This is an onsite edited excerpt of the G|O Briefing newsletter
“A financial crisis is a bank run writ large, a run on the entire financial system. People lose confidence that their money is safe—whether they’re stockholders or bondholders, institutional investors, or elderly widows—so they pull it out of the system, which makes the money remaining in the system even less safe, which makes everyone less confident,” Timothy Geithner, the former US Treasury Secretary, summed up in his candid memoir, Stress Test.
Geithner’s somber description of the 2008-2009 global financial crisis, however, is also front and center on people’s minds these days. The ongoing COVID-19 economic shock that has knee-capped global growth and ushered in widespread uncertainty poses systemic threats to the stability of the global financial system, warns a report by the Geneva-based UN Conference on Trade and Development. Other economic and financial experts say that regaining confidence will be critical for the world to avert another deep recession post-COVID-19.
“COVID-19 is not only a wake-up call, it is a dress rehearsal for the world of challenges to come. We must move forward with humility—recognizing that a microscopic virus has brought the world to its knees." - Antonio Guterres
But this will also require, they argue, a strong dose of international cooperation and coordination, which they lament is sorely lacking in some centers of power, as witnessed by the public spectacle of great power leaders bickering during the UN General Assembly, and ignoring the prescient pleas of the UN Secretary-General António Guterres. “Those who built the United Nations 75 years ago had lived through a pandemic, a global depression, genocide, and world war. They knew the cost of discord and the value of unity. They fashioned a visionary response, embodied in our founding Charter, with people at the center. Today, we face our own 1945 moment. The pandemic is a crisis unlike any we have ever seen,” the UN chief declared.“COVID-19 is not only a wake-up call, it is a dress rehearsal for the world of challenges to come. We must move forward with humility—recognizing that a microscopic virus has brought the world to its knees. We must be united. We have seen when countries go in their own direction, the virus goes in every direction. We must act in solidarity.”
One of the UN’s top economists, however, put aside diplomatic speak. “We’re all talking about the pandemic with parallels to the war economy, and the UN celebrating 1945 and 75 years, (but) when you look at the world today, it looks like a hell of a long way from 1945, and the people making the decisions, do not look like the Roosevelts, and the Churchills, or even the Stalins of this world—they really don’t, and that’s got to be a worry,” Richard Kozul-Wright, Director of Globalization and Development Strategies at UNCTAD, the Geneva-based UN Conference on Trade and Development told The Geneva Observer.
With a possible second wave of the pandemic infections looming on the horizon, concerns about systemic threats that could seriously hamper the abilities of the global financial system to weather the storm are also focusing minds. High on the warning list is that despite the massive infusion of public funds—in particular by G20 countries—to keep economies afloat (over US$13 trillion), there are growing fears the damage inflicted by the crisis, including a blow-out in public and private debt, could heighten financial vulnerabilities in both advanced and emerging economies.
“The heightened debt distress from COVID-19 is not confined to public balance sheets. The debt splurge, in both developed and developing countries, since 2009, has been driven by private borrowing with growing concerns...about high and rising corporate debt levels." Unctad
On October 1, IMF chief Kristalina Georgieva, and others, warned that the COVID-19 crisis has pushed debt levels to new heights and pointed out that compared to end-2019, average 2020 debt ratios are projected “to rise by 20 percent of GDP in advanced economies, 10 percent of GDP in emerging economies, and about 7 percent in low-income economies.
The further rise in debt is alarming.” Indeed, as UNCTAD succinctly warns in its flagship Trade and Development Report 2020: “The heightened debt distress from COVID-19 is not confined to public balance sheets. The debt splurge, in both developed and developing countries, since 2009, has been driven by private borrowing with growing concerns...about high and rising corporate debt levels.” One area of anxiety is that the COVID-19 economic shock could see a marked deterioration in low-quality corporate debt in financial markets which has grown massively in recent years, in part due to years of accommodating monetary policy and low-interest rates, and may trigger a wider financial crisis. The UNCTAD report says that in the decade since the global financial crisis (2008-09), non-financial corporations “have become addicted to cheap debt.”
The data assembled in the report highlight the debt growth in this sector and should be a wake-up call for world leaders in advanced and emerging economies. They include:
- Since 2008, non-financial corporations worldwide have issued about $1.8 trillion in new bonds each year, a pace roughly double that in the seven years prior to the global financial crisis
- At the end of 2019, the outstanding stock of non-financial corporate bonds was at an all-time high of $13.5 trillion, twice what non-financial corporations (NFCs) owed in 2008 If one adds what NFCs owe to banks and other creditors, their indebtedness comes to $75 trillion, up from $45 trillion in 2008
- It is not only the volume of debt that gives cause for concern but also its quality, which appears to have deteriorated markedly since 2008
- In 2019, only 30 percent of the outstanding global stock of NFCs bonds was rated A or above.
In addition, UNCTAD says that in the first half of 2020, non-financial corporate bond issuance stood at a record US$2 trillion, a 49 percent increase from the same period a year earlier, and adds there are growing concerns much of this borrowing is sub-standard. Moreover, financial markets in the United States, it says, “are likely to face the greatest risks,” and goes on to reveal that almost half of the non-financial corporate bond issuance is dominated by US corporations and stands at US$9.6 trillion, up by more than 50 percent in a decade. Overall, UNCTAD’s assessment is that it is the lower quality non-financial corporate debt that “does pose a risk to financial fragility.”
The red alert for UN analysts is the marker that half of the US corporate bonds maturing in the next five years are below investment grade. “Corporate debt rated BBB, the lowest investment-grade rating, is at a historic peak ... In post COVID-19 times, these securities will be hard to refinance, while corporations that issued the bonds may face a growing threat of bankruptcy ... The defaults may cascade through the shadow banking system and impact the financial system at large,” it cautions.
The instruments most likely, UNCTAD says, to trigger a wider financial crisis are Collateralized Loan Obligations (CLOs)—financial products which gather and then structure risky corporate loans into a group of new securities. “CLOs today have corporate junk bonds as one of their main ingredients ... the extent to which banks are exposed to potential CLO losses is a further source of uncertainty,” it says.
UNCTAD’s Kozul-Wright says the worry is that within the CLOs, there’s a package of companies that are only kept going by being able to access these kinds of loan obligations. “It’s Ponzi financing, again. What seems to be the difficulty is understanding who is lending the money.” Because they are coming from shadow banking, he says, part of the problem is this sector is unregulated, so “we don't exactly know the details (of the CLOs).” Looking back at the 2008-09 crisis to illustrate the opacity of complex financial instruments, Kozul-Wright, who holds a Ph.D. in economics from Cambridge University, says at the end of the day, “we did not even know the details” of the Collateralized Debt obligations (CDOs). CDOs, the toxic products that included mortgage-backed securities, were at the epicenter of the 2008-09 financial crisis.
“The levels of intricacies were astounding. But we only found out when we went belly up in 2008.” But we’re even further behind, he says, “in understanding the financial intricacies involved in these things (CLOs). That’s one problem. The other aspect is, of course, that they’re very heavily focused on the US,” the UN economist remarked. According to a 2019 research paper by Claudiu Moldovan, a financial expert at the European Central Bank, “The lack of clarity about who holds the risk of many CLO tranches raises a number of financial stability concerns that require further investigation and monitoring.” The paper goes on, “The ultimate risk holders of CLO tranches remain unknown as asset managers and hedge funds, which purchase the majority of the CLO tranches in the primary market, invest mainly on behalf of third parties. This raises questions about whether the ultimate investors have the capacity to bear potential severe losses, or how losses may be transmitted across the financial system.”
Robert Patalano, deputy head at the OECD’s directorate for financial and enterprise affairs, when asked about the potential systemic risks from CLOs and low-quality non-financial corporate debt, told The Geneva Observer, “You’ve got over US$2 trillion leveraged loans and a good US$600+ billion of that has been packaged into CLOs, and they’re sitting broadly across banks, insurance companies, pensions, etc.” Patalano, who is also coordinator of the OECD’s influential Committee on Financial Markets, says lower-quality debt—that has grown tremendously—is now sitting across institutions not just in the United States and parts of Northern Europe but also in many other OECD countries, “because large banks and insurance companies and pension funds are looking for a ‘reach for yield’ and even if you are reaching out for an AAA CLO, if they give you a better yield than AAA sovereign bonds, you want the yield. “
That’s why some large Japanese and US banks, for instance, he says, are sitting on a lot of senior CLO tranches, so it’s a widespread issue. But due to the heightened risks, he noted, “some major banks and insurance companies have reduced exposures.”
And then the question is, he pondered, how much of a downturn will occur in the system, which turns the credit quality, and what will be the implications for debt. “Obviously, with investment-grade debt if there’s a default,” he says, “it’s quite idiosyncratic.”
But for defaults to occur, they generally occur in BBB CCC (ratings)—this is the neighborhood, he noted—and underlined, “defaults normally occur during periods of economic stress, and that’s in the realm of high-yield leveraged loans and CLOs.” Even where CLO tranches such as AAA tranches are sitting in large institutions—and in the last crisis, the CLOs did not lose cash value—Patalano says they certainly lose market value, however, and sometimes institutions “are forced to get rid of them when their value is at the lowest.”
The other issue, he says, is the lack of covenants (causing most of the new issuance to be “cov-lite”) in leveraged loans. “For this reason, when defaults occur, the losses in the defaults will be much higher this time than in the last crisis, and that could start to burn through buffers, and that could affect the structural deficiencies in these CLOs and cause losses on major institutions,” the OECD financial expert noted. Similarly, Caroline Roulet, economist and policy analyst in the OECD’s directorate for financial and enterprise affairs, told The Geneva Observer that to estimate how bad the situation could get with a second wave, computations by the agency showed that “probabilities are rising on mortgage loans and high-yield corporate bonds with potential spillovers to real estate structured products like RMBS ( Residential Mortgage-Backed Securities) and CMBS ( Commercial Mortgage-Backed Securities).”
Tranches B, in particular, are at risk, she says, especially in the retail and hotel sectors in the US and in Europe.
Moreover, estimates about bank non-performing loans (NPLs)—should a second wave occur—found that in advanced and emerging economies, bank NPL ratio, Roulet declared, “double under a single hit scenario and culminate under the (second-shock) scenario at levels that may exceed levels during (the) previous crisis.” Deteriorating creditworthiness, combined with high debt-rollover risks, Roulet says, could result “in higher corporate defaults as a consequence of the impact from COVID-19 including higher credit costs and lower earnings, which in turn would spill over to the financial system.”
When asked why, given the concerns aired about the vulnerability of CDOs and other instruments, financial regulators have not zoomed in on them, Kozul-Wright countered: “Because the regulators across the financial world have essentially thrown in the towel. The shocking thing is that you would have thought after the 2008-09 financial crisis—because the promise was: Look, this will not happen again; we recognize the regulators took their eye off the ball. But all these similar types of toxic instruments have now come back into play.” “There has not been a systemic attempt to clamp down,” he added.
Research conducted by Roulet and published in a report by the OECD in August carried out rigorous corporate debt stress testing on a sample of financial statements from over 12,000 firms worldwide to estimate the potential effects of a shock. It revealed the precarious situation many exposed and at-risk firms could face or if exposed to downside risks. Roulet told The Geneva Observer that under stress testing conditions (20 percent fall in corporate earnings, a 6.5 percent rise in the cost of credit, and currency depreciation against the dollar of 30 percent for firms in EMEs) the findings show that under stress conditions a lot of firms can have problems in terms of debt repayment and also funding conditions.
“This is particularly the case in the US and also in emerging markets, where a substantially high share of debt is in low-grade debt and may be prone to downgrade and default. So, I think this illustrates the point about creating expectations about massive downgrades of high-yield bonds and leveraged loans.” The study, which included a review of over 8,300 at-risk and distressed firms, concluded that “Corporate sector stress will affect the banking sector through increases in non-performing loans as well as other investors in high-yield corporate bonds like insurance companies, pension funds, and asset managers.”
UNCTAD says that while low-quality non-financial corporate debt has been more prevalent in advanced economies, the corporate bond market has also grown substantially in some large emerging countries since the financial crisis, rising in total from US$380 billion in 2007 to US$3.7 trillion in 2017, with Chinese firms accounting for almost two-thirds of the total by 2017.
Looking ahead, Kozul-Wright says if a premature austerity is ushered in as countries exit the COVID-19 crisis, “then the chance of a double-dipped recession late next year or early 2022 is significant.” “The point of the UNCTAD report is that the fear is that if they (governments) do go into a cutting spree prematurely, then the world economy will be in very serious trouble. The recovery from 2009 has been a long recovery, it has been a very weak recovery, and part of the reason was premature austerity. Having spent significantly in 2009, and to some extent into 2010, they cut back far too early,” he says. “The evidence is out on the notion of expansionary austerity, and it’s a fraud. Austerity leads to contraction and leads to a worsening of the fiscal position of governments. You hit the denominator just as hard as you hit the numerator, right?”
On a brighter note, Kozul-Wright says UNCTAD offers a growth scenario driven by ensuring the public sector spending is maintained until the private sector consumers and businesses are in a position to spend. And if you are willing to persist with that, he says, and coordinate that internationally “we do show that it's not only good for growth, it's good for jobs, it's good for wages, and it's good for public finances in the longer-term.”