There is a feeling in the air on Wall Street that is eerily reminiscent of the subprime boom a decade ago, and if you want to go a little further back, the Michael Milken 80’s era. The junk bond party is in full swing. Earlier this spring, the Federal Reserve issued guidelines to banks and lending institutions that essentially gave them the green light to provide additional leverage to highly indebted companies. One has to wonder if this monetary policy will lead to the crash and burn of junk bonds and those affiliated with them in the previously mentioned periods. There’s been plenty of excess lately. Protections for junk bond investors have been steadily weakening for nine months as of January, according to Moody’s Investors Service. The following chart shows the steady rise of which Moody’s speaks.
In addition to the traditional corporate lenders, there are other lenders, commonly referred to as “shadow lenders,” who are groups such as private boutiques, small banks and others who want in on this risk versus reward scenario. Packaging of corporate debt is increasingly complex, as products are being rolled out to investors. This has the trappings of the savings and loan crisis that brought such banks as Drexel to its knees in the post-merger mania boom of the 80’s and 90’s. The victims of that day were the big insurance companies and pension funds who were buying up this junk as there appeared no end in sight to high yield.
This, in essence, is the free market at work. Business will follow the money trail where there is the least regulation. “Business is going to go wherever it can to get business done, and that’s wherever the regulators are not,” said Danielle DiMartino Booth, a former adviser to the Federal Reserve Bank of Dallas. Guidelines drawn up by the Fed are just that; guidelines, and not regulations. Currently, government guidance from the Fed, the FDIC, and the Office of the Comptroller of the Currency cautioned that any buyout adding debt more than six times a firm’s earnings before interest, tax, depreciation and amortization (EBITDA) would attract scrutiny.
The supply of capital for mergers and acquisitions, as well as organic corporate growth is certainly needed. The question that again confronts regulators is if this increase in leverage is under control. The advent of shadow lenders who are virtually unregulated has thrown a new iron into the fire. The Financial Stability Board, an international body, said shadow banking assets that pose risks to the financial system grew 7.6 percent to $45 trillion in 2016. The Fed suggested in a May 2017 report that because leverage had migrated to the shadow banking system its guidance failed to reduce risk in the financial system overall. I don’t know about you, but that sends goosebumps up one’s spine. When regulators restrained the big banks five years ago, Pandora’s Box was opened to non-conventional lenders.
Looking back to Black Monday in 1987, one might look at the tell-tale signs that were giving signals prior to that day, and how analogous they are to the inflection points of today. Economic growth had slowed while inflation was rearing its head. U.S. wholesale prices rose in the 12 months ended in June by the most since November 2011 as the costs of services accelerated, a Labor Department report showed yesterday in Washington. This indicates that inflation pressures in the production pipeline are firming amid rising demand and tariffs on steel and other goods.
The strong dollar was putting pressure on U.S. exports. The dollar is strong as well in today’s market. The stock market and economy were diverging for the first time in the bull market, and as a result, valuations climbed to excessive levels, with the overall market’s price-earnings ratio climbing above 20. The current price-earnings ratio of the S&P 500 today is over 24. All one can say is that the pieces are in place for a correction parallel to that of 1987. Not many on Wall Street were there in those times. I was. It wasn’t a lot of fun. Have I ever said that history continues to repeat itself?