By Steven Pearlstein, June 2018

Let’s recall those heady days of 2006 when home prices were rising 10, 15, even 20 percent a year, allowing millions of homeowners to refinance mortgages and collectively take out more than $300 billion in cash from the increased value of their properties.  Some spent the money on furniture, appliances, cars and vacations, adding fuel to an already roaring economy.

Others reinvested it in the already booming real estate and stock markets.  When it finally occurred to everyone that those houses and those stocks weren’t really worth what the debt-fueled market said they were, markets crashed, banks flirted with insolvency, and the economy sank into a deep global recession.

Now, 12 years later, it’s happening again.  This time, however, it’s not households using cheap debt totake cash out of their overvalued homes.  Rather, it is giant corporations using cheap debt – and a one-time tax windfall – to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks.  As before, the cash-outs are helping to drive debt – corporate debt – to record levels.  As before, they are adding a short-term sugar high to an already booming economy.  And once again, they are diverting capital from productive long-term investment to further inflate a financial bubble – this one in corporate stocks and bonds – that, when it bursts will send the economy into another recession.

Welcome to the Buyback Economy.  Today’s economic boom is driven not by any great burst of innovation or growth in productivity.  Rather, it is driven by another round of financial engineering that converts equity into debt.  It sacrifices future growth for present consumption.  And it redistributes even more of the nation’s wealth to corporate executives, wealthy investors and Wall Street financiers.

Corporate executives and directors are apparently bereft of ideas and the confidence to make long-term investments.  Rather than using record profits, and record amounts of borrowed money, to invest in new plants and equipment, develop new products, improve service, lower prices or raise the wages and skills of their employees, they are “returning” that money to shareholders.  Corporate America, in effect, has transformed itself into one giant leveraged buyout.

Consider Apple, the world’s most valuable enterprise.  As a result of a $100 billion share buyback announced last month, Apple will have returned $210 billion to shareholders since 2012.  How much is $210 billion?  As Robin Wigglesworth of the Financial Times reminded his Twitter followers, that’s enough to buy up the bottom 480 companies of the S&P 500.

And Apple is not alone.  Last year, public companies spent more than $800 billion buying back their own shares and, thanks to all the cash freed up by the recent tax bill, Goldman Sachs estimates that share buybacks will surge to $1.2 trillion this year.  That comes at a time when share prices are at an all-time high-so companies are buying at the top – and when a growing global economy offers the best opportunity to expand into new products and new markets.  This is nothing short of corporate malpractice.

The best recent research on the folly of buybacks is by two professors at Europe’s top business school, INSEAD.  Looking at the 60 percent of companies that have bought back their stock between 2010 and 2015, Robert Ayres and Michael Olenick calculated that the firms, as a group, spent more than 100 percent of their net profits on dividends and share repurchases.  They also found that the more a company spent on buybacks, relatively speaking, the less good it did for the stock price.

At the 535 firms that spent the least, relatively speaking, on stock repurchases (less than 5 percent of the company’s market value), market value grew by an average of 248 percent.  These companies included Facebook,, Google, Netflix and Danaher, all of which mainly used the buybacks as compensation for employees.  (Amazon chief executive Jeff Bezo owns The Washington Post.)

By contrast, the 64 firms that spent the most repurchasing shares (the equivalent of 100 percent of market value) saw an average 22 percent decline in the firm’s market value.  These include Sears, J.C. Penney, Hewlett-Packard, Macy’s, Xerox and Viacom, for all of which, the primary purpose of the buybacks was to prop up the stock price in the face of disappointing operating results.

Corporate buybacks don’t just affect individual companies, however.  At this scale, buybacks are also a factor in the performance of the overall economy.

Consider that $1.2 trillion is the equivalent of more than 6 percent of the annual output – or gross domestic product – of the United States, the world’s largest economy.  It is larger than the GDP of all but the 15 largest countries in the world.  And it is a sum that will likely far exceed the amount of money raised by the corporate sector’s issuing new stock, meaning that for another year, more equity capital is flowing out of publicly traded corporations than flowing in.

As the accompanying chart indicates, over the past decade, net issuance of public stock – new issues minus buybacks – has been a negative $3 trillion.  This reduction in the supply of public shares in American companies, coupled with an increased global demand for them, goes a long way toward explaining why stocks are now priced at 25 times earnings, well above their historical average.

The most significant and troubling aspect of this buyback boom, however, is that despite record corporate profits and cash flow, at least a third of the shares are being repurchased with borrowed money, bringing the corporate debt to an all-time high, not only in an absolute sense but also in relation to profits, assets and the overall size of the economy.

It used to be that issuing bonds was the most common way for corporations to borrow money.  A decade ago, in 2008, there was $2.8 trillion in outstanding bonds from U.S. corporations.  Today, it’s $5.3 trillion, after the record $1.7 trillion of new bonds issued last year, according to Dealogic, and $500 billion more issued this year.

In recent years, at least half of those new bonds have been either “junk” bonds, the riskiest, or BBB, the lowest rating for “investment-grade” bonds.  And investor demand for riskier bonds has largely been driven by the growth of bond ETFs – or exchange traded funds – securities that trade like stocks but are really just pools of different corporate bonds.  ETFs have made it easier for individual investors to participate in the corporate bond market.  A decade ago, about $15 billion worth of bond ETFs were being traded.  Today, that market has grown to $300 billion.

Moreover, a greater part of corporate borrowing has come in the form of bank loans that are quickly packaged into securities known as CLOs, or collateralized loan obligations, which are sliced and diced and sold off to sophisticated investors just as home loans were during the mortgage bubble.  Bloomberg News recently reported that pension funds and insurance companies, particularly those in Japan, can’t get enough of the CLOs because of the higher yields that they offer.  Wells Fargo estimates that a record $150 billion will be issued this year, roughly double last year’s issuance.  And as happened with the late-cycle home mortgages in 2007 and 2008, analysts are noticing a marked decline in the quality of loans in the CLO packages, with three-quarters of them now without the standard covenants designed to reduce the chance of default.

As a result of all this corporate borrowing, Daniel Arbess of Xerion Investments calculates that more than a third of the largest global companies now are highly leveraged – that is, they have at least $5 debt for every $1 in earnings – which makes them vulnerable to any downturn in profits or increase in interest rates.  And 1 in 5 companies have debt-service obligations that already exceed cash flow – “zombies,” in the felicitous argot of Wall Street.

“A new cycle of distressed corporate credit looks to be just around the corner,” Arbess warned in February in an article published in Fortune.

Mariarosa Verde, senior credit officer at Moody’s, the rating agency, warned in May that “the record number of highly-leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives.”

“Flashing red” is how this buildup of corporate debt was characterized by the U.S. Treasury’s Office of Financial Research in its latest annual report on the stability of the financial system.  The International Monetary Fund recently issued a similar warning.

What concerns these regulators is not simply the growth of the corporate debt market but also the change in its structure and how it will perform during a sell-off.

In the past, more corporate loans were made and held by banks, while corporate bonds were held by pension funds, insurance companies and mutual funds.  They held them to maturity, keeping bond prices stable.

But with the rise of ETFs, some market analysts and observers have begun to worry about what would happen if, in response to a sudden spike in interest rates or defaults, large numbers of individual investors rushed to sell at a time when nobody is interested in buying, sending ETF prices into a tailspin.

According to a recent paper by Kevin Pan of Harvard and Yao Zeng of the University of Washington, this lack of “liquidity” in the bond market could send prices down sharply, trigger waves of panic selling and cause the market price of the ETFs to fall far below the price of the underlying bonds.

The ETF industry has mounted a concerted PR campaign to convince regulators and investors that the market will be able to cope with a rush of sell orders.  But because these products are relatively new, nobody really knows how they will perform in a crisis.  Certainly the experience with complex mortgage securities and credit default swaps during the 2008 crisis does not inspire confidence.  There is also the danger of contagion – that panic selling and falling prices of corporate bonds and ETFs will spread to other credit markets.

The bigger reality is that the global economy is now awash in debt – not complete debt but also record amounts of government debt, household debt and investor debt – at a time when interest rates are rising from historically low levels.

Here in the United States, the federal budget deficit is expected to top $1 trillion a year in 2019, on top of the $20 trillion of outstanding debt, crowding out other borrowing and putting upward pressure on interest rates.  The Congressional Budget Office projects that interest payments on the federal debt will grow from $316 billion this year to $915 billion by 2028.  Not only does the new debt need to be financed, but trillions of dollars in old debt will also need to be refinanced when it comes due. And then there is household debt.  After the last financial crisis, American consumers made a concerted effort to save more, borrow less and pay off credit card and auto loan debt.  But memories are short, and a decade later, mortgage debt, credit card debt, student loan debt, and car loan debt are all, once again, at record levels and growing briskly.  Among the 38 percent of households with credit card debt, the average balance is nearly $11,000 according to ValuePenguin, based on data from the Federal Reserve.  The Consumer Financial Protection Bureau recently reported that, among subprime borrowers, credit card debt is up 26 percent in just the past two years.Finally, there is the debt that investors large and small take on to buy stocks, bonds, derivatives and other securities.  That’s also at an all-time high.

As Stephen Blumenthal of CMG Capital sees it, this is the “mother of all credit bubbles.”  And with the Federal Reserve and central banks now bringing the supply and cost of credit back to normal levels, and with demand for credit continuing to soar, heavily indebted businesses, governments and households will soon be hit with big increases in interest payments.

As interest payments begin to crowd out spending on other things, the economy will slow.  We’ve seen this self-reinforcing downward cycle before, and it invariably leads to market sell-offs, loan defaults, bankruptcies, layoffs and, quite likely, recession.

Although banks are in better shape than in 2008 to withstand the increase in default rates and the decline in the market price of their financial assets, they are hardly immune.

“Banks will reap what they have sowed in having created all this debt,” said James Millstein, an expert in corporate and government debt who oversaw the restructuring of insurance giant AIG for the treasury during the 2008 financial crisis.  “Banks are still the most highly leveraged financial institutions in the economy.  They remain vulnerable to a recession-driven increase in delinquencies and defaults in their corporate, real estate and household loan books.”

It’s hard to say what will cause this giant credit bubble to finally pop.  A Turkish lira crisis.  Oil prices topping $100 a barrel.  A default on a large BBB bond.  A rush to the exits by panicked ETF investors.  Or the fallout from ill advised trade wars with U.S. allies!

Trying to figure out which is a fool’s errand.  Pretending it won’t happen is folly.

July 10, 2018
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