The credit cycle is kind of like a Monty Python skit where the humor has reached a point of diminishing marginal returns. At that point, they might blow something up, and move onto the next skit. Credit cycles end with a bang, not a whimper. Take a spin down the last few cycles:
- 2000 — Nasdaq, dot-coms
- 1997-98 — Asia/Russia/LTCM
- 1994 — Mortgages/Mexico
- 1989 — Banks/Commercial Real Estate
- 1987 — Stock Market
- 1984 — Continental Illinois
- Early ’80s — LDC debt crisis
In each case, we had assets that were weakly financed. When liquidity began to become scarce, the entities that were weakly financed faced sharply rising borrowing costs, and many defaulted. The purpose of this piece is to muse about what entities in our world today are reliant on the presence of favorable financing, and would suffer if that financing ceased to exist. Here’s my initial list. Can you give me some more ideas?
- Too obvious: CCC-rated bond issuers. We’ve had a lot of them issue debt over over the past three years. Those that have not shored up their balance sheets and paid down debt will suffer if they need additional financing.
- Yield-seeking hedge funds. When the credit cycle turns, yield becomes poison. Those holding the equity of Collateralized Debt Obligations, and other levered forms of credit will have a rough time, particularly if their investors ask for their money back.
- Dodgy mortgages. We’ve already seen the beginning with subprime mortgages, but there are more loans that will hit resets over the next twelve months. The troubles with Alt-A lending will be more spread out, but it really hurts to have your financing rate jacked up at a time that the asset financed is experiencing weakness in price.
- Private equity over-borrowing. Much of private equity relies on the idea that they can have an easy liquidity event five years from now. What if interest rate are three percent higher then? P/E and EV/EBITDA multiples will be lower, not higher, and then what do you do with all of the debt used to finance the purchase?
- Overly indebted cyclicals, and mergers that increase leverage. Companies that presumed too much about the future get killed when the cycle turns. The mergers and recapitalizations that looked so promising are horrid when the willingness to take risk drops.
- Mis-hedged investment banks. This is a little more speculative, but in a credit crisis, investment banks without adequate liquidity are in the soup. Lehman Brothers barely survived 1998; in a more severe crisis, who would get harmed?
- Sovereign nations with large current account deficits. This is the most controversial category. I am not talking about the main emerging markets here; I am talking about developed countries that lack discipline, like Iceland, New Zealand, and the United States. The large emerging markets are in better shape than the derelict nations that they fund. If the debt is in their own currency, the nation has more options than merely defaulting. They can inflate, or create a two-tier currency system to give foreigners the short end of the stick. (Think of Argentina, or South Africa back in the 80s.)
These are the weak entities that I can think of. There are more, I am sure, particularly as the demographic crises emerge over the next decade, but for now, if liquidity becomes scarce, these are the entities that will suffer.