We have never seen countrywide lockdowns to prevent the spread of a virus. It is right that governments compensate citizens for quarantines that prevent them from working and central banks prevent a short-term liquidity crisis from becoming a crisis of solvency. But the response must not be a cover to bail out bust borrowers and out-of-pocket speculators.
Yet last week we witnessed unprecedented moves by the US Federal Reserve to buy low-rated bonds and even exchange traded funds of junk debt. Markets reacted with glee at being rescued yet again. One strategist on Wall Street even called it a “gift from the Easter bunny”.
Former Treasury secretary Timothy Geithner once described Walter Bagehot’s Lombard Street as “the bible of central banking.” According to that 1873 book, central bankers are supposed to avert panic by lending early and without limit to solvent companies, against good collateral, and at a penalty rate.
However, when it came to the crunch in 2008 Mr Geithner consciously disregarded that sacred text. He and then Fed chairman Ben Bernanke lent freely to possibly insolvent groups at zero rates. Those actions encouraged moral hazard on a grand scale. Instead of promoting prudence, central bankers since then have continuously spiked the punchbowl.
In a recent report, the IMF warned that central banks have increased financial fragility by encouraging companies to pursue “financial risk-taking” and gorging on debt. Rather than target lower debt levels, companies learned that they would be bailed out if they borrowed.
But with or without coronavirus, we would have seen a wave of bankruptcies. Corporate debt in the US has never been higher, at 47 per cent of gross domestic product. Globally, non-financial corporate debt has doubled since the last financial crisis.
Vast swaths of the economy are now inhabited by “zombie” companies, which have not generated enough cash over the past few years to cover their interest costs. Researchers at the Bank for International Settlements suggested that the proportion of zombie companies in more than a dozen advanced economies had risen from 4 per cent in the mid-1990s to more than 12 per cent by late 2018. Debt is used to finance more debt, and zombies lead to overcapacity and lower productivity.
After a decade of economic growth and generous tax relief, US companies should have held cash piles to sustain them for short periods without revenue. But most borrowed all they could and never saved for a rainy day.
Today credit spreads are increasing, indicating a higher probability of default. However, the anomaly is not the current levels of stress but the unnatural calm that came before. Research by Variant Perception shows that, historically, companies with high levels of net debt compared with their cash flows have had higher costs of funding. But this relationship broke down after the last crisis. It is only now, during the coronavirus crisis, that fundamentals are reasserting themselves and terrible companies are seeing their spreads widen.
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The stance of Fed chair Jay Powell, a governor of the central bank since 2012, should not be a surprise. Four years ago he noted in a speech that “a long period of very low interest rates could lead to excessive risk-taking and, over time, to unsustainably high asset prices and credit growth.” Many times he warned against suppressing volatility. Yet as soon as markets swooned in December 2018, he immediately reversed course. He has gone from preaching about the risks of credit growth to providing liquidity to junk bond ETFs.
Lending to potentially insolvent companies is bad enough, but buying corporate bonds and ETFs in the secondary market is of questionable legality under Section 13 of the Federal Reserve Act, which allows for lending against collateral in “exigent” circumstances. It also does nothing to help fund the economy, and merely helps the returns of investors who have already bought corporate bonds. It is a paradise for speculators.
The obvious beneficiaries of the junk bond-buying programme are overleveraged private equity groups and unhealthy borrowers. This is not surprising. Mr Powell spent years at Carlyle, the private equity giant. After the last financial crisis, Mr Geithner, too, moved through the revolving door to the position of president at Warburg Pincus, another private equity firm.
Investors and chief executives are learning that no matter how imprudent their borrowing in the good times, when the bad times inevitably arrive, they will be thrown a lifeline.
The writer is chief investment officer at Prevatt Capital and founder of Variant Perception, a research firm
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