October 12, 2018
As we mark the 10th anniversary of the peak of the financial crisis, news outlets continue to feature pieces how another one, possibly worse, is just around the corner. This mostly shows that the folks who control these outlets learned absolutely nothing from the last crisis. As I have pointed out endlessly, the story was the collapse of the housing bubble that had been driving the economy. The financial crisis was an entertaining sideshow.
There is one story in the coming crisis picture that features prominently — the corporate debt burden, as discussed here. (This Bloomberg piece is actually well-reasoned.) The basic story is a simple one: corporate debt has risen rapidly in the recovery. This is true both in absolute terms, but even in relation to corporate profits.
The question is whether this is anything that should worry us. My answer is “no.”
The key point is that we should be looking at debt service burdens, not debt, relative to after-tax corporate profits. This ratio was was 23.1 percent in 2017, before Congress approved a big corporate tax cut. By comparison, the ratio stood at more than 25 percent in the boom years of the late 1990s, not a time when people generally expressed much concern over corporate debt levels.
It is true that the burden can rise if interest rates continue to go up, but this would be a very gradual process. The vast majority of corporate debt is long-term. In fact, many companies took on large amounts of debt precisely because it was so cheap, in some cases issuing billions of dollars worth of 30-year or even 50-year bonds. These companies will not be affected by a rise in interest rates any time soon.
But clearly, there are some companies that did get in over their heads with debt. There are two points to be made here.
First, with the stock market at extraordinarily high levels (this is true even with the selloff of the last two days), companies can still raise a large amount of capital by issuing new shares. If their debt burden poses serious risks to the company, presumably they will go this route. In many cases, companies will have subsidiaries, land, or other assets that they can use to raise money if it is needed to pay off its debt.
Second, some companies will undoubtedly face financial distress and need relief from creditors, either through renegotiating debt or bankruptcy. The question here is, so what? Companies are always going bankrupt. Our laws are designed to allow companies to continue to operate through a bankruptcy. Creditors are forced to take a loss on their loans, the size of which will depend both on the financial shape of the company and where they stand in line as a creditor.
So let’s say that a substantial portion of the $1.3 trillion of speculative debt cited in the Bloomberg piece faces a credit downgrade, with some of it going into default. This means that some investors lose money. We have a $20 trillion economy. If the losses amounted to 40 percent of these bonds (which would be huge), that still only amounts to $520 billion, or 2.6 percent of GDP. The impact of this loss would barely be felt in the economy as a whole.
In short, even in the really bad story here, we are not talking a major financial crisis or a second Great Depression. Some investors get hit as a result of making some bad picks. This may be a serious problem for them, but it’s not the sort of thing the rest of us need to worry about.