In the sound money community it’s generally understood that abandoning the last vestige of the gold standard in 1971 gave major countries effectively-unlimited credit cards – which corrupted them irredeemably.
Now – with government bonds yielding either next to or less than nothing – that corruption has begun to spread to corporations, whose bonds are being snapped up by yield-deprived investors. For example:
In the wake of the 2008 financial crisis, managers shunned debt. But the Bank of Japan’s “a new phase of monetary easing,” which began in the spring of 2013 was a game-changer. The BOJ’s ultraeasy monetary policy has sharply lowered borrowing costs. Among Japanese companies that have taken on more debt since the central bank’s new policy, 70% have seen their market capitalization rise.
Thus, from both a corporate and an investor perspective, debt is not necessarily a bad thing.
The positives of negative
Earlier this year, the BOJ introduced negative interest rates for the first time to try and restore the moribund economy to health. The BOJ set an interest rate of minus 0.1% for some current account deposits held by commercial financial institutions at the central bank. Under normal conditions, borrowers must pay interest rates to their creditors. Under negative interest rates, lenders, in effect, pay borrowers to take their money.
Corporate Japan is adjusting to the reality of negative interest rates. The BOJ’s below-zero rates have pushed corporate bond yields sharply lower as well. A financial subsidiary of Toyota Motor recently issued three-year bonds paying an annual interest rate of 0.001%. This translates to yearly interest of just 1,000 yen ($9.43) per 100 million yen borrowed. Many market participants believe it is only a matter of time before yields on corporate bonds slip into negative territory, just as those on government bonds have.
Hulic, a real estate company, is taking advantage of the new environment. Backed by a 250 billion yen line of credit from 10 financial institutions, Hulic bought Grand Pacific Le Daiba, a big hotel in Tokyo’s Odaiba district, from railway operator Keikyu for just over 60 billion yen in May.
“Without [this] funding capacity, our company would not have the ability to procure properties, and would not be able to maintain its growth potential,” said Hulic President Manabu Yoshidome, a former banker.
Nearly 60% of listed Japanese companies are now effectively debt-free. But if they remain risk-averse and complacent, they will have a hard time generating growth and winning investor support.
That last sentence is chilling. In a credit bubble, a rock-solid balance sheet becomes “risk-averse and complacent” while borrowing record amounts of money to make historically-huge acquisitions is just good business.
Since corporate CEOs, being human, find it hard to resist the siren call of empire, expect the negative interest rate world to generate a deluge of M&A which in turn produces mal-investment on a scale that dwarfs that of the junk bond, dot.com and housing bubbles.
Two more-or-less random illustrations of the ability of easy money to turn corporate CEOs into raging idiots:
William F. Farley is not a household name today, but during the junk bond bubble of the 1980s – when credulous investors lent money to almost literally anyone with a plan to acquire almost literally anything – this guy was a roll-up artist who eventually bought and ran the Fruit of the Loom underwear company. As Wikipedia tells it:
Farley would soon establish himself as a nationwide leader in leveraged-buyout transactions. Over the next decade, Farley Industries would grow to encompass numerous companies within the manufacturing, mining, and apparel industries, the largest acquisition of which was Northwest Industries, for $1.4 billion in July 1985. This acquisition brought Farley national attention for its size and boldness.
Farley served as president and CEO of Fruit of the Loom from 1985 to 2000. During that time, Fruit of the Loom’s revenue grew dramatically, from $500 million to almost $2.5 billion. At its peak, Farley Industries employed over 30,000 employees worldwide. Even while the company’s revenue was rising sharply, its debt proved increasingly unwieldy amid the shifting economy. In 1999 Fruit of the Loom posted a net loss of $576 million, and Farley stepped down from his position.
Illustrating the absurdity of credit bubble dynamics, at the peak of his illusory power, Farley actually considered running for president – and was taken seriously by many who mistook access to cheap capital for actual expertise, intelligence, and/or character.
And then of course there’s the legendary Chuck Prince, whose famous “dance” quote solidified his place in the pantheon of truly dumb bankers. A Time Magazine piece from 2007 (just as, we now know, the housing bubble had begun to burst) captures the judgmental if not moral corruption of easy money:
He denied that Citigroup, one of the biggest providers of finance to private equity deals, was pulling back.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he said in an interview with the FT in Japan.
Now the prospect of Chuck Prince dancing is in itself unsettling. But his account amounts to quite an elegant explanation of why financial bubbles persist. Even if Citigroup’s executives were worried that private equity valuations have gotten too frothy and loan terms too loose, it would make little sense for them to pull back. Because they can never know for sure when the music’s going to stop, and they’d be crazy to forego all those underwriting fees for the year or two or three before it does. So they keep dancing.
Then again, maybe some of us are just too eager to call this boom a bubble. Yesterday Moody’s reported that global defaults of speculative-grade debt (a.k.a. junk) in the second quarter were at their lowest level since 1995. I would bet that default rate is about to start rising, but still: The world’s big corporations are doing spectacularly well at the moment. Can you blame Chuck Prince for wanting to throw more money at them?
The crucial thing to understand about credit bubble dynamics is that borrowing money from people desperate to lend and using the proceeds to overpay for assets requires only monkey-level intelligence. So while a bubble is inflating it’s impossible for most of the media, banking and political communities to tell the legitimate operators from the hopelessly corrupt and/or extremely stupid. That’s the world we’ve created by handing monetary printing presses to governments, and by extension to corporate CEOs.
Today’s bubble is global, as capital sloshes from one country to the next in search of safety and/or yield. So this time around virtually all major governments have been corrupted, and now every country’s major corporations are about to suffer the same fate. We have, in short, the mother of all crack-up booms coming our way.