The subprime mortgage world has been reduced to rubble with no lasting impact on another, larger, credit market dancing on an equally fragile precipice: high-yield corporate debt. In this fast-growing arena of loans to business—these days, mostly, private equity deals—lending proceeds as if the subprime debacle were some minor skirmish in a little known, far away land.
How curious that so many in the financial community should remain blissfully oblivious to live grenades scattered around the high-yield playing field. Amid all the asset bubbles that we’ve seen in recent years—emerging markets in 1997, Internet and telecom stocks in 2000, perhaps emerging markets or commercial real estate again today—the current inflated pricing of high-yield loans will eventually earn quite an imposing tombstone in the graveyard of past manias.
Like past bubbles, the current ahistorical performance of high-yield markets has led seers and prognosticators to proclaim yet another new paradigm, one in which (to their thinking) the likelihood of bankruptcy has diminished so much that lenders need not demand the same added yield over the treasury or “risk-free” rate that they did in the past.
To be sure, the emergence in the past 20 years of more thoughtful policy making may well have sanded the edges off economic performance—what some economists call “the Great Moderation”—thereby reducing the volatility of financial markets and consequently the amount of extra interest that investors need to justify moving away from treasuries.
But to think that corporate recessions—and the attendant collateral damage of bankruptcies among overextended companies —have been outlawed would be... foolhardy.
And just as the unwinding of the subprime market occurred at a time of economic prosperity, the high-yield market could readily unravel before the next recession. With the balance sheets of many leveraged buyouts strung taut, a mild breeze could topple a few, causing the value of many leveraged loans to tumble as shaken lenders reconsider their folly.
The surge in junk loans has also been fuelled by a worldwide glut of liquidity that has descended more forcefully on lending than on equity investing. Curiously, investors seem quite content these days to receive de minimis compensation for financing edgy companies, while simultaneously fearing equity markets.
Assessing the likely consequences of a correction is more daunting than merely predicting its inevitability. The array of lenders with wounds to lick is likely to be far broader than we might imagine, a result of how widely our increasingly efficient capital markets have spread these loans. No one should be surprised to find his wallet lightened, whether out of retirement savings, an investment pool or even the earnings on their insurance policy.
The bigger—and harder—question is whether the correction will trigger the economic equivalent of a multi-car crash, in which the initial losses incur large enough damages to sufficiently slow spending enough to bring on recession, much like what happened during the telecom meltdown a half-dozen years ago.
But we have little choice but to sit back and watch this car accident happen. It would have been a mistake to dispatch the Federal Reserve to deflate the dot-com mania or the housing bubble. And it would be a mistake now for the Fed to rescue imprudent high-yield lenders. They have to learn the hard way. Hopefully, not too many innocent bystanders will share their pain.
Edited excerpts from The Wall Street Journal
Steven Rattner is managing principal of the private investment firm Quadrangle Group LLC. Comments are welcome at firstname.lastname@example.org