US corporate debt similar to subprime mortgage crisis, says Moody’s Analytics

Staff
stand in a meeting room at Lehman Brothers offices in the
financial district of Canary Wharf in London September 11, 2008.
Lehman’s collapse was the biggest single moment of the financial
crisis.
REUTERS/Kevin
Coombs

• An overlooked area of the debt markets has “eerie
  similarities” to the 2008 sub-prime mortgage crisis.
• Mark Zandi, the chief economist at the analytics arm of
  the ratings agency Moody’s, argued that rising risk taking and
  falling standards of underwriting in the corporate bond and
  leveraged debt space are a big threat.
• The amount of leveraged loans to non-financial
  companies has now risen to around $1.4 trillion.

Wall Street may have just seen US stocks enter their longest bull
market in history, but there are “eerie similarities” between one
area of the market and the sub-prime mortgage crisis that
triggered the last crash in 2008, according to research from the
ratings agency Moody’s.

Writing this week, Mark Zandi, the chief economist at the
analytics arm of Moody’s, argued that rising risk taking and
falling standards of underwriting in the corporate bond and
leveraged debt space are, at least partially, analogous to what
happened in 2007 and 2008.

Noting that we are very much in the midst of the boom period of
the business cycle, Zandi argued that such phases are generally
characterised by “excessive risk-taking somewhere in the
financial system.”

“This fuels the boom and is eventually at the center of the
subsequent bust,” he said.

“Subprime mortgage loans were the obvious culprit a decade ago,
runaway internet stocks that pumped up a stock market bubble were
the problem in the early-2000s recession, and the savings and
loan crisis incited the early 1990s downturn.”

Right now, Zandi says, that excessive risk taking is happening
within the leveraged-lending space, particularly with regard to
non-financial businesses.

“The most serious developing threat to the current cycle is
lending to highly leveraged nonfinancial businesses,” Zandi
wrote.

On the surface things look basically fine. While the ratio of
outstanding debt to GDP in the US is at its highest level in
history, that is generally believed to reflect a “broadening in
the availability of credit to more businesses,” and is a trend
that has been visible for decades. Zandi also points to the fact
that the ratio of debt to business profits is virtually unchanged
since the 1980s.

“Businesses appear to be in good shape in aggregate,” Zandi says,
but there’s a sting in the tail in the form of a “significant
number of highly leveraged companies are taking on sizable
amounts of debt.”

This trend, he says, is evident in the rise in volumes of
leveraged loans to businesses, which are “setting records.”
Statistics show “double-digit” annual growth in such loans, with
a total value of more than $1.3 trillion.

Moody’s

“Businesses use the loans to finance mergers, acquisitions and
leveraged buyouts, followed by refinancing, and to pay for
dividends, share repurchases and general expenses,” Zandi says.

The ballooning leveraged loans in and of themselves may not be
massively troubling, Zandi says, but while the total stock of
debt rises, the standards required to get such loans is also
falling.

“To meet the strong demand for leveraged loans from the CLO
[collateralized loan obligation] market, lenders are easing their
underwriting standards,” Zandi writes.

“According to the Federal Reserve’s survey of senior loan
officers at commercial banks, a net 15% of respondents say they
lowered their standards on commercial and industrial loans to
large and medium-size companies this quarter compared with the
previous quarter.”

This combination, he adds, has only really occurred once before:
just before the financial crisis.

“The only other time loan officers eased as aggressively on a
consistent basis was at the height of the euphoria leading up the
financial crisis in the mid-2000s,” he writes.

Lowering standards for underwriting of loans are also evident in
another area of the debt markets — the junk corporate bond space.

“The junk market hasn’t kept pace with the surging leveraged loan
market, but it is nearly as big, with more than $1.3 trillion in
outstandings,” Zandi said.

In total, that’s close to $2.7 trillion of debt being hit by
falling underwriting standards, close to the value of the
sub-prime mortgage market pre-crisis. “Consider that subprime
mortgage debt outstanding was close to $3 trillion at its peak
prior to the financial crisis,” Zandi said.

“Insatiable demand by global investors for residential mortgage
securities drove the demand for subprime mortgages, inducing
lenders to steadily lower their underwriting standards.”

Ultimately, he concludes, it is “much too early to conclude that
nonfinancial businesses will end the current cycle in the way
subprime mortgage borrowers did the previous one,” but warns
there are “eerie similarities.”