“A Dozen Pockets of Extreme and Growing Risk”

Source: Dollarcollapse.com

The economy is chugging along at a 3% growth rate, unemployment is hitting record lows, productivity is surging. The economy looks like it’s in fantastic shape. A friend of mine and long-time Trump hater, normally disinclined to give the president credit for anything, marveled recently that the low-inflation, low-unemployment economy “is as good as it gets.” I hope like heck it stays that way.

But I am an inveterate worry wart. I’ve lived through booms before — the 1980s savings & loan bubble, the 1990s tech bubble, the 2000s real estate bubble. I’ve heard the promises that “it’s different this time.” And I’ve seen the busts that followed. It’s a universal rule that most “experts” did not foresee the meltdowns coming. The same thing may be happening again. Very few are paying attention to the build-up of highly leveraged corporate debt, both in the U.S. and abroad.

I don’t know if the “junk bond” sector will precipitate the next recession. Perhaps the next downturn will originate overseas and spread to the U.S., and a meltdown in junk bonds will merely act as an accelerant to a broader collapse. Whatever the case, the $1 trillion market now represents a significant risk. State and local governments in Virginia need to acknowledge this and other risks lurking in the economy as they go about making spending and taxing decisions. Only a fool would assume that the decade-long expansion, one of the longest in U.S. history, will last forever.

As seen in the chart above, reproduced in John Rubino’s blog, Dollarcollapse.com, leveraged loans made by banks to companies with weak balance sheets “clocked a 20% increase in the past year.” The expansion of the junk bond market was accompanied by rapid growth of less-regulated private credit and a weakening of underwriting standards generally.

(The Washington Post documented in April how the surge in junk bonds results from actions by the Trump administration and Republicans in Congress to reverse banking regulations enacted during the Obama administration. While I find the Post to be highly partisan and tendentious in its reporting on Trump, it does get the story right occasionally. This is one of those cases. Trump has been highly vocal about his support for an easy-money economic policy.)

The volume of leveraged loans in the U.S. financial system now exceeds $1 trillion and is twice as high when the economy collapsed in 2008. Writes Rubino:

This is the kind of problem that festers under the surface for a time before “surprising” everyone by blowing up and causing/contributing to a crisis. The reason it can fester is that in good times when credit is freely available, low-quality borrowers don’t fail. There’s always someone willing to refinance whatever loans come due, so default rates are extremely low. …

Today’s leveraged loans occupy just one of maybe a dozen pockets of extreme and growing risk that’s mostly hidden from even professional investors. Sub-prime auto loans and the bonds in which they reside, student loans, emerging market dollar-denominated debt, peripheral eurozone country (read Italy and Spain) sovereign debt, tech stocks; the list just keeps going. When one of these goes several if not all of the rest will follow, in what promises to resemble a fire in a munitions factory..

In 2003 Rubino, whom I had been fortunate enough to engage as a contributor to Virginia Business magazine when I was publisher there, wrote a book, “How to Profit from the Coming Real Estate Bust.” He highlighted the interrelated phenomena of the housing bubble, rising mortgage indebtedness, the decline in home equity, rising consumer indebtedness, the mortgage securitization mania, and the proliferation of financial derivatives such as credit default swaps. He saw the 2007 financial debacle coming years before most other people — so far ahead that had you taken his financial advice at that time, I’m not sure you would have made any money. Market manias persist far longer than any rational person would expect.

Junk bonds are just one pocket of risk. Rubino takes note of sub-prime auto loans and student loans here in the U.S. The federal government, of course, is $21 trillion in debt and running giant deficits. Though technically required to balance their budgets, many state/local governments have compiled massive “debts” in the form of unfunded pension liabilities and decaying infrastructure. And that doesn’t even touch upon the systemic risks posed by zombie corporations in China, over-leveraged banks in Europe, and Third World nations like Venezuela and Argentina teetering on the brink of sovereign default. In a globally connected world, financial catastrophe in one corner of the globe can transmit rapidly to other sectors via mechanisms we don’t even know exist.

The state of Virginia has made modest efforts this year to shore up its balance sheet, adding to its Rainy Day fund and financial reserves. But the state also increased taxes and expanded spending programs. It has huge future liabilities coming down the road — increased Medicaid expenditures, constitutional obligations to increase spending on K-12 to meet the so-called Standards of Quality, giant unfunded pension liabilities, and a deteriorating infrastructure. Those are the things we know are coming.

The General Assembly has made moves to identify weaknesses in local government finances in the hope of heading off another Petersburg-like meltdown. But no one is looking at the dozens (perhaps hundreds) of independent water/sewer authorities, solid waste authorities, industrial and economic development authorities, port and airport authorities, higher-ed institutions, transit authorities, community development authorities, and god knows what else. In other words, there are billions of dollars in obligations about which we know very little at all.

In the next post, I will explore how Virginia might turn this systemic risk and uncertainty to its advantage.

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6 responses to ““A Dozen Pockets of Extreme and Growing Risk”

  1. Good points Jim. I am concerned about the narrative that our economy is “as good as it gets.” Such notions are founded on misleading numbers and such statements from the federal government cause people to take actions that could harm them in the long run.

    Much of our current prosperity is illusory. We are undergoing the weakest recovery in our history. In the past ten years, our GDP has increased by just 19.8%. This is lower than the 20% recorded in the 1930s during the ten years following the market crash.

    Much of our sense of well-being and the prestige of our politicians is attached to our rising stock market. Experts say that over 80% of the increase in stock values has to do with corporate stock buybacks. Recent earnings excitement is due to about the same amount of earnings spread over a smaller number of shares outstanding, so it appears our corporations are doing very well.

    Even with all-time low interest rates, little new investment has occurred in the U.S. Our greatest companies have become addicted to artificially low interest rates and are continuing to favor short-term bonuses over long-term investments in their productive capability. The outlook for the U.S. manufacturing sector has declined for the first time in a while.

    Only a portion of the offshore profits have been repatriated. This money was supposed to be reinvested in the U.S. as a result of the tax cut. The money that did come back was used mostly to repurchase stock to give the appearance of prosperity and provide significant bonuses.

    Jim is right about increases in junk bond financing and the bubble brewing with toxic auto loans. But what most people don’t realize is that the largest portion of “investment grade” debt is in the BBB sector, just one step above “junk” ratings. I believe that this debt is at least 40% of the investment grade debt and rising. We are just a hiccup away from many of corporations falling into the junk category.

    Dominion and many other utilities are in this category. They are extremely capital intensive enterprises. With that much debt, just like our federal government, any increase in interest rates makes servicing that debt much more expensive. Dominion had to sell some of its merchant power plants and have an equity raise in order to preserve its present rating.

    This is happening in the “good times.”

    But are they really that good? We are mislead by the jiggering that has gone on with the numbers that report unemployment levels and cost of living increases. Every time a new smartphone or computer is released our productivity index is adjusted which decreases our cost of living index. Which, of course, no longer includes food and energy costs.

    The middle class hears about all of this prosperity, but doesn’t feel it. Households now work more hours but have less buying power than what we had in the early 1970s, even with the manipulated numbers.

    We are reminded each month about our “about as low as it gets” unemployment levels, but our current surveys do not reflect how many workers have given up looking for work or are significantly underemployed.

    Much of this “newspeak” is intended to keep the mob from getting restless as we are distracted by TV, sports, political hoopla, and social media. But the cracks are beginning to show.

    What isn’t talked about is that we have used up most of our ammunition. If the President must lobby the Fed to reduce interest rates during the best of times, what levers are left to pull when things get bad? And our demographics are working against us.

    We have little choice but to continue to base our economy on a flood of phony currency. Any attempt to reduce our debt would also reduce our money supply and create havoc worldwide.

    We have built a house of cards that is beginning to teeter. I fear we are in for a rough ride beginning in the next 12-24 months, maybe sooner. Our “too big to fail” banks now control a much greater portion of our financial sector than they did in 2007-2008.

    It is hard to have any fruitful discussions about this because our conversations are based on information that is not accurate. And very are moved away from the opinions that they already hold.

  2. I’ll say this. The view of folks who have identified themselves in the past as fiscal-conservatives who worried about deficits and debt – has dramatically changed.

    During the depths of the recession under Obama – he proposed “stimulus”, i.e. give tax cuts and rebates to help restart the economy an he was roundly rejected because it would add to the deficit and debt.

    Now, we’re doing “stimulus” during a red hot economy – still adding to deficits and debt and these same folks claim it’s the “best” it’s ever been.

    I don’t want to see it come crashing down at all.. but it sure looks like “stimulus” ( borrowing money to put into the economy (tax cuts) without spending cuts) .. “works” at least for now.

  3. Interesting.

    Seems to me that the business cycle is more man-made disaster than it is an inevitable artifact of capitalism. Three factors usually play a part in undermining a healthy economy.
    1. Excessive borrowing.
    2. High taxes.
    3. High tariffs.

    To some degree we are see all three of these problems. Trump, to his credit, reduced taxes, and Trump is using tariffs as a lever to reduce tariffs. So he appears to be doing the right thing with respect to the latter two items.

    Is Trump good with respect to borrowing? Not sure. I will have to look into the junk bond situation.

    • A recent study by Columbia University showed that for the new tariffs applied in 2017 and 2018, the entire impact was borne by U.S. consumers. Not only that, after factoring in retaliation by other countries, the main victims of the current trade wars are U.S. farmers and blue-collar workers.

      Our balance of payments with China has been reduced and this maneuvering might result in better long-term behavior on the part of China, but so far the impact of it has been borne by the U.S. economy and American workers.

      For example, the tariffs on solar last year decreased the number of solar installations considerably below what was planned. This hurt the fastest growing job category in the U.S. – solar installers. It also postponed having the benefits of lower-cost electricity from solar.

      This illustrates the point that I was writing about. The public narrative is different from what is actually happening. Federal officials are saying that billions are being made because of the current tariffs, when the costs of the tariffs are actually being paid by American consumers.

      It might be the proper strategy for adjusting our long-term trade relations with other nations, but it is not helping our current economy.

      • @TomH

        The problem with any decision is that we have to evaluate the tradeoffs. Overall, when it comes to trade, free trade delivers the optimum tradeoffs. One sided free trade, however, is not free trade. One sided free trade allows one nation to manipulate the other nation’s economy.

        Conservatives advocate free trade. We have become so committed to the idea that won’t even retaliate when another nation imposes tarrifs on our products and subsidizes its own. That’s tantamount to abandoning our most valuable industries to the tender mercies of foreign powers. The politicians who do that are either corrupt or foolish.

        We want free trade? Then we have fight for it. Freedom is not free.

  4. Dear Jim,

    High immigration keeps wages down while raising the cost of living (i.e. rents) and taxes (subsidized housing and school lunches, school construction) in impacted areas.

    Sincerely,

    Andrew

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