Once upon a time, the late, great Paul Samuelson, the first American to win the Nobel Prize in economics, quipped that the stock market had predicted “nine of the last five” recessions. The simple reality, as Samuelson recognized, is that economic forecasting is hard—and that you can find false positives anywhere. No one rings a bell at the top of the market and says, “Thanks everyone! It’s been a fun ride up, but it’s all downhill from here.” Instead, you have to look for crumbs along the trail. And there are plenty of them lying around these days. The widely watched Dow Jones Industrial Average hit its peak on January 26 and has fallen roughly 10 percent since then. Oil prices are on the rise, as is the annual inflation rate. Financial markets have been spooked by the prospect of a trade war with China and a number of our close allies—a self-inflicted wound, courtesy of Donald Trump and some of his more zealous economic advisers. Predatory mortgages are back. Consumer debt is on track to reach a record $4 trillion by the end of the year. There also has been much talk lately about the so-called “inverted yield curve,” where longer-term Treasury securities yield less than shorter-term Treasury securities—a historic signal that a recession is on the horizon. Normally, bonds with longer maturities offer investors higher interest rates than those with shorter maturities for the simple reason that more bad things can happen to effect the chances of repayment over a longer period of time. When that gets flipped on its head, as is nearly happening now, things can go awry in the markets. Wall Street, The New York Times tells us, is scared.
These are all interesting indicators of possible trouble. But for me, there is a far more powerful harbinger of our coming financial apocalypse: the systematic mispricing of risk. The problem has been staring us in the face since 2008, at the height of the financial crisis, when the Federal Reserve lowered short-term interest rates to near zero and embarked on an eight-year experiment in “quantitative easing,” buying trillions of dollars of risky securities—mostly from the wounded big banks—and driving up the prices of those squirrelly bonds and driving down their yields. The consequence was that both short-term and long-term interest rates were reduced to unnaturally low levels—the lowest levels in our lifetime. The Fed’s logic was not without merit. Having plentiful cheap capital around could put the paddles to a moribund economy. And it made sense to get the crappy securities off the banks’ balance sheets and into the hands of the Federal Reserve, an entity without public shareholders that could never go belly-up. (During this period, the Fed’s balance sheet exploded to $4.5 trillion, from $800 billion before the crisis.)
But oh, the unintended consequences. Investors are in a constant search for risk-adjusted yield. They want to find the highest-yielding securities they can without ratcheting up too high the risk of the securities they are buying. This never-ending search has led to nothing less than the Yield Hunger Games, a death match that ends in the mispricing of risk, where investors bid up the price of junk bonds, lowering their yields. (Bond prices trade in inverse proportion to their yields.) As a result, investors have continuously paid higher and higher prices for risky bonds and are getting paid less and less for taking that increasing risk. That’s a recipe for financial disaster.
Consider the example of Toys “R” Us, the toy retailer whose bonds were trading near par—or 100 cents on the dollar—right up until the company filed bankruptcy protection last September. It’s now being liquidated, and its bonds are trading for pennies on the dollar, having lost some 92 percent, or more, of their value. Investors have lost billions of dollars as a result. But the incentive structure for investors is still skewed. So-called “junk bonds,” bonds issued by companies with lower credit ratings, should yield on average something like 10 percent to compensate investors for the risks they are taking. But because of the Yield Hunger Games, those bonds are now yielding, on average, something like 6 percent. That’s how risk gets mispriced.
Supposedly sophisticated banks are also mispricing risk on a regular basis, making loans they should probably not be making. Take, for instance, the $3.75 billion leveraged-loan package being put together for Asurion, a provider of insurance for wireless phones. Asurion has been a major financial success story for years, and its original investors have become fabulously wealthy. Eleven years ago, a trio of private-equity firms—Madison Dearborn Partners, Providence Equity Partners, and Welsh, Carson, Anderson & Stowe—bought the company. Now, thanks to the big banks—led by Bank of America, Morgan Stanley, Goldman Sachs, and a squad of foreign banks—Asurion is borrowing nearly $4 billion, bringing its overall debt load to $11.3 billion, and its debt-to-EBITDA ratio to around seven. That’s some serious leverage.
But it gets worse and worse. The new loans are so-called “cov-lite” loans, meaning they have few of the “covenants” or protections for the banks that once upon a time were standard in such loans. Covenants act as early warning signs of trouble, and if they are tripped can result in a default event, protecting the lenders by giving them power over the borrowers they otherwise would not have. The new Asurion loans will have minimal such protections, in keeping with the trend in recent years. If that weren’t bad enough, Asurion is using the loan proceeds not to build a new plant and equipment, or to hire new employees, or to pay its existing employees higher salaries. No, Asurion is taking the proceeds, less fees for the banks, and paying them to the private-equity firms as a massive dividend. In other words, the rich get richer. According to S&P Global Market Intelligence, the Asurion deal, which wraps up on June 27, is an “opportunistic issuance” by the company to take advantage of the “red-hot” leveraged-loan market to pay a dividend to its private-equity overlords.
But that’s not the end of the story. There’s one more beatdown. Once the deal closes tomorrow, the underwriting banks will then turn around—and for more fees—package up the loans into various tranches, and sell them off to investors all around the world as great investments, once again feeding the ravenous beast that is in search of yield. I’d tip my hat to the cleverness of it all, if it didn’t seem like just yesterday that we all got a massive dose of reality about how poorly these types of things end.
The financial engineering at Asurion could be written off as just another example of unbridled vulture capitalism—the same sort of private-equity chicanery that led Toys “R” Us into an early grave. But the growing preponderance of these deals, with higher and higher risks, suggests a more fundamental flaw in the thinking of people who pilot our economy. Instead of remembering the lessons of the 2008 financial crisis—the importance of prudent risk-taking, the value of meaningful credit standards—we have lapsed back into our bad habit of rewarding bankers on Wall Street for taking big risks with other people’s money.
