This time is different - zombie companies, corporate debt, and GFC 2.0

What is different this time is that unlike earlier times, the impending global financial crisis is not made in Wall Street or banking sector. Instead, it looks set to have its origins in the non-financial corporate board rooms. More specifically in the decisions take during the last decade of extraordinary monetary accommodation to gorge up on debt.

The dangers of rising corporate debt has been flagged several times in recent years, including this and this reports by MGI and BIS respectively.

The FT had this assessment about US corporations, citing this recent study by the US Federal Reserve Board,

The average ICR is a rather low 3.7 and the percentage of debt at risk (with ICR < 2) is a non-negligible 31.7 per cent.<2 31.7="" a="" b="" cent.="" is="" non-negligible="" per="">

The Economist writes,

The locus of concern is in the world’s ocean of corporate debt, worth $74trn. On Wall Street the credit spreads of risky bonds have blown out... The scare has four elements: a queasy long-term rise in borrowing; a looming cash crunch at firms as offices and factories are shut and quarantines imposed; the gumming-up of some credit markets; and doubts about the resilience of banks and debt funds that would bear any losses... Global corporate debt (excluding financial firms) has risen from 84% of GDP in 2009 to 92% in 2019, reckons the Institute of International Finance. The ratio has risen in 33 of the 52 countries it tracks. In America non-financial corporate debt has climbed to 47% of GDP from 43% a decade ago, according to the Federal Reserve. Underwriting standards have slipped. Two-thirds of non-financial corporate bonds in America are rated “junk” or “bbb”, the category just above junk. Outside America the figure is 39%... Naughty habits have crept in: for example, using flattering measures of profit to calculate firms’ leverage...

To get a sense of the potential damage in other countries The Economist has done a crude “cash-crunch stress-test” of 3,000-odd listed non-financial firms outside China. It assumes their sales slump by two-thirds and that they continue to pay running costs, such as interest and wages. Within three months 13% of firms, accounting for 16% of total debt, exhaust their cash at hand. They would be forced to borrow, retrench or default on some of their combined $2trn of debt. If the freeze extended to six months, almost a quarter of all firms would run out of cash at hand.

John Detrixhe in Quartz writes about zombie companies,

About 17% of the world’s 45,000 public companies covered by FactSet haven’t generated enough earnings before interest and taxes (EBIT) to cover interest costs for at least the past three years. Bank for International Settlements economists, using a similar but narrower definition, find that the world’s equity markets’ share of zombies has risen to more than 12%, up more than 8 percentage points since the mid 1990s... While unemployment in the US and parts of Europe are at multi-decade lows, a growing number of businesses may be held together by little more than cheap financing, instead of their ability to sell things and make a profit... Zombie companies have contributed to the glut of $3 trillion of risky borrowing around the world...

“You have delayed the normal lifecycle of companies with low interest rates,” said Alberto Gallo, a portfolio manager at Algebris Investments. “You keep alive business models that are unsustainable.”... John McClain, a money manager at Diamond Hill Capital Management... thinks a number of venture-capital funded companies with high valuations—privately funded “unicorns” with price tags of more than $1 billion—are effectively zombies as well...

There’s a close link between lower interest rates—central banks’ primary weapon for giving the economy a boost—and the stock market’s share of zombie companies, according to BIS economists Ryan Banerjee and Boris Hofmann. They found that these weaker companies are spreading because zombies aren’t dying. That is, they’re staying in a “zombie state” for longer instead of regaining their corporate health or reorganizing in a bankruptcy, and potentially weakening economic productivity...Instead of defaulting, companies can end up tying up resources—talented employees, and capital—that could be more useful somewhere else... Lower rates can beget more zombie companies, crowding out resources that could have been available for healthier enterprises. This in turn weakens the economy, causing lower interest rates and sustaining more companies with weaker finances.

Policy makers face a Hobson's choice in the circumstances,

Allowing interest rates to jump higher could set off a string of defaults, threatening livelihoods. But delaying the day of reckoning is showing few signs of bringing zombie companies back to life, and there are signs that current policies are starting to backfire. In the worst case, they may be setting up another debt crisis.

Rana Faroohar writes about its knock-on effects on the banking sector too,

It’s one thing for the aircraft manufacturer Boeing to draw down its entire $13.8bn credit line. It’s another for multiple big corporations to draw theirs at the same time. Still, as a recent Credit Suisse report pointed out, “we now have a global banking system where all major banks have to pre-fund 30-day outflows” with high-quality liquid asset portfolios. This is one important reason why these corporate funding stresses haven’t caused a real time banking crisis in the way that the 2008 subprime crisis did. Another reason is that the Fed is backstopping the banking system with its repo operations, as banks exchange Treasury bills for cash. All of this underscores a fundamental truth — regulators usually tend to fight the last war. The dollar deposits that corporations are currently drawing down are one of the highest-quality types of funding for banks, the same kind that the Basel III rules stipulate they should keep on hand. Nobody assumed that a pandemic would result in huge credit drawdowns by many companies all at once. Losing these deposits so quickly threatens the liquidity profile and regulatory compliance of banks themselves. And that is before we start to see the spike in corporate downgrades and defaults that will create even more funding pressure.

The fact is that the banking system has already been pulled into the corporate credit crisis that many people predicted would be the cause of the next big market downturn. It’s all too easy to see how the problems of individual companies — technology firms, retailers, airlines and insurance companies — could be passed to individual banks and then to countrywide banking systems. Ultimately, they could spread throughout the global financial system, leaving central bankers once again the lender of last resort, standing between us and another global financial crisis. That is pretty much what is already happening, and we haven’t even seen the next phase of falling dominoes — the meltdown of passive and algorithmic investing, the unwinding of exchange traded funds, and the sale of even the highest quality assets by people who are desperate to raise cash in the midst of a liquidity crisis. All this means that central bankers will have to keep the money taps on, and probably increase the variety of assets that they are buying or backstopping.

It is not just corporates, even countries are exposed to debt burdens which could turn unsustainable with a deep slowdown. FT writes,

This disease-induced shock to supply and demand could not have come at a worse time for a world economy awash in debt: $72.7tn (92.5 per cent of global gross domestic product) for sovereign borrowers and $69.3tn (88.3 per cent of GDP) for non-financial corporate borrowers, according to the Institute of International Finance. Many highly indebted sovereign and corporate borrowers will be in distress.

Lebanon has just defaulted. Zimbabwe, Zambia, Republic of Congo, Mozambique, and Angola are struggling at the margins of default. Italy, the worst affected European country, as the FT report writes, is the perennial "elephant in the room".

Update 1 (18.03.2020)

The global non-financial corporate debt has been on a rising trend since the last crisis.