Month: October 2014

In the aftermath of the Great Recession, we all learned to beware complex lending structures, which can crumble like a house of cards if repayments don\’t happen on time. A central ingredient in the financial crisis from 2007-9 were \”collateratized debt obligations,\” which were essentially a way of putting a group of subprime mortgage loans into a financial security, structured in a way that the credit rating agencies would rate a large portion of their value as safe. Financial regulators and the Federal Reserve didn\’t pay enough attention to the dangers of this financial legerdemain.

Now yellow warning lights should be blinking in the area of \”leveraged loans,\” which can be defined as \”a large, variable-rate loan originated by a group of banks (sometimes called a syndicate) for a corporate borrower who is perceived to be riskier than most.\”  Alex Musatov and William Watts lay out the issues in \”Despite Cautionary Guidance, Leveraged Loans Reach New Highs,\” in the September 2014 Economic Letter published by the Federal Reserve Bank of Dallas.

The issuance of leveraged loans spiked just before the financial crisis of 2007-9, then collapsed in 2008, but has now rebounded to new highs.

The basic idea of a leveraged loan is that because of the size of the loan and the risk posed by the borrowing firm, no individual bank wants to lend the money. However, a group of banks get together as a syndicate to organize the loan. \”The banks retain portions of the loan on their own books, but the majority of it is packaged for other investors—typically finance companies, insurance companies and hedge funds.\” A leveraged loan can be organized in several ways, as Musatov and Watts explain:

Specific lending arrangements reflect the size of the loan and riskiness of the borrower. In an underwritten deal, the syndicate issues the full amount of the loan and then tries to sell portions to outside investors. Underwritten deals are generally the most attractive loans to borrowers because they ensure that the entire amount of needed capital is raised; the lead bank gets higher fees for the risk of holding the debt while looking for investors. A “club deal,” used for smaller loans,involves several banks raising the money within the group while splitting the fees charged to the borrower. Finally, in “best effort” syndication, the arrangers of the loan underwrite less than its entire value and attempt to raise the remainder in the credit market. This type of syndication is generally used for
the riskiest borrowers or the most complex loan agreements.

Of course, there\’s nothing wrong or underhanded about leveraged loans. It\’s just one of the ways in which modern finance works. It\’s not easy for firms with with a less-solid credit record to borrow, and this is one of the ways it can happen. Of course, because such firms pose greater risks, they also need to pay a higher interest rate. But if the syndicates are making too too many of these loans, while taking the fees and then selling the loans along to investors who are eager for a higher return, then there a danger that a bubble is rising in this market.

In March 2013, as as Musatov and Watts note, financial regulators began to express concerns about the leveraged loan market: \”[T]he Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corp. (FDIC) and Board of Governors of the Federal Reserve System (FRS) issued “Interagency Guidance on Leveraged Lending” in March 2013, outlining principles of safeand-
sound leveraged lending activities …\” What are some of the danger signs in this kind of market?

One signal is that the firms that are borrowing in the market sign a \”covenant\” contract, in which they make various promises about the total amount that the borrower will borrow, the value of short-term assets on hand that can easily be sold, limits on long-term investments, and so on. However, more and more leveraged loans are using \”covenant-lite\” approaches, where these rules are loosened–thus making the loan a riskier one.

While covenant-lite loans are becoming more popular, the additional interest rate charged to the borrowing firms–to account for their higher risk–has been coming down. The red line shows how much the interest rate \”spread\” on leveraged loans, above the baseline rate on U.S. Treasury borrowing, has been sagging over time. The green line shows the default rate on such loans, which has been rising over time. In short, the risks of such  borrowing seem to be rising while the extra interest rate charged to such borrowers to compensate for the risks is falling.

As noted earlier, financial regulators are keeping an eye on the leveraged loan market. As Janet Yellen testified before Congress in July 2014:

The Committee recognizes that low interest rates may provide incentives for some investors to \”reach for yield,\” and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance.

What ultimately concerns me is not the specifics of the leveraged loan market by itself, but the thought that there are likely to be similar niche markets out there, invisible to most of us in their day-to-day operations, but with some potential to melt down in a way that could cause broader financial and economic distress.

The prospect of an infrastructure push is seductive. Economic and job growth has been sluggish. Interest rates and thus borrowing costs remain relatively low. At least some kinds of infrastructure might help to boost long-term growth. Thus, the October 2014 World Economic Outlook from the IMF includes a chapter on \”Is It Time for an Infrastructure Push? The Macroeconomic Effects of Public Investment.\” The IMF writes:

[I]ncreased public infrastructure investment raises output in both the short and long term, particularly during periods of economic slack and when investment efficiency is high. This suggests that in countries with infrastructure needs, the time is right for an infrastructure push: borrowing costs are low and demand is weak in advanced economies, and there are infrastructure bottlenecks in many emerging market and developing economies. Debt-financed projects could have large output effects without increasing the debt-to-GDP ratio, if clearly identified infrastructure needs are met through efficient investment.

Like so many statements by economists, this may seem straightforward, but it is actually hedged with qualifiers. For example, the first sentence refers to the positive outcomes arising \”when investment efficiency is high,\” and the closing line states \”if clearly identified infrastructure needs are met through efficient investment.\” In the middle, there is a reference to \”infrastructure bottlenecks in many emerging market and developing economies,\” but this sentence carefully does not claim that infrastructure bottlenecks are a first-order problem in advanced economies.

I take from this that the case for an infrastructure push is especially strong right now in those \”many emerging and developing countries.\” Here\’s a figure showing current levels of electricity, roads, and phone lines by region. But of course, infrastructure would also include water and sewage, airports and seaports, rail, wireless connections, natural gas and oil pipelines, and more.

Japan offers a mildly cautionary tale for advance economies on the limits of infrastucture investment.

What about for the advanced economies? The IMF chapter goes through a variety of calculations that attempt to separate out the specific effect of a boost in public infrastructure spending. The report notes (footnotes and references to figures omitted):

The macroeconomic effects of public investment shocks are very different across economic regimes. During periods of low growth, a public investment spending shock increases the level of output by about 1½ percent in the same year and by 3 percent in the medium term, but during periods of high growth the long-term effect is not statistically significantly different from zero. Public investment shocks also bring about a reduction in the public-debt-to-GDP ratio during periods of low growth because of the much bigger boost in output.

What about infrastructure in the United States? Here\’s a figure from the ever-useful FRED website run by the St. Louis Fed showing total public construction spending in the U.S. In rough terms, about one-third of this is highways and streets and another one-tenth is other transportation, one-quarter is education-related construction, about one-sixth is sewage and water. Other categories include power, public safety, and conservation and development. I\’m not surprised to see a boost in infrastructure spending during the Great Recession; after all, that was part of the \”economic stimulus\” package that passed in 2009. But I had not realized that public construction spending had actually been rising fairly briskly since about 2005, well before the recession hit.

As someone who lives in Minnesota, I favor more infrastructure spending. After all, about seven years ago a major bridge in Minneapolis collapsed during rush hour. After the brutal Minnesota winter, the potholes on the roads are large enough to swallow dogs, and sometimes appliances. But like a lot of economists, I have two concerns about how to focus and direct a push for more infrastructure, so that it means more a nice shiny bridge-to-nowhere in every Congressional district.

1) There\’s always a tension between civil engineers and economists. The engineers often look at every infrastructure limitation and see a building project that ought to happen. Economists often look at the same problem and see ways that  the existing infrastructure might be used more effectively. For example, instead of just automatically trying to build more roads, water-mains, electrical capacity, and the like, how about looking for ways to conserve on the need for using this infrastructure. Many economist favor finding ways to charge more at peak usage times as a way of spreading the use of infrastructure over a wider time period each day.

2)  I have a hard time believing that U.S. economic prosperity in the 21st century is going to be built on concrete and asphalt. As I said, I\’m all for fixing bridges and potholes, updating the municipal water pipes, and the like.  But what about infrastructure for the 21st century? Some of this infrastructure may be funded directly by the government, but most of it will require a fairly high level of government support and cooperation if it is going to happen. For example, as we repair current highways and bridges, how about starting to build the capacity for smart highways and self-driving cars?  What about a smart electricity grid, both to facilitate the use of decentralized renewable energy sources and to implement higher prices for large users at peak times? The U.S. needs to update its rail-freight system, which could move large numbers of trucks off the highways–thus reducing congestion and saving on road repair costs. The U.S. needs to update its network of oil and gas pipelines.  When the IMF talks about \”clearly identifiable needs\” and \”efficient investment,\” these seem to me some of the main U.S. infrastructure issues, although the list could doubtless be lengthened.

When talking about how infrastructure spending could boost a sluggish economy, the case of Japan often comes up. After all, didn\’t Japan boost infrastructure spending in the 1990s in an attempt to boost economic growth, but with little effect? The IMF report notes that the patterns of what happened in Japan are more complex:

It is true that Japan briskly increased public investment in the early 1990s, but the increase was unwound after just a few years to finance higher social security spending for a rapidly aging population. In particular, after the bursting of the bubble economy in the early 1990s, the government increased public investment spending by 1½ percent of GDP, with such spending reaching a peak of 8.6 percent in 1996. After that, the ratio of public investment to GDP steadily declined, picking up only recently in the aftermath of the global financial crisis, the 2011 earthquake, and the start of Abenomics. In the 20 years after 1992, the last year in which Japan recorded a fiscal surplus, social spending increased by 10.6 percent of GDP, and public investment declined by 2.3 percent of GDP.