Corporate debt – the IMF gets worried

20 November 2018 by Michael Roberts

Federal reserve building (CC - Flickr - Rafael Saldaña)

The IMF does not pull any punches in its latest post on the IMF blog. It is really worried that so-called ‘leveraged loans’ are reaching dangerous levels globally.

These loans, usually arranged by a syndicate of banks, are made to companies that are heavily indebted or have weak credit ratings. They are called “leveraged” because the ratio of the borrower’s debt to assets or earnings significantly exceeds industry norms. The level of these loans globally now stands at $1.3trn and annual issuance is now matching the pre-crash year of 2007.

“With interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
extremely low for years and with ample money flowing though the financial system, yield Yield The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. -hungry investors are tolerating ever-higher levels of risk and betting on financial instruments Financial instruments Financial instruments include financial securities and financial contracts. that, in less speculative times, they might sensibly shun.”
says the IMF IMF
International Monetary Fund
Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.

When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.

As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).

The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.
. About 70% of these loans are in the US; so that is where the risk of a credit crunch is greatest. And more than half of this year’s total involves money borrowed to fund mergers and acquisitions and leveraged buyouts (LBOs), pay dividends, and buy back shares from investor—in other words, for financial risk-taking rather than productive investment.

And even though corporate earnings in the US have risen sharply in 2018, the share Share A unit of ownership interest in a corporation or financial asset, representing one part of the total capital stock. Its owner (a shareholder) is entitled to receive an equal distribution of any profits distributed (a dividend) and to attend shareholder meetings. of companies that have raised their debt to earnings above five times has reached a higher level than in 2007.

New deals also include fewer investor protections, known as covenants, and lower loss-absorption capacity. This year, so-called covenant-lite loans account for up 80% of new loans arranged for non-bank lenders (so-called “institutional investors Institutional investors Entities which pool large sums of money and invest those sums in securities, real property and other investment assets. They are principally banks, insurance companies, pension funds and by extension all organizations that invest collectively in transferable securities. ”), up from about 30% in 2007.

With rising leverage Leverage This is the ratio between funds borrowed for investment and the personal funds or equity that backs them up. A company may have borrowed much more than its capitalized value, in which case it is said to be ’highly leveraged’. The more highly a company is leveraged, the higher the risk associated with lending to the company; but higher also are the possible profits that it may realise as compared with its own value. , weakening investor protections and eroding debt cushions, average recovery rates for defaulted loans have fallen to 69% from the pre-crisis average of 82%. So any sizeable defaults would hit the ‘real’ economy hard.

Back in 2007, the debt crunch was exacerbated by the phenomenal growth in credit derivatives Derivatives A family of financial products that includes mainly options, futures, swaps and their combinations, all related to other assets (shares, bonds, raw materials and commodities, interest rates, indices, etc.) from which they are by nature inseparable—options on shares, futures contracts on an index, etc. Their value depends on and is derived from (thus the name) that of these other assets. There are derivatives involving a firm commitment (currency futures, interest-rate or exchange swaps) and derivatives involving a conditional commitment (options, warrants, etc.). issued by non-banks, the so-called ‘shadow banks’, not subject to central bank Central Bank The establishment which in a given State is in charge of issuing bank notes and controlling the volume of currency and credit. In France, it is the Banque de France which assumes this role under the auspices of the European Central Bank (see ECB) while in the UK it is the Bank of England.

controls. Now again, it is in the shadow bank area that a debt crisis is looming. These institutions now hold about $1.1 trillion of leveraged loans in the US, almost double the pre-crisis level. On top of that are $1.2 trillion in high yield, or junk bonds Junk Bonds The nickname in the USA for high-risk bonds, also called High Yield Bonds, issued by a company whose solvency is considered doubtful. This type of bond is considered highly speculative by the rating agencies. , outstanding. The non-bank institutions include loan mutual funds, insurance companies, pension funds Pension Fund
Pension Funds
Pension funds: investment funds that manage capitalized retirement schemes, they are funded by the employees of one or several companies paying-into the scheme which, often, is also partially funded by the employers. The objective is to pay the pensions of the employees that take part in the scheme. They manage very big amounts of money that are usually invested on the stock markets or financial markets.
, and collateralized loan obligations (CLOs), which package loans and then resell them to still other investors. CLOs buy more than half of overall leveraged loan issuance. Mutual funds (which are usually bought by average savers through their banks) that invest in leveraged loans have grown from roughly $20 billion in assets in 2006 to about $200 billion this year, accounting for over 20% of loans outstanding.

All this debt can be serviced as long as earnings pour into companies and the interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. rate on the debt does not rise too much. Corporate earnings appear to be strong at least in the US. In the latest quarter of reported company earnings, with 85-90% of companies having reported, US corporate earnings are up nearly 27% from the same period last year (although sales revenues are up only 8%). US sales revenue growth is about 20% higher than in Europe and Japan but earnings growth is two to three times larger. That tells you US earnings are being inflated by the one-off Trump corporate tax cuts etc.

Moreover it is earnings in the energy/oil sector that have led the way, as oil prices rose through the last year. Recently, the oil price has taken a serious plunge as supply (production in the US) has rocketed. That’s going to reduce the contribution of the large energy sector to earnings growth.

Anyway, the reported earnings by companies in their accounts are really smoke and mirrors. The real level of profits is better revealed by the wider data provided in the official national accounts. And the discrepancy between the rise in profits as recorded there and the company earnings reports has not been as high since the bust of 2000, which eventually presaged the mild economic slump of 2001. Reported US corporate earnings per share are rising fast, but ‘whole economy’ profits are basically flat.

The other moving part is the cost of borrowing. The decade of low interest rates is over as the US Fed FED
Federal Reserve
Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank :
continues with its policy of hiking its policy rate.

The Fed policy sets the floor for all borrowing rates, not only in the US economy, but also abroad whenever borrowing dollars.

As I have explained in a number of posts, the Fed’s hiking policy will add to the burden of servicing corporate debt, particularly for those companies that have resorted to leveraged loans and junk bonds. Herein lies the kernel of a future slump.

Michael Roberts

worked in the City of London as an economist for over 40 years. He has closely observed the machinations of global capitalism from within the dragon’s den. At the same time, he was a political activist in the labour movement for decades. Since retiring, he has written several books. The Great Recession – a Marxist view (2009); The Long Depression (2016); Marx 200: a review of Marx’s economics (2018): and jointly with Guglielmo Carchedi as editors of World in Crisis (2018). He has published numerous papers in various academic economic journals and articles in leftist publications.
He blogs at

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