Thursday, August 8

An unstable recovery built on debt

An unstable recovery built on debt
| By Jim Jubak

Don't be fooled by the huge run in the US stock market and the rebound in the housing market. The financial crisis never really ended, and its effects continue to roil the global economy.

This is the financial crisis that keeps on giving.

Right now, I find myself asking many of the same questions about debt, risk and collateral that investors were asking in the run-up to the bankruptcy filing of Lehman Brothers in September 2008.

The two big questions I have at the moment: Where's the collateral for all this debt -- private, corporate and governmental -- that has been issued in efforts to prop up global growth? And what's that collateral worth?

Here's a brief survey of some recent high (or low) points. Please note that the examples are from pretty much everywhere.

· On July 19, the European Central Bank announced it would accept lower-rated assets, including asset-backed securities, as collateral from banks. The asset-backed securities would have to be simple, plain-vanilla instruments, the bank said, and in exchange, the eurozone central bank would accept assets rated as low as A instead of the current AAA. Reminds me of the good old days when Wall Street added a thin dose of AAA credits to a bundle of risky subprime mortgages and called the whole thing an AAA credi

Jim Jubak

· Fitch Ratings and other credit analysts have warned that many of the wealth management products being sold to Chinese savers anxious to earn more on their deposits than the 3% that banks are allowed to pay are invested in loans backed by inadequate or shaky collateral. In the worst cases, no one can identify exactly what collateral stands behind a loans.

· Companies in Europe, Africa and the Middle East with sub-investment-grade credit ratings -- that is, "junk" ratings -- owe $114 billion that's due in 2014. That's up from $84 billion in 2013, according to Moody's Investors Service. Half of that debt carries a negative outlook, up from 34% with negative ratings in 2012.

· Credit outstanding to Brazilian consumers has climbed to 44% of disposable income, from 18%, in the past decade. The default rate on consumer borrowing did fall for the fourth straight month in April to the lowest level since November 2011, although I would note that, at 7.5%, the default rate in Brazil is still extraordinarily high. One explanation for the drop in default rates: Interest rates in Brazil fell to a historic low of 7.25% by April. Unfortunately for Brazil's consumers, the central bank raised rates in April in what looks like the beginning of a fight to reduce inflation that's likely to last for the remainder of 2013.

· In Japan, the good news is that the nation's budget for the fiscal year, which started on April 1, will see the government raise a higher percentage of spending from tax revenue than at any other time in the past four years. The bad news is that the government will still cover 46.3% of its spending from borrowing. The Organisation for Economic Cooperation and Development estimates that Japan's budget deficit for 2013 amounted to 10.3% of gross domestic product. In comparison, countries such as Spain and the United States that generate a fair amount of worry about the size of their deficits come in with estimated budget-deficit-to-GDP ratios of "just" 6.9% and 5.4%, respectively, for 2013. The CIA World Factbook estimated Japan's accumulated government debt in 2012 at 214% of GDP, the highest ratio in the world.

· Back in the U.S. of A, Moody's Investors Service recently warned of a rise in loans with fewer investor protections, or covenants. The volume of these covenant-lite loans approached $80 billion in the first quarter of 2013. That's close to the total for all of 2012, according to Thomson Reuters. Among new, speculative-grade corporate bonds rated B1 or below, through April, 35% received covenant quality ratings of weak 3.8 to 5.0 scores from Moody's. In the same period a month ago, 29% of new issues had equivalently low scores.

I could go on and on. For example, there's Russia's recent decision to borrow money from its state pension funds to spend on expanding the Trans-Siberian Railway, building a high-speed rail line from Moscow to Kazan and constructing a new ring road around Moscow. Or the eurozone's decision to leverage the credit ratings of member countries to sell debt so it can raise money for its bailout fund -- a decision that showed its downside when Fitch Ratings simultaneously downgraded France to AA+ from AAA and dropped its rating on the European Financial Stability Facility to AA+ from AAA. Cutting the rating on the European rescue fund seemed only logical, Fitch said, because France is the second-largest guarantor of the fund's debt issues.

Why is all this important now?

As the recent on-again, off-again bankruptcy filing by the city of Detroit serves to remind us, the ultimate collateral behind any debt is the borrower's ability to pay.

Oh, yes, such issues as the specific collateral pledged to a debt, the actual value of that collateral and the ease or difficulty in converting that collateral to cash are important, as U.S. banks learned during the subprime mortgage crisis, when the houses used to secure mortgages turned out to be worth much less than banks had calculated and when selling foreclosed houses turned out to be amazingly difficult. (Turns out – surprise -- that when you foreclose on so many houses, you depress the market price for all foreclosed houses, even if you can manage to sell them at all.)

And this level of debt, the sinking quality of loans and the questionable value of collateral will become huge issues if the national and global economies slow and some borrowers become unable to pay.

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