LIBOR Pains

Wrong Focus

If one searches for news on LIBOR (=London Interbank Offered Rate, i.e., the rate at which banks lend dollars to each other in the euro-dollar market), they are currently dominated by Deutsche Bank getting slapped with a total fine of $775 million for the part it played in manipulating the benchmark rate in collusion with other banks (fine for one count of wire fraud: US$150 m.; additional shakedown by US Justice Department: US$625 m., the price tag for a deferred prosecution agreement).

London Interbank Offered Rate - 3 Months, April 2016 - 2017

Since mid 2015, 3 month LIBOR has soared from a low of approx 22.5 basis points to its current level of 115 basis points – i.e., it is now more than 5 times higher than two years ago. The “ouch” is explained further below. - Click to enlarge

Along with the surge in LIBOR we have seen a widening in the TED spread (the spread between 3M LIBOR and the t-bill discount rate). Normally this is a sign of increasing stress in the banking system, but we are not sure if that interpretation is currently applicable. The absolute size of the spread is still a far cry from what was seen during past crisis situations. The spread is also well off its 2016 spike high, which we take as an indication that the disruption caused by the retreat of US MM funds from funding European banks is abating.

So what is the problem? It is actually not the banking system that gives cause for immediate concern. One must keep in mind that risks in the financial system have shifted since the 2008 crisis. Eventually, these risks are still going to redound on the banking system, but it is so to speak one step removed from the currently ticking time bomb, rather than being right at its center.

TED Spread, Sep 2013 - Jan 2017

TED spread: still high, but not as high as it was last year - Click to enlarge

The Nature of the Problem

As mentioned above, LIBOR is a benchmark reference rate (which explains why some banks were so eager to manipulate it). The pricing of all kinds of floating-rate debt is tied to it (corporate loans, mortgages, student loans, credit card debt, and assorted derivatives, such as currency and interest rate swaps, etc.). That has now become a problem. Before we get to that, here is some background information:

One of the components of the global debtberg that has grown at a particularly breath-taking pace in recent years is corporate debt. As we have often mentioned in these pages, we regard it as a major Achilles heel of the Bernanke echo bubble. It already looked dubious before the recent rise in rates (see “A Dangerous Boom in Unsound Corporate Debt”) and has kept growing since then.

We often post a chart that adds up outstanding corporate bonds and bank debt, but the chart actually shows less than half of total US corporate liabilities, which currently amount to more than $18 trillion. There are also the “forgotten” $3 trillion in off-balance sheet operating leases, which are currently only known to avid readers of footnotes found in earnings reports, as Bloomberg recently reported.

Corp Liabilities and Wilshire, 1975 - 2015

Debt of US non-financial corporations: total liabilities (blue line), outstanding bonds + bank debt (red line) and the Wilshire Total Market Index (black line) – the Wilshire Index reflects the bubble in asset prices; these are prone to suffering a “reversal to the mean”. Debt levels will remain where they are when that happens, but the collateral backing a lot of debt will be perceived to be less valuable. There is a multi-layered feedback loop between asset prices and debt that has become quite important for the economy. - Click to enlarge

Obviously, the gap between spending and cash flows is funded with debt, which in this context probably deserves to be called Ponzi debt. Not to forget, debt is an absolute figure. The same cannot be said of income or the value of assets, both of which are moving targets. Everything is fine as long as the latter are moving up – alas, it is in their nature to occasionally misbehave.

US Corporates, Feb 1996 - 2016

The gap between non-financial corporate spending on capex/ investment/ dividends and stock buybacks vs. gross cash flows is at a new record high. Such expressions of unbridled overconfidence are usually soon punished - Click to enlarge

US Nonfinancial Companies

US corporate profitability produces a record as well, but the wrong kind - Click to enlarge

As an aside, since the next crisis is far more likely to be focused on corporate debt rather than mortgage debt, it is irrelevant that CLOs have held up better than CDOs during the GFC. Similarly, triple-A ratings of structured credit products can quickly become meaningless in a credit crisis. CLOs repackage junk and make it fit for top ratings by means of overcollateralization rather than the creation of tranches of different seniority, but ultimately this is exactly the same trap in different clothing.

Commercial Loan Growth, Jul 2010 - Jan 2017

Corporate & Industrial loans, y/y growth rate. Growth in bank lending to companies has slowed from an interim peak of 13.30% in 2015 to 3.16% currently (“cold feet syndrome”). In the absence of QE, this slowdown in credit growth affects money supply growth, which in turn increases the probability that asset prices will fall - Click to enlarge

Conclusion – A Bug Waiting for a Windshield

We don’t expect this first round of debt repricing to necessarily trigger a crisis – we don’t know what the threshold will be. We note though that demand for corporate debt and in particular junk debt has been enormous, and corporations have obviously sated it by producing more debt than ever before (with covenants becoming progressively less stringent). The liquidity of many of these debt instruments is a lot worse than it once was, as banks have vacated their previous role of market makers.

Both the companies most at risk (i.e., those mentioned by Fitch) and the most highly leveraged investors operate at the fringes of the system and occasional defaults are normally easily absorbed. Even an entire (and fairly sizable) sector getting into trouble is not necessarily a big deal as long as system-wide free liquidity remains plentiful, as was demonstrated by the energy sector’s woes in 2015. All of the above describes a latent risk, but one that keeps growing – a happy bug in search of a windshield, so to speak.

Is is also worth noting that the echo bubble doesn’t have a particular focus – it is diffuse in the sense that it has become a “bubble in everything”. This is inter alia illustrated by the median price-revenue ratio of the stocks in the S&P 500 Index shown by John Hussman not too long ago:

On the one hand this makes it difficult to pinpoint a likely trigger – in contrast to the situation prior to the GFC. At the time it was crystal clear that a crisis would most likely be centered on the housing sector and the financial engineering associated with it (OK, it wasn’t clear to Fed officials, politicians, regulators, most mainstream economist and most of Wall Street, but it was definitely clear to people in possession of a modicum of common sense).

On the other hand, an ominous implication of the diffuse nature of the bubble is that there will be “no place to hide” when the above-mentioned latent risks materialize. If the oil sector’s problems had emerged amid a lack of system-wide liquidity, they would likely have proved contagious. Rising interest rates and a slowdown in credit growth imply that this precondition is very likely to prevail when the next batch of problems shows up.

Hussman Strategic Advisors, 1986 - 2017

The “bubble in everything” – on a cap-weighted basis, the market was more overvalued at the peak in 2000, but from a more holistic perspective it has never been more overvalued than today - Click to enlarge

Bonus Chart: Rate Comparison

The chart below shows LIBOR, interest paid on bank reserves held at the Fed and the effective FF rate:

Rate Comparison, Sep 2013 - Jan 2017

LIBOR (3M) – blue line, IOR – black line, FF rate – purple line. Payment of IOR is what makes it possible for the Fed to hike rates without selling the assets it has accumulated via QE. Allegedly there is a plan to “normalize” the balance sheet, but that would shrink the money supply unless commercial banks were to vastly expand credit at the same time (read: it’s not going to happen) - Click to enlarge