America’s looming corporate bond crisis

America’s looming corporate bond crisis

Those that tend to forget history are doomed to repeat it - Bond market economic catastrophe ahead

WASHINGTON, April 14, 2015 – Imagine if Walmart were penalized because their inventory of a product was too large. Imagine as well that the mom and pop store that buys in bulk from Walmart were required to have more money in their savings account to protect them from the possibility that – all of a sudden – no one would buy that particular product from them.

This is a bit of a picture into the part of the world of finance today called the corporate bond market. And it is the setting for the next financial crisis.

Understanding a ‘Bond’

In 1997 my wife and I – with a little help from my parents and a terrific real estate agent – went to work on applying for a mortgage to buy our first house – the one we still live in today. The bank we started with assumed the risk of lending us the needed money in a traditional 30 year mortgage. But let’s say we wanted to be creative. Theoretically – if we were a corporation – we could have “floated” a “bond offering.”

Instead of one lender providing us the whole amount (the house cost a little under $200K back then), we could have done something like this: Issue ten bonds payable in 15 years, denominated each at $10,000. If we could find ten “buyers,” that would raise the first $100K. Then ten more bond payable in 30 years, each being $10,000. That second tranche would raise the second $100K. The first set would be cheaper for us (interest rate wise) since they were payable in 15 years (for the same reason a 15 year mortgage has a lower interest rate than a 30 year mortgage). At the end of the day we would still be able to buy the home for $200K.  But the risk to the bond “buyers” (those lending us the money) would be spread out among 20 lenders instead of just one.

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This is one way corporations raise cash. The other way is to issue stock. The difference between buying stock and buying bonds is one of risk. If you buy stock in my company and I go under, you’re hosed. If you buy my bond and I go under, you are first in line to get paid when the bankruptcy court oversees the sales (in a liquidation, for example) of my company.

So investors tend to see bonds as lower risk. But this depends on being able to sell them if needed. And that is where things are getting tricky.

Let’s go back to Walmart. Think of any basic consumer product. What Walmart does is make a market (in Wall Street parlance) for consumer products. It is a lot easier to go to Walmart for your consumer product needs than it would be to go multiple producers – each for a separate product. Shopping at Walmart – or any grocery store for that matter – is such an ubiquitous part of our lives that we take such market makers for granted.

Financial markets have, too. When a company wants to issue bonds to raise money, they depend on primary dealers to buy those bonds in bulk.  This basically means the primary dealer is the first lender to these companies.  But these dealers then turn and do exactly what Walmart does with consumer products – they sell these bonds to institutional investors.  And so they are the market makers for corporate bond issues.

Now let’s step back into the world of mortgages. The subprime mortgage market – which most people at least have heard about in the news stemming from the last financial crisis – was “made” by these Get Support dealers. To raise the money needed to make these mortgage loans, the companies that originated them would issue bonds. And the dealers would buy these bonds – known as mortgage backed securities – in bulk and then sell them to others who would use them as supposedly lower-risk investments.

Until no one wanted to buy them.

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The problem was, large investment banks like Lehman Brothers used money provided by their other business to buy these bonds from the dealers. As people started to default on loans made with little to no regard for the ability to repay them, the bonds that were based on these loans were all of a sudden no longer the presumably lower risk investments they were portrayed to be. Everyone wanted to sell and no one wanted to buy.

When you have something that everyone is selling and no one is buying, that thing becomes – by definition – worthless.

Having used other parts of their business to fund their trades in these subprime mortgage bonds, and with no one to buy these bonds, Lehman Brothers went under, causing enormous panic and dislocation in the banking and lending community. The financial crisis raged, with enormous consequences that still remain.

As the excellent MarketWatch article shows, there is a great deal of concern that the bond market might now be a bubble that will ultimately pop in an uncontrollable way. To understand why, we first have to note that bonds are priced in such a way that the cheaper the money is to “borrow” (remember my tranche of ten 15-year bonds and ten 30-year bonds), the more expensive that money is to “lend.”  So that investor buying my 15 year bond will pay a higher price – in the sense that we will pay a lower interest rate or yield – than the investor who buys my 30-year bond.

We all know that interest rates are currently at historic lows, which means bond prices are at historic highs. Because interest rates are so low, right now we have the spectacle of companies sitting with huge amounts of cash (Apple and Microsoft come to mind) actually issuing bonds. These companies are not even close to being in need of this capital, but the high prices they can get for their bonds are just too attractive to pass up.

But if/when the Federal Reserve begins to raise interest rates, bond prices must go down. What happens then? If there are one or more viable, virtual Walmarts – or market makers for bonds – those who want to sell their bonds at their historic highs will be able to move them and the larger financial system will be able to absorb the activity. But the Dodd-Frank financial reforms have made this nearly impossible, all in the name of avoiding another crisis.

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If these bonds cannot be sold in a sane, structured way, they will sold in an insane, unstructured way. This will mean bond prices will collapse further and faster, driving interest rates up higher and faster, in such a way that the larger financial system will not be able to absorb.

The companies with bonds outstanding that need to roll them over into new bonds will find it impossible to do so. They will end up in default, file for bankruptcy, with their employees out of work and their shareholders in a panic.

What is so maddening about all this is just how ridiculous and unnecessary it is. The corporate bonds which are most at risk are generally known as “junk bonds.” These are bonds issued – loans taken out – by companies with questionable ‘credit ratings’. Does this sound familiar?  Thus, the junk bond is simply the corporate version of the subprime mortgage.  All of the money – and then some as the Fed printed up a lot more – that went into the housing bubble has now gone into the junk bond bubble.

When it all blows up in our faces, you’ll be forgiven for asking: “Are you kidding me! We did it again?”

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John H. Horst
John H. Horst earned his Master of Arts in Theology from Asia Pacific Theological Seminary and holds a Master of Divinity from Bethel University. As an active member of his community, Horst is the Treasurer of three organizations including, the Mira Mesa Town Council, the San Diego Chapter of ICS2, and Pacific Lighthouse Christian Fellowship. He is currently an information security engineer and trainer. He resides in San Diego, CA with his wife and two sons. Website: Facebook: Twitter: Google+: CommunityConservative/posts The Secret to Winning the Hearts and Minds of the Next Conservative is available for purchase at Amazon and Barnes and Noble.