The recent chaos created by COVID-19 in the markets has many economists worried and asking for the Fed and the government to take action. The Fed cut interest rates to zero on March 15 as a response to the panic created by the virus. Yet, while the virus can negatively affect the economy if it is only temporary and the economy is strong, the Fed and the government should not be this worried. Once the virus is under control, the economy should bounce back up.
The issue here is that there are many structural problems in our economy. During and after the last recession, the Fed and the government bailed out many at-risk businesses instead of allowing the market to “clean-up the bad businesses” and allow resources to be allocated to those that were sufficiently healthy. In addition, the Fed lowered interest rates to “help the economy.”
This kept the economy weak since then and has created more structural problems that only need an event such as the one we are experiencing to appear. So, the recent response of the Fed and the federal government have nothing to do with the virus outbreak but rather with the structural problems that underlie our economy.
In what follows I look at three important debt markets and the problems they carry with them.
Paul Krugman, in an opinion piece for The New York Times after the recession of 2001, wrote:
To fight this the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.
The Fed “listened” to Krugman and we all know how this turned out, but that did not stop Keynesians from asking for more from the Fed after the Great Recession. People like Ezra Klein, by 2012, were arguing that the Fed should buy mortgage backed securities to lower mortgage rates to about 2.5 percent and hold them there for one year only. He argued this would solve the slow economic growth that the US economy was experiencing at that time. In other words, he asked for another housing bubble.
And while the Fed did not go that extreme, the Fed did keep interest rates artificially low for a long period of time and this has created many problems. While many think the economy is strong, the underlying problems in the housing market have only been “awaiting” for an event like the one we are experiencing to resurface. But, do not take my word for it. Here is the president of Ginnie Mae, Ted Tozer, talking about the mortgage market in 2015:
… Today almost two thirds of Ginnie Mae guaranteed securities are issued by independent mortgage banks. And independent mortgage bankers are using some of the most sophisticated financial engineering that this industry has ever seen. We are also seeing greater dependence on credit lines, securitization involving multiple players, and more frequent trading of servicing rights and all of these things have created a new and challenging environment for Ginnie Mae. … In other words, the risk is a lot higher and business models of our issuers are a lot more complex. Add in sharply higher annual volumes, and these risks are amplified many times over. … Also, we have depended on sheer luck. Luck that the economy does not fall into recession and increase mortgage delinquencies. Luck that our independent mortgage bankers remain able to access their lines of credit. And luck that nothing critical falls through the cracks…
This explains very well why the Fed was so anxious to cut interest rates to zero, to restart quantitative easing to the tune of $700 billion, and why investors like Carl Icahn are worried about the housing market. The recent QE includes $200 billion for Mortgage Backed Securities, aimed to ease any problems in the housing market. But, if it is true that the housing market is strong and with interest rates already very low it makes no sense for the Fed to be involved, unless they know this is not the case.
Auto Loan Debt
Low interest rates have also affected the auto market tremendously. Since the highest point before the Great Recession, the auto loan debt has increased by just over 70 percent—from a total of $700 billion to about $1.2 trillion. What is more, the standards of these car loans are so low that they resemble the standards that were being followed before the last recession in the housing market.
Because of this, and for other reasons, delinquencies have been increasing since the third quarter of 2014 and are now reaching the highest levels since late 2010. Now, with the new shock to the economy this can be exacerbated further, but while any crisis in this market will be attributed to the virus outbreak this will only be the match that lights the fuse.
The problem with the car market is not only with delinquencies but also with car owners being under water. The Wall Street Journal recently reported:
Some 33% of people who traded in cars to buy new ones in the first nine months of 2019 had negative equity, compared with 28% five years ago and 19% a decade ago, according to car-shopping site Edmunds. Those borrowers owed about $5,000 on average after they traded in their cars, before taking on new loans. Five years ago the average was about $4,000.
Hence, the problems in the car market are not recent but have been part of the market since the start of this expansion and were made worse by ultra-low interest rates.
Corporate debt has also increased by about 67 percent since the end of the Great Recession, from about $6 trillion to $10 trillion in just 10 years. The last time corporate debt increased like this was during the 1990s and that was followed by the Dotcom bubble. It seems we are headed for a big crisis in corporate debt. In fact, the corporate debt will likely take the place of mortgage debt in the new recession that may have already started. What is more, corporate debt is the only major private debt sector that has increased as a percent of GDP and is now at the highest level it has ever been at 46 percent.
There are many reasons why corporate debt has increased at such a fast pace, but a big contributor to this has been Collateralized Loan Obligations (CLOs). During the Great Recession Collateralized Debt Obligations (CDOs) were hit very hard because of the mortgage crisis, but one area that did very well was the CLOs. So the demand for CLOs increased after the last recession and this led corporations to borrow even more, even unprofitable corporations who were able to borrow at low rates.
This has given rise to zombie companies—“a publicly traded firm that’s 10 years or older with a ratio of earnings before interest and taxes (EBIT) to interest expenses of below one.” (In other words, these are companies that cannot even pay interest on their debt with their earnings.)
The number of zombie companies has been increasing rapidly since the last recession. Today about 12 percent of the world’s companies are “zombies,” compared to just 2 percent in the 1990s. In the US, the figure is even higher: 16 percent.
In a paper published in BIS Quarterly Review in September 2018, Banerjee and Hofmann find that low interest rates are in part to blame for the high percentage of zombie corporations. Their results “… suggest that lower nominal interest rates predict an increase in the zombie share, while the effect of bank health is less clear-cut.”
This, along with the overexpansion of CLOs, has some economists very worried. Bank of International Settlements writes that “CLOs have surged—reminiscent of the steep rise in collateralized debt obligations that amplified the subprime crisis.” Hence, the corporate debt is not in a good shape and a crisis like the one created by COVID-19 may bring these problems to the surface.
Again, the rush from the Fed to lower interest rates and start quantitative easing may mask these issues for now, but if the US falls into a recession the Fed will find it much harder to control the situation.
Blame the Structure
If the structure of the economy was in a good place, the Fed would not be as worried about the COVID-19 outbreak as it appears to be. But the economy, despite its appearance of strength, has many underlying problems stemming from the Fed’s policy of artificially low interest rates. If the novel coronavirus brings these problems to the surface, it will not just be the US facing recession. It will be global.
This recession will likely be worse than the last one, but unfortunately it will be blamed on the virus outbreak rather than the underlying problems of the economy. I say unfortunately because it will mean we have not learned anything from the last global crisis. In fact, we will likely go further and the Fed will use “new unprecedented measures.”
Janet Yellen has already said since 2016, that the Fed may buy stocks and corporate bonds. More recently, Laurence Kotlikoff wrote “…if the market continues to fall, the government should borrow and buy a 10 percent share of each listed U.S. company.”
These and other measures may bring us out of the next recession, but they will only make the problems worse for the next time. This will mean we will not have learned anything from the past and will continue to concentrate in the short-run, but as Henry Hazlitt put it in his book Economics in One Lesson, “we are already suffering the long-run consequences of the policies of the remote or recent past. Today is already the tomorrow which the bad economist yesterday urged us to ignore.”