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As Lending Standards Fall, Worries of a New Bust Rise – George Pickering (02/21/2019)

With more than a decade having passed since the financial crisis of 2007/8, the mainstream economics profession still seems to be almost as far from agreeing on the ultimate causes of that crisis as they were from being able to foresee its arrival back in the mid-2000’s. If asked about the causes of that crash, the average non-Austrian economist is unlikely to dwell on the prickly question of what ultimately caused the housing bubble and bust, and will more likely pivot to the easier, more widely agreed upon issue of how collateralized debt obligations (CDOs) created channels for the housing crisis to spread into a full-blown financial crisis. In the run-up to the crisis, US financial institutions heavily invested in particular types of CDOs called mortgage-backed securities, which essentially packaged together mortgages from a wide array of different locations. It was thought unlikely that house prices could decline across the whole of the US simultaneously, and the housing market was booming, so packaging together mortgages from different locations into CDOs seemed like a profitable and risk-free investment. By the time house prices began to decline, however, key banks had invested so heavily in these mortgage-backed CDOs that the housing crash brought down the whole financial system with it. Such, in very broad and simple terms, is the account of the causes of the 2007/8 crash with which many mainstream economists would agree.

In light of this, it can easily be understood why the financial press assumed such a worried tone when reporting on recent research by the Bank of England, which revealed the extent to which financial institutions around the world have again begun heavily investing in CDOs. The report revealed that international financial institutions have so far amassed a $405 billion exposure to ‘junk debt’ packaged within CDOs, while the broader market for this low-rated debt has swelled to $1.4 trillion.

Discussing the research during a Treasury committee hearing last month, Bank of England Governor Mark Carney said that the Bank was “concerned” by the “rapid” growth of this market, which he said had “all the hallmarks” of the sub-prime mortgage bubble which preceded the 2007/8 crash. One MP present at the hearing warned Mr Carney “you can hear the ghosts of sub-prime mortgages clanking their chains”, and the report apparently also sparked fears amongst policymakers at the Federal Reserve and the European Central Bank.

The key difference between this new wave of CDOs, compared with those that precipitated the 2008 crash, is that the new CDOs are packages of low-rated ‘junk’ business debt, rather than packages of ‘sub-prime’ mortgages. This rapidly growing market for high-risk, high-return debt is currently populated by hundreds of US companies with ‘below investment grade’ credit ratings, including such household names as American Airlines, Uber, and Burger King. It has also been argued that these sorts of leveraged loans played a role in the recent bankruptcies of such companies as Toys R Us and Sears.

Just as mainstream economists struggled to explain the ultimate causes behind the housing bubble of the mid-2000s, so too have the explanations for this new boom in the junk debt market been brief and vague; the Bank of England report which raised the issue gave the non-answer of simply attributing it to “strong creditor risk appetite”. Viewed from the perspective of Ludwig von Mises’ Austrian Business Cycle Theory, however, the picture becomes much clearer. The ultra-low interest rates which central banks have facilitated since 2008 have lowered borrowing costs and lending standards, allowing companies to pursue risky and long-term projects by taking on more debt than they otherwise would have found possible, while at the same time making creditors more eager to lend to high-risk companies in pursuit of their accompanying slightly higher returns. When the threat of inflation finally forces central banks to raise interest rates again, as they are already beginning to do, many of these borrowers will be forced to default on their increasingly expensive debts, and the crash will have begun. The greater the extent to which global financial institutions have exposed themselves to these junk debt CDOs by that point, the more quickly will the crisis spread throughout the financial system.

Evidence of these declining lending standards is given by the fact that, at present, around 80% of the leveraged loan market consists of “covenant-lite” loans, as compared with around 25% before the 2007/8 crisis. ‘Covenant-lite’ loans are loans which have partly or wholly discarded the ‘covenants’ which traditionally protected investors by requiring borrowers to meet various financial health standards before the loan is granted.

Furthermore, the stimulus to risk-taking encouraged by artificially low interest rates is illustrated by the fact that $150 billion worth of the ‘junk’ debt CDOs are currently being held by insurers and pension funds, institutions typically characterized by their desire to hold safe assets.

As central banks continue to slowly normalize interest rates, the foundations of the overinflated junk debt market have already begun to crumble away. This past December saw the leveraged loan market suffer its biggest monthly decline since mid-2011, wiping out nearly the entirety of 2018’s gains in the S&P/LSTA leveraged loans index. This sharp and sudden decline bumped 2018’s overall performance in that index down to the third worst in the past 20 years.

Predictably enough, the guardians of conventional opinion have already begun preparing their usual shallow, politically-motivated arguments about what caused this phenomenon and what needs to be done. The Telegraph’s article, for example, warned that a potential junk debt crash, if it arrives, would have been caused by the “eagerness in the US to liberate Wall Street from Obama-era restrictions”, citing a US appeals court ruling from last year which found that CDO managers no longer had to hold onto a portion of the risk they sold to others. The application of these politically convenient cure-alls can do nothing, however, to shield the true responsible parties from scrutiny, provided that priority is given to spreading public understanding of Mises’ Austrian Business Cycle Theory, which alone is capable of shedding light on the real causes of the coming crash.

George Pickering is a 2018 Mises Institute Research Fellow and a student of economic history at the London School of Economics.