businesses and projects which were launched and sustained as a consequence of the artificially-low rate of interest reveal themselves to be unprofitable. Their actual or expected profitability was contingent upon the continuation of the boom; but in its absence they cease either to be profitable or to have the prospect of profitability. Compounding the woe is the fact that these businesses and projects are often financed largely by long-term borrowings at fixed rates. During the bust the cost of this debt does not decline – indeed, in real terms it increases and becomes onerous. These aspects of the bust, which is also a belated recognition of the artificiality and unsustainability of the boom, manifest themselves in the liquidation of assets, transfer of assets from debtors to creditors, reconfiguration of companies’ bases of capital and, ultimately, bankruptcy. It is through these processes, which are simultaneously necessary, salutary in the long-term but painful in the short term, that production by business is brought back into conformity with consumer demand. 

Observation #3: Deterioration of Credit Quality

Three signs suggest that a credit-induced bust of unknown severity may be occurring. First, as Barron’s Online (4 December 2000) editorialised, “the credit quality of U.S. corporations has been in nearly as steep a free fall as the Nasdaq, and for much the same reason: earnings have failed to meet investors’ once-heady expectations. That points to a rising tide of defaults, especially among junk companies. Even better-rated companies have become vulnerable....” Creditors are discovering that during the boom years they lent money to many enterprises which, in retrospect, should not have been supported with so much money and such generous terms. Since 1998, Standard & Poor’s has concluded that the general quality of credit in Anglo-American countries has been deteriorating. It has therefore downgraded the ratings of far more bonds than it has upgraded. So too has Moody’s: in the first three quarters of 2000, downgrades of high-yield American bonds outnumbered upgrades by a ratio of three to one. In the fourth quarter of 2000 they did so by five to one – the worst ratio since 1990.

The preponderance of downgrades to upgrades is an imperfect but nonetheless important leading indicator of the rate at which companies default on their obligations to repay debt. Default rates, already at historically-high levels, have been rising since 1998 and in some instances accelerated during 2000. The default rate of high-yield (known colloquially as ‘junk’) bonds is currently more than 5%; and the distressed ratio, another leading indicator of default rates in the junk bond market, reached its highest level since the 1990-91 recession. Between 1970 and the mid-1980s, according to figures compiled by Merrill Lynch, rates of default of high-yield bonds averaged 2%. In some years, such as 1979 and 1981, default rates were less than 0.5%; and in others, such as 1972, 1975, 1977 and 1982, they exceeded 2%. In contrast, between 1986 and 1992 rates of default never fell below 4%, averaged 5.5% and in 1990 and 1991 exceeded 10%. Between 1993 and 1998, default rates fell to 1.5%, but in 1999 rose to 4.25%. Today’s default rate is the highest in nearly a decade. And by 2001, Moody’s predicts, 8.4% of the high-yield debt now outstanding will default. In November 2000 Standard & Poor’s issued a report forecasting record corporate defaults in 2001. That report also stated that “due to the volume of outstanding debt by financially weak companies, we expect defaults to remain high for the best part of 2002.” 

Observation #4: A Misallocation of Funds? 

As a second indication of a credit-induced bust, during 2000 it became apparent that by no means all of the debt obligations assumed by companies since the mid-1990s were used to create productive capital. Rather, disproportionate amounts financed speculative ventures such as start-ups and floats of new companies, ‘New Economy’ infrastructure and intellectual property such as IT and biotechnology. It now transpires, in other words, that much debt has been devoted to speculation rather than investment. Hence more and more clusters of entrepreneurial error and malinvestments are making their presence felt. 

Massive amounts of debt, particularly in the U.S., have also been put to the ignoble purpose of financing companies’ buy-backs of their own overvalued shares (see the circular to shareholders dated 1 April 2000 and entitled Bouquets for Share Buybacks). Much debt, in other words, has been used to boost returns on equity and earnings per share in an artificial manner. (Since 1991 American companies’ ROE has virtually doubled and now stands approximately one-third above its long-term average. Return on assets, however, has increased by little more than 10% and now stands at its long-term average of 9%). This has occurred because more and more executives’ remuneration is contingent upon short-term ‘performance’ such as increases in ROE and EPS. Although it is never stated in these terms, this practice (incorrectly and potentially harmfully, in my view) regards the phrases “increasing the company’s debt load” and “creating shareholder value” as synonyms. It is also disingenuous: under the cloak of the fair-sounding phrase “increasing shareholder value” its effect is primarily to enrich executives at the expense of – and only incidentally and infrequently to the benefit of – shareholders. 

Observation #5: A Credit Crunch?

Mr Greenspan, in testimony to Congress on 14 February 2001, stated that “there are no problems with a tightening of credit” in the U.S. Yet a third indication of a credit-induced bust hangs in the air. According to the U.S. Federal Reserve’s latest survey of senior loan officers, reported in The Wall Street Journal (6 February 2001), banks’ lending standards “are being tightened at a faster clip than at any time in the last ten years, including the 1990-91 recession. They are also charging risky borrowers higher interest-rate premiums. At the same time, demand for loans has slumped as companies scale back capital-spending and acquisition plans. However, the survey did find most borrowers went ahead with their plans despite more onerous financing conditions.” More than one-half of the domestic banks surveyed expected to tighten their lending standards in 2001.

Tougher lending standards are facilitating a form of corporate finance known as ‘asset-based financing’ which in the past was utilised during hard times. ABF is the corporate equivalent of a home-equity loan. Much as a home owner pledges a house as collateral for a consumer or home-improvement loan, a company pledges assets (ranging from plant and equipment to receivables and intellectual property) in return for a corporate loan. Decades ago a borrower would pledge assets only as a last resort, and such a pledge was regarded as a move by the least creditworthy in order to avert collapse. Today, however, these loans are commonplace: they have grown at a compound rate of more than 20% per annum since 1993 and in 2000 their volume exceeded $300 billion. 

Clearly, then, growing numbers of companies that until recently could readily borrow all that they wanted are now meeting chillier receptions from lenders, and a deepening division may be distinguishing corporate haves from have-nots. Those which boast strong credit ratings or are in favourable sectors can still obtain plenty of debt finance (albeit on less generous terms). But for the others, or for any arrangement that looks risky, the flow of finance has been reduced to a trickle. And if the would-be borrower has negative cash flow or an unproven business plan, lenders are tending more and more to show him the door. 

...continued in Part III

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