The recession (we’re undoubtedly in already) is not the worst of our woes. It’s unlikely the FED would have taken such drastic measures because of the coronavirus or even the prospect of recession. I’ve mentioned in previous articles that corporate debt was viewed as a key vulnerability in the economy.
The following quote is from back in November 2019 from the Financial Stability Report of the US Federal Reserve. It is one of what they consider the ‘vulnerabilities’ of the financial system highlighted in their report:
Borrowing by businesses is historically high relative to gross domestic product (GDP), with the most rapid increases in debt concentrated among the riskiest firms amid weak credit standards. By contrast, household borrowing remains at a modest level relative to income, and the amount of debt owed by borrowers with credit scores below prime has remained flat.
It should come as no surprise, given the ‘easy money’ policy of the central bank since the Great Recession, that companies have chosen to use debt financing rather than equity over the past 5 – 10 years. Private equity has also been a source of funding, as I indicated in a prior article – but remember private equity firms also lend huge sums to needy corporations. The number of companies choosing to go the public route has shrunk considerable over recent years as a result of these attractive alternatives which don’t require a substantial loss of control over the businesses.
Thriving and surviving depends on the ability of companies to pay their obligations. With the exception of one rough spell a couple of years ago, cash flow for corporate America has managed to grow enough to carry more indebtedness.
United States – Corporate Net Cash Flow with IVA
However, there comes a point at which the economy becomes too vulnerable and we’ll soon be suffering the consequences. So far, we’ve experienced a massive re-valuation of assets. What we will soon see, and I suspect the FED saw this coming when they elected to aggressively cut interest rates by 50 basis points (and may get more aggressive yet). Disruptions ignited by COVID-19 exposed just how vulnerable the credit situation really is. As the following chart clearly illustrates, the trajectory of non-financial debt taken on by corporations is much steeper than the rise in the ability of corporations to carry the debt load.
United States – Nonfinancial corporate business; debt securities; liability, Level
What happens when debt-laden companies experience a catastrophic hit to revenues and cash flows? Anyone with a mortgage knows exactly what happens when they lose their job and income. Oil prices for example have plunged, and although energy companies are fast revising down their spending and capital budgets, it is inevitable that their lenders must do the same – call their loans to maintain their own solvency. I’ve professionally experienced the same phenomenon; lenders ask for their money back from companies that ‘can pay’ (not in dire financial straights, yet) because the more troubled borrowers cannot pay at all. A credit crisis is underway.
As more businesses are impacted by the economic slowdown, the more the multiplier effect works in reverse – literally shrinking the money supply. Perhaps the FED is hoping to mitigate this process, but just as it took a long time to reverse the last crisis, it will take a significant amount of time to forestall this one. In the meantime, the market meltdown will continue. Airlines and countless travel-dependent businesses (the more capital-intensive, the worse it will be), and all those industries dependent on global supply chains will be hit. The narrowing of spreads at the largest lenders will demand they also contribute to the deleveraging of the financial system.