While no recession or financial crisis starts in exactly the same way, or follows the exact same pattern when it does kick off, there is always a catalyst that triggers the cascade failure. As 2019 grinds to a close, there are numerous potential triggers to consider.
However, perhaps the most concerning is the increasing risk of a corporate debt meltdown. Indeed, as I discussed in a previous article for GuruFocus, legendary bond investor Jeffrey Gundlach thinks increasing amounts of corporate debt, combined with laxer lending standards, will likely prove to be this economic expansion’s downfall.
Fake earnings getting faker
In an article for GuruFocus published earlier this month, I discussed the increasing propensity of companies to massage their earnings, especially their calculations of Ebitda (earnings before interest, taxes, depreciation and amortization), which are often used by private lenders as a proxy for borrowers’ financial health. In it, I discussed how a recent machine learning analysis of 4,000 public filings found that, perhaps unsurprisingly, “The simpler the definition, the less 'creative' the Ebitda.”
Corporate finance has become increasingly awash in these creative Ebitda calculations. Venture capital backed WeWork, the co-working company now infamous for suffering arguably the single most catastrophic pre-IPO implosions in financial history, attempted to sell investors on the idea of “community-adjusted Ebitda,” a metric with little relation to traditional Ebitda – and which the investment community found wanting.
Yet, while WeWork failed to convince markets with its highly dubious Ebitda metric, other companies have managed to sell Wall Street and investors on highly creative interpretations.
Corporate debt crisis
Alan Waxman, a leading light of the bond investment world, has been sounding the alarm about “fake Ebitda” with increasing fervor. At a private conference in early December, he declared it an epidemic afflicting debt markets:
“It’s not normal, as a lender, to lend money against fake Ebitda and fake collateral...The sacred lending principle of loan-to-value integrity is the single most important thing in credit investing. When it is severely compromised, as it is now, credit stops being credit. It’s just cheap capital.”
Combined with the reflation of credit ratings courtesy of Moody's (MCO, Financial) and its competitors, the deteriorating quality of private corporate debt tells a worrying story. The BBB-rated credit market, which lies on the cusp of investment grade, looks especially dangerous. According to Waxman, 43% of debt in this category is quadruple levered, setting up a potentially severe downturn in the event of a loss of confidence.
Catalyst for crisis
The dangers facing corporate credit markets do not appear to be fully appreciated by the broader market, which continues to have a big appetite for questionable credit exposure. According to Waxman, “The party will go on in the leverage finance markets until we have a catalyst.”
Gundlach echoed these fears in a Dec. 4 interview with Yahoo! Finance, in which he argued that high leverage ratios will spark mass downgrading of, and subsequent exodus from, corporate bonds:
“[It will] lead to very significant divestment of a lot of the naive money that's gone into the corporate bond market. Because it's been a pretty smooth ride for the last 10 years. And it's been pretty rewarding this year as well."
Verdict
About 70% of BBB-rated bonds are currently at risk of losing their investment grade status. A slight shock to the credit market could spark exactly the sort of mass exodus that would result in a financial firestorm. Under such circumstances, investors would be wise to heed Gundlach’s advice:
“Corporate bond exposure should be at absolute minimum levels right now.”
Disclosure: No positions.
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