On September 15, 2008 the unthinkable happened: Lehman Brothers, the fourth largest investment bank in the USA that had been operating for 158 years and held over USD 600 billion in assets filed for bankruptcy. This sent shockwaves through global financial markets. Banks stopped lending to each other and to customers and tried to reclaim securities handed over to other financial institutions. The world was on the brink of a financial meltdown of epic proportions and was only rescued by governments and central banks who flooded markets with trillions of dollars.
Many people are not aware that during the Great Financial Crisis (GFC) of 2007-09 we got very close to an economic standstill. Without severe state intervention we would most likely have experienced a substantial drop in production and a collapse in global supply chains resulting in mass unemployment and food shortages. Fortunately, the worst was avoided but instead of fixing our corrupt financial system, tackling rampant market inefficiencies, and reducing the overwhelming debt pile to a healthy level our politicians and central bankers acted as they knew best. They bailed out corrupt financial institutions that were to a large extend to blame for the GFC and implemented measures that suppressed the symptoms but did not combat the causes of the crisis. As a consequence, the world is now in worse shape than it was at the start of the GFC.
According to the official narrative we have successfully overcome the GFC and even though not everything is perfect the economy is robust and well positioned to withstand the next downturn. What is usually not mentioned is that the meagre growth over the last decade has only been achieved because the world went deeper and deeper into debt.
An analysis conducted by the Institute of International Finance (IFF) sets global debt at USD 245 trillion or 320 % of global GDP. Between 2007 and 2017 debt has exploded by USD 73 trillion and just in the past two years an additional USD 24 trillion debt was created with government and non-financial corporate debt being the main driver. Such figures are already shocking but the actual situation is much worse. First, not all forms of borrowing are fully included such as shadow banking activities, peer-to-peer lending, non-bank leasing, seller installment contracts, as well as the use of pawn shops and loan sharks which is prevalent in many emerging economies. Second, unfunded public liabilities for medical services, pensions, etc. are not taken into account as contrary to private companies, governments don’t have to report them. It is clear that the current huge pile of debt can never be fully repaid, at least in real (inflation-adjusted) terms.
Taking on debt makes sense if the loan amount is used for activities that will generate high returns in the future. Governments are therefore justified to borrow money for smart investments in infrastructure or education and private companies can use loan proceeds to invest in new business activities with good growth and profit outlook. However, loans are more and more likely to be used to pay back maturing debt, increase leverage for risky financial investments or finance consumption. The “Return on Debt” is rapidly declining. Whereas in the past 1 additional USD or EUR of debt increased GDP by a factor well above 1 it is now generating only cents to the USD or EUR. The behavior of our governments and companies resembles that of a drug addict who needs to gradually increase the daily dose in order to achieve the same level of “comfort”. We are now at a point where any rehabilitation effort requires severe measures and will cause excruciating pain over an extended period. If we wait much longer complete collapse is certain.
The central banks of the world try to keep the bubble alive with bizarre unconventional monetary policies. In 2001 the Bank of Japan (BoJ) first introduced Quantitative Easing (QE) which is a more sophisticated wording for printing money to prop up overindebted governments and failing private companies. It now holds 50% of all government bonds, is a Top-10 shareholder in 50% of all Japanese companies and boasts total assets larger than the Japanese GDP. The U.S. Federal Reserve (FED) started QE in 2008 by buying U.S. Treasuries and debt obligations issued by Fannie Mae and Freddie Mac whose reckless behavior had substantially contributed to the GFC. This caused the FED balance sheet to grow from below USD 1 trillion to USD 4 trillion between 2008 and 2018. Even though the European Central Bank (ECB) was last to jump on the QE bandwagon in 2015, it did so with an enormous vigor previously unthinkable of any EU institution. Within 4 years it bought assets worth EUR 2.8 trillion, mostly government debt but also corporate debt, asset-backed securities and bonds.
The BoJ not only spearheaded QE but also in 1999 was the first central bank to introduce Zero Interest Rate Policy (ZIRP). However, it was overtaken by central banks in Europe who spearheaded Negative Interest Rate Policy (NIRP). Sweden started in 2009 followed by Denmark in 2012. But the big bang came in 2014 when the European Central Bank (EZB) started NIRP on a much larger scale. For those of you who face an intellectual barrier to understand what negative interest rates mean here a short explanation: You have to pay someone to borrow money from you. For instance, you lend someone 1,000 EUR on the condition that you will get back 980 EUR in 5 years resulting in a guaranteed loss of 20 EUR even without considering inflation and the risk of losing part or all of your principal. If you think this is insane and defies logic …… well, then you are unsuitable to be a central banker or politician.
ZIRP was quickly adopted by the Swiss National Bank (SNB) and the BOJ and in August 2019 there were bonds worth more than USD 17 trillion (equivalent to more than 20% of world GDP) that carried a negative yield, among them over USD 1 trillion from private corporations. That this is worrisome was even pointed out by Claudio Borio, Head of the Monetary and Economic Department at the Bank of International Settlements (BIS), which is often called the central bank of central banks as the BIS is owned by 60 central banks around the world. In an official podcast given on 19 September 2019 Mr. Borio remarked: “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis (GFC) of 2007-09, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”
Financial institutions are undeterred in buying negative yielding bonds hoping to sell them before maturity for a much higher price. It goes without saying that the buyer then faces an even lower negative interest rate and will have more difficulties in finding a new buyer to generate a profit. For holding the bond to maturity is not an option due to the guaranteed loss. History shows that there is always another sucker willing to buy a bad product …… until there isn’t. They usually call that a Ponzi scheme but you are not allowed to say that in relation to a system devised and implemented by our sacrosanct central bankers.
More ingenious measures such as “Helicopter Money” (= free money for all) are in the pipeline. And according to the “Modern Monetary Theory (MMT)” our governments will in the future rely on the central banks to finance limitless debt. Why did humanity have to wait thousands of years to find out that eternal prosperity can be created out of nothing?
The impact of all these desperate unconventional measures has been positive only on the surface. Boosted by readily available cheap money prices of stocks, bonds and real estate skyrocketed. Stocks are now trading near or even above historical peaks. For instance, since 2009 the S&P 500 index in the U.S. is up 230 % and the NASDAQ Composite, that comprises mostly Tech companies, is up 410%. Over the same period the U.S. economy did only grow by 43%. Many “Tech” companies with questionable business models and substantial losses have achieved market valuations in the tens or even hundreds of billions of dollars. In the old days the large majority of stocks were bought and sold by active investors who based their decisions on an in-depth analysis of the underlying assets. Nowadays Exchange Traded Funds (ETFs), that replicate a specific index, and automatic computer based algorithmic trading dominate the market. This is very nice on the way up but will accelerate losses once the market turns. Stock exchanges that used to be places of true price discovery have degenerated into gambling dens rigged by the big players resulting in stock quotations that are severely out of touch with the real world.
In the past the price of bonds used to go down when stocks went up but not this time. With everyone expecting that central banks will buy more and more bonds in the future their prices have continued to go up. As higher bond “prices” go along with lower bond “yields” this has allowed corporations to borrow money at very low or even negative rates. Many companies with low credit rankings can sell their “junk bonds” at rates close to the rates for allegedly “risk free” government bonds. Traditional requirements for strong loan covenants and adequate financial disclosure have been diminished to the point that a large part of so-called “investment grade” debt is now “covenant-lite” and appraised by the rating agencies as BBB which is just a level above junk status. Considering the rating quality of the same agencies prior to the GFC it can safely be assumed that many BBB bonds are in fact already at junk level. Similar to the stock market the bond market is a disaster waiting to happen.
Hedge funds and financial speculators have achieved amazing returns by borrowing huge amounts of money at near zero interest rates and investing them into all kinds of financial assets expecting that the central banks will prop them up at the slightest hint of something going wrong. And the use of derivatives has proliferated. For those of you who don’t know what derivates are, they are financial products that derive their value from the performance of an underlying asset (or a derivative, or a group of derivatives, or groups of derivatives of derivatives) and are often highly leveraged and severely exposed to counterparty risks. Warren Buffett therefore called them “financial weapons of mass destruction”.
Real Estate prices in the U.S. and many European countries tanked during the GFC. People who had bought a new home mostly on credit just before the crisis were all of a sudden “underwater”. As the market value of their property plummeted below the value of the mortgage principal many families lost not only their homes but also all their savings and some of them are still paying off their debts. By now real estate prices in many countries have not only recovered but – thanks to a never-ending stream of cheap money – gone well above their previous peaks. Price increases of well over 100 % are not uncommon. To be able to purchase a home, families nowadays have to go very deep into debt. Particularly the housing market in Canada and New Zealand is in bubble territory closely followed by Sweden, Norway, and Australia. But prices in many other countries in Europe as well as in the U.S. have also approached levels that give reason for concern. China is truly in a league of its own. Property values in most big cities have risen so steeply that they are well beyond the reach of middle-income families. Irrespectively investors still pour additional money into apartments that they never intend to live in or to rent out in the hope of further price appreciation (you find whole condos or even districts in China that are virtually empty). Once the housing bubble bursts prices will crash and many families will again lose their homes.
Central bank activities have caused the share of the finance sector in the overall economy to grow from about 3% to over 8% at the expense of the “real” economy. Nevertheless, the solvency of many banks has not improved due to the negative effect of very low or even negative interest rates. In particular banks in Europe are in a precarious position and bankruptcies can be expected once an economic downturn gets on the way. Savers, who already suffer from low/negative interest rates are likely to see their savings further diluted or completed wiped out by so called “bail-ins”. With this legal instrument, that is already statutory in the U.S. and Europe, insolvent banks can use the money of unsecured creditors (such as savers) to restructure their capital so they can stay afloat. If you think this won’t happen in the Western World just look at Cyprus that is a member of the EU since 2004 and a member of the EUR area since 2008. As part of a 10 billion bailout by the European Central Bank (ECB) and the International Monetary Fund (IMF) Cyprus agreed to accept a bail-in at two of its insolvent banks resulting in substantial losses for deposits above 100,000 EUR. Don’t count on any government “guaranteed” deposit insurance scheme to protect your assets once a real global crisis strikes.
Insurance companies are also vulnerable. The business model of life and health insurances is based on achieving decent capital returns over the long term. ZIRP and NIRP have caused them havoc. If you wonder why life insurances have kept reducing the forecasted end payment every year or why health insurances implement annual premium hikes of two, three, four or more times the rate of inflation then you now have the answer. ZIRP and NIRP are to blame as well as government regulations in many countries that require insurance companies to keep a high percentage of their assets in “save” government bonds. A European insurance manager is therefore forced to invest in negative yielding governments papers even though it is undeniably clear on the date of the purchase that the insurance (and eventually the insured) will heavily lose money. But it gets even better. Falling bond yields have forced many insurance companies to invest in risky “investment grade” assets to maintain their capital returns. Many of them are junk and once they blow up so might your insurance company. As with the banks don’t count on the government to bail you out.
When we look at the “real sector” that is producing actual goods and tangible services the situation is not as rosy as stock prices make you believe. Cheap money has induced many large companies to go deep into debt making their balance sheets much more vulnerable in case of an economic downturn. And instead of investing money into research and development companies nowadays prefer to increase dividend payments, buy other companies at inflated prices and purchase back their own shares.
Analyst justify rising stock prices with continued growth in profitability but a closer look at the annual reports of many corporations reveals that real profits are often stagnant or even declining. Most analysts use “adjusted profits” instead of real profits based on generally accepted accounting standards. What is often added back to the actual result are unusual or one-time taxes, acquisition and restructuring cost, impairment and litigation charges as well as stock-based compensation. On the other hand, extraordinary positive effects are seldom deducted. As a result, by cooking their books companies can easily improve their profits by ten, twenty or more percent and even turn a loss into a profit. Another reason for growing stock prices is the widespread use of debt funded stock buybacks to boost “Earnings Per Share (EPS)”. As EPS has a huge impact on top management compensation CEOs and CFOs have a strong incentive to borrow cheap money to buy back shares. For even if total earnings stay flat EPS will go up. It is a clear sign of the depraved ethics of our business community that top management gets paid for increasing their company’s future cost and risk.
Margins of many good businesses are squeezed by so called “zombie companies”. These are enterprises whose profits do not cover their interest expenses over a longer period of time let alone allow for the repayment of loan principles. There are estimates that they amount to 10-15 % of listed companies in the Western world and roughly 20% in China. Instead of allowing them to go bust governments and central banks are artificially perpetuating their existence thereby stifling innovative competitors who would otherwise create new jobs and increase productivity.
Prospects for most small and start-up companies are bleak. Banks are reluctant to lend them money and the issue of low yielding bonds is not a valid option for them. They face heavy competition from larger enterprises with easier access to cheap money. Nowadays not the best but the biggest wins and consequently industry concentration has increased in many sectors. Consumers suffer by paying higher prices and getting lower service.
A bubble in asset prices coupled with a sluggish economy has had a very detrimental impact on income and wealth distribution. The Rich who own most of the stocks, bonds and real estate have gotten even richer. The rest of the population has been faced with stagnant or declining salaries (at least in real terms), falling income from savings and life insurance as well as higher mortgages for the purchase of an apartment or house that are only partially offset by lower interest rates. The divide between the Rich and the Poor is fast-growing and the middle class, whose consumption is the main driver of the economy, has become increasingly indebted and decimated in size.
History has taught us two lessons. First that excessive debt usually does not end well and second that economic development is a sequence of booms and busts. Today we face record debt not only on a country but for the first time on a global level. Governments and central bankers indulge in overconfidence that they have the right tools to suppress the business cycle and create eternal growth. The GFC was a first warning shot. Instead of taking unpopular actions to reduce debt, reform our rotten financial system and strengthen fair competition our politicians and central bankers decided to bail out those who had caused the GFC and embark on reckless monetary policies. Today we are facing a new crisis that could make the last one look like a walk in the park.
Most members of the establishment are fully aware that we are close to an abyss. Hence the ECB has just implemented another interest rate cut and unleashed a new round of QE. The FED, that had been able to raise its fund rate from 0.25% to 2.50 % between 2015 and 2018 has now reversed course and started a new reduction cycle that will likely lead to the zero or negative interest rate environment that President Trump is requesting. Another round of QE is about to start. Other Central banks will follow suit. It seems that our ruling elites are not aware of the saying that “insanity is doing the same thing over and over again and expecting different results”. If you still think that everything is fine with our economy than you are just as deluded as those central bankers who are convinced that they have found the holy grail to subdue the business cycle forever.
© 2019 Live Beyond Borders. All rights reserved