The Global Economy Is Partying Like It’s 2008
In late 2008, at a meeting with academics at the London School of Economics, Queen Elizabeth II asked why no one seemed to have anticipated the world’s worst financial crisis in the postwar period. The so-called Great Recession, which had begun in late 2008 and would run until mid-2009, was set off by the sudden collapse of sky-high prices for housing and other assets — something that is obvious in retrospect but that, nevertheless, no one seemed to see coming.
*(For the record, I did see it coming in the summer of 2006, and told everyone in my inner circle and in my organization. The pattern of consumer spending started to decline rapidly as the banks dramatically cut back on home equity loans - PM)*
Are we about to make the same mistake? All too likely, yes. Certainly, the American economy is doing well, and emerging economies are picking up steam. But global asset prices are once again rising rapidly above their underlying value — in other words, they are in a bubble. Considering the virtual silence among economists about the danger they pose, one has to wonder whether in a year or two, when those bubbles eventually burst, the queen will not be asking the same sort of question.
This silence is all the more surprising considering how much more pervasive bubbles are today than they were 10 years ago. While in 2008 bubbles were largely confined to the American housing and credit markets, they are now to be found in almost every corner of the world economy.
As the former Federal Reserve chairman Alan Greenspan recently warned, years of highly unorthodox monetary policy by the world’s major central banks has created a global government bond bubble, with long-term interest rates plumbing historically low levels.
He might have added that this bubble has hardly been confined to the sovereign bond market. Indeed, stock values are at lofty heights that have been reached only three times in the last century. At the same time, housing bubbles are all too evident in countries like Australia, Britain, Canada and China, while interest rates have been driven down to unusually low levels for high-yield debt and emerging-market corporate debt.
One reason for fearing that these bubbles might soon start bursting is that the years of low interest rates and avid central bank government bond buying that spawned the bubbles now appear to be drawing to an end.
The Federal Reserve has already started to raise interest rates — on Wednesday it hiked the benchmark rate by a quarter of a percentage point — and has announced a schedule for reducing the mammoth amount of government securities it holds. At the same time, with the European and Japanese economic recoveries picking up pace, both the European Central Bank and the Bank of Japan are hinting that they are likely to soon follow the Fed’s lead in tightening monetary policy by raising rates.
Other reasons for fearing that the bubbles might soon start bursting are the fault lines in a number of major economies. Italy has both a serious public debt problem and a shaky banking system. Brazil is experiencing political turmoil while its public finances are on a clearly unsustainable path. China has a housing and credit-market bubble that dwarfs the one in the United States at the start of this century. And both Brazil and Italy will be holding contested parliamentary elections next year.
This is not to mention the economic dislocation that could result from a termination of the North American Free Trade Agreement, or from the accentuation of other protectionist tendencies, whether by the United States or by another big country. Nor is it to mention the risk that events in the Korean Peninsula could spin out of control.
Economic policymakers seem to have lulled themselves into a false sense of security by trusting the stricter bank regulations put in place after the collapse of Lehman Brothers in 2008. They seem to be turning a blind eye to the dominant role that so-called shadow banks (hedge funds, private equity funds, large money market funds and pension funds) play in the American financial system now. Unlike the banks that were covered by the Dodd-Frank regulations, these institutions are lightly regulated — but, as we painfully learned in 1998 when the hedge fund Long-Term Capital Management had to be bailed out, are subject to deposit runs just like banks.
It is too late for policymakers to do much to prevent bubbles from forming. However, it’s not too early for them to start thinking about how to respond in a manner that might free us from the boom-bust cycles that we seem to be experiencing every 10 years. They could, for example, create a program that in a severe downturn would give every citizen a cash grant to be spent at their discretion, what Milton Friedman called “helicopter money.”
It’s unclear, however, whether the world’s largest economy can take the lead this time. The Trump administration’s budget-busting tax cuts risk overheating markets even further and limiting the government’s ability to respond when the bubbles pop. This heightens the risk that when the bubbles burst, we’ll be forced to rely yet again on artificially low interest rates, which will set us up yet again for another boom-bust cycle.
Subprime delinquency rate for non-bank lenders back near recession levels
A Perella Weinberg Partners fund has been sitting on an IPO of Flagship Credit Acceptance for two years as bad loan write-offs push it into the red. Blackstone Group LP has struggled to make Exeter Finance profitable, despite sinking almost a half-billion dollars into the lender since 2011 and shaking up the C-suite multiple times.
And Wall Street bankers in private say others would love to cash out too, but there’s currently no market for such exits.
In the years after the financial crisis, buyout firms poured billions into auto finance, angling for the big profits that come with offering high-interest loans to buyers with the weakest credit. At rates of 11 percent or more, there was plenty to be made as sales boomed. But now, with new car demand waning, they’ve found the intense competition -- and the lax underwriting standards it fostered -- are taking a toll on profits.
Delinquencies on subprime loans made by non-bank lenders are soaring toward crisis levels. Fresh investment has dried up and some of the big banks, long seen as potential suitors, have pulled back from the auto lending business. To top it off, state regulators are circling the industry, asking whether it preyed on borrowers and put them in cars they couldn’t afford.
“The PE guys sailed into this thing with stars in their eyes. Some of the businesses have done fine and some haven’t,” said Chris Gillock, managing director at Colonnade Advisors, a boutique investment bank. But right now, “it’s about as out-of-favor a sector as I can think of.”
The apparent turnabout represents a sobering shift in what has been a booming market. Since the turn of the decade, buyout firms, hedge funds and other private investors have staked at least $3 billion on non-bank auto lenders, according to Colonnade. Among PE firms, everyone from Blackstone and KKR & Co. to Lee Equity Partners, Altamont Capital and CIVC Partners waded in.
Many targeted smaller finance companies that often catered to the least creditworthy borrowers with nowhere else to turn. Overall, subprime car loans -- those extended to people with credit scores of 620 or lower -- have increased 72 percent since 2011. Last year, about 20 percent of all new car loans went to subprime borrowers.
It usually works like this. Subprime finance companies first borrow money from the big banks and then compete for loans from car dealers. They make their margin from the spread between their funding costs and the interest they can charge, minus operating expenses and whatever losses occur when borrowers can’t pay. What they don’t keep on their books usually gets bundled into bonds and sold as asset-backed securities. Some will also sell loans to banks or brokers to raise cash.
For many PE-backed subprime lenders, which invested heavily to expand, margins have shrunk as delinquencies spiked and auto sales peaked.
In some ways, buyout firms can only blame themselves. Because of the limited time to show a return on their investments, usually four to six years, there was immense pressure to grow. That led many finance companies to loosen their standards -- like lengthening repayment periods and lending to borrowers with lower credit scores -- to gain an edge as car sales roared back from the depths of the recession and competitors jumped in. Many pushed into “deep subprime,” the riskiest part of the business that’s grown in recent years.
The results haven’t always been pretty.
Take Exeter. The company, which is licensed in all 50 states and works with roughly 10,000 dealerships, was unprofitable from 2011 -- when Blackstone took a majority stake -- through 2015, according to S&P Global Ratings. That’s even as the PE firm invested $472 million to help Exeter expand and cycled through three CEOs at the lender.
On a pretax basis, S&P said Exeter turned a profit last year, and Matthew Anderson, a spokesman at Blackstone, says the company will do so again in 2017. He added the New York-based firm hasn’t tried to sell the lender.
Blackstone may look to unload Exeter later next year, said a person familiar with the matter, who asked not to be identified because it’s private.
Bad loans remain an issue. This year, a rash of delinquencies in two bonds stuffed with loans that Exeter made in 2015 caused the securities to dip into their extra collateral to keep investors whole.
Another example is Flagship, which Perella Weinberg bought in 2010. (Innovatus Capital Partners, which manages the lender on behalf of Perella Weinberg, was formed by former Perella Weinberg managers last year after they split from the firm.)
As its loan portfolio surged to almost $3 billion from just $89 million in 2011, bad loan write-offs mounted and left the company with losses last year. Since then, it’s been forced to cut back origination and tighten underwriting standards. Kroll Bond Rating Agency said in November it expects Flagship to post another loss this year before returning to profitability in 2018.
“We’re concerned about the company’s ability to earn a satisfactory return,” S&P said in August.
That might not bode well for Flagship’s initial public offering, which could potentially provide an exit for its owners. The IPO has languished and its prospectus hasn’t been updated since July 2015.
Representatives for Perella Weinberg, Flagship and Innovatus declined to comment.
In hindsight, the planned sale may have come a year too late.
Santander Consumer USA Holdings Inc., whose investors included KKR and Warburg Pincus, went public in January 2014, turning then-CEO Thomas G. Dundon into a billionaire. (He didn’t respond to a request for comment.) The shares have lost about a quarter of their value since then as the lender restated earnings going back to 2013 and agreed to pay almost $25 million to two states to settle a probe into predatory lending. Santander says it has improved its governance, risk management and capital buffers.
“Tom Dundon at SC timed it perfectly,” said Dan Parry, co-founder of Exeter who now runs TruDecision, a fintech firm that serves car dealers and lenders. “Others haven’t been that fortunate.”
Indeed, while subprime delinquencies of 90 days or more have stabilized at banks, the rate at non-banks is close to the highest since 2009, according to the Federal Reserve Bank of New York, which noted the industry’s hasty underwriting standards.
Many of the large banks that provide funding to subprime auto lenders have taken notice and become far more conservative in doling out credit lines, says David Knightly, a vice-president at Innovate Auto Finance, which buys loans from dealerships and auto finance companies to help them raise cash.
“From a standpoint of subprime auto right now, if you’re small, people aren’t lining up,” he said. “Everybody’s trying to guess when the next 2008 is.”
Bigger subprime auto lenders can still turn to the capital markets. Sales of subprime auto ABS have reached $25 billion, topping last year’s total and almost triple the amount in 2010. They’ve also shored up finances by lending to borrowers with stronger credit, said Amy Martin, an analyst at S&P. That in turn has buoyed shares of some of the biggest ones in recent months.
Martin expects a lot of mergers as car sales slow. In the meantime, PE firms have largely lowered their expectations for a big exit and are trying to make their companies leaner to extract a dividend or sell the loan portfolios.
“Nobody wants to pay much more than book value” for these companies, said Colonnade’s Gillock. “It’s not a disaster, but it’s a failure.”
Bitcoin Starts New Year by Declining, First Time Since 2015Updated on
For the first time since 2015, the cryptocurrency began a new year by declining, extending its slide from a record $19,511 reached on Dec. 18.
The virtual coin traded at $13,624.56 as of 5 p.m. in New York on Monday, down 4.8 percent from Friday, according to data compiled by Bloomberg. That’s also a fall from the $14,156 it hit Sunday, according to coinmarketcap.com, which tracks daily prices. The cryptocurrency fluctuated in early Asian trading on Tuesday.
Bitcoin got off to a much stronger start last year, and then kept that momentum going, helping to create a global frenzy for cryptocurrencies. It rose 3.6 percent on the first day of 2017 to $998, data from coinmarketcap.com show. It ended the year up more than 1,300 percent.
That rally drew a growing number of competitors and last month brought bitcoin to Wall Street in the form of futures contracts. It reached the Dec. 18 peak hours after CME Group Inc. debuted its derivatives agreements, which some traders said would encourage short position-taking.