IMF Sounds Alarm on $19 Trillion of Risky Corporate Debt, Finds Disturbing Parallels to 2008 Crisis

By:
Chris Gaetano
Published Date:
Oct 18, 2019
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The International Monetary Fund has issued a dire warning that years of easy financing have created mountains of risky corporate debt that could pop in a manner similar to the 2008 global economic crisis. 

In its October 2019 Global Financial Stability Report, the IMF said that interest rates, already historically low, have sunk even further over the past few years and are expected to stay that way for the immediate future. This environment has led to sharp increases in corporate debt, as companies found it easier and easier to access credit. Having such large amounts of credit at their disposal, the IMF said, has allowed firms to fund more financial risk taking such as mergers and acquisitions and investor payouts. Beyond even risky actions, the IMF also pointed out that the borrowers have become riskier as well, saying that there are rising loans to BBB-rated bond issuers and leveraged loan borrowers. 

At the same time, corporate profits, which presumably would be used to pay off those debts, have themselves been mediocre. The IMF said that small and medium entities remain highly profitable in China but large firms there have relatively weak profitability; the United States has the opposite situation, with large firms remaining highly profitable but small and medium entities remaining weak, and Europe and Japan have profitability around the global median levels. 

While the aforementioned easy-credit environment has allowed companies to maintain business as usual, even in these conditions, the report says that, "in a material economic slowdown scenario, half as severe as the global financial crisis," the amount of debt-at-risk (defined as debt owed by companies whose earnings are insufficient to cover interest payments) would amount to $19 trillion, or roughly 40 percent of all global corporate debt. When aggregated down to individual countries, the IMF said that certain areas have at-risk debt levels equal to, or even beyond, those prior to the financial crisis. 

"In France and Spain, debt-at-risk is approaching the levels seen during previous crises; while in China, the United Kingdom, and the United States, it exceeds these levels," said the IMF report. "This is worrisome given that the shock is calibrated to be only about half what it was during the global financial crisis. This increase in debt-at-risk can be explained by the growth in indebtedness after the global financial crisis."

This conclusion bears a similarity to other research that found that 12 percent of public companies are, effectively, "zombie companies." This was the conclusion of the Switzerland-based Bank for International Settlements, which defined a zombie company as one that cannot cover its debt service costs with current earnings. The bank also said that the condition has been spreading, as such companies made up only 2 percent of the population in the 1980s. The study said that because credit is so cheap, banks find it easier to keep failing companies on life support and hope that they will recover than it is to watch them collapse, which would then force them to write off the loan. 

NY Federal Reserve economist Richard Peach, who spoke at the Foundation for Accounting Education's recent Business and Industry Conference, was rather bullish on the global economy overall, but, like the IMF, he noted slowing corporate profits as a potential area of concern. However, at least in the United States, he said this might be a statistical leftover from the Tax Cuts and Jobs Act. Because the Tax Cuts and Jobs Act introduced 100 percent expending, the tax bill may have had the effect of pulling future investments into the present, "and now we're just seeing the payback for that episode." He also noted that business investment, while down overall, has been ramping up spending on intellectual property products. Such purchases right now make up just short of half of all business investment spending. 

A previous Federal Reserve report also made note of rising corporate debt as a risk to the global economy. The central bank said that the share of newly issued large loans to corporations with high leverage—defined as those with ratios of debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) above 6—has increased in recent quarters and now exceeds previous peak levels observed in 2007 and 2014 when underwriting quality was notably poor." 

The Fed at the time noted that the share of investment-grade bonds rated at the lowest level has reached near-record highs, making up about 35 percent of corporate bonds outstanding, amounting to roughly $2.25 trillion in debt. In an economic downturn, widespread downgrades of these bonds might spark a rapid sell-off, which could increase liquidity and price pressures in the corporate bond market. 

Another concern is who is doing the borrowing. The report noted that, in previous years, primarily high-earning firms with relatively low leverage were taking on the most additional debt. Over the past year, however, that spot goes to firms with high leverage, high interest expense ratios and low earnings and cash holdings. However, at the same time, the Fed noted that with interest rates low by historical standards, debt service is a lot cheaper, particularly for risky firms. Overall corporate credit performance has remained generally favorable. 

Credit rating agency Moody's, however, was a little more worried, according to remarks from its chief economist. Mark Zandi, the chief economist for Moody's Analytics, said that there is an "eerie" resemblance between the recent explosion of corporate debt and the  proliferation of subprime mortgage securities preceding the 2008 financial crisis. Zandi warned that, as interest rates rise, people should watch to see what happens to the most indebted U.S. corporations, noting that there could be an implosion similar to that which popped the subprime real estate bubble.  

Zandi also pointed out that, like subprime mortgages, today leveraged loans are being packaged into collateralized debt obligations, with roughly half of such loans worked into such products. Also, much as with subprime mortgages, demand has been facilitated by the easing of standards: A net 17.4 percent of senior loan officers at commercial banks said they'd relaxed the terms of their loans for medium and large businesses over the last three months. While new protections were put in place following the crisis, the surge in leveraged loans is being driven by issuers such as private equity companies, which were not placed under those same strict regulations. 

Yet Fed Chair Jerome Powell, in recent remarks, expressed a more sanguine view, saying that elevated corporate debt levels aren't a risk to the economy in and of themselves, but conceded that they would make responding to a sudden downturn much more difficult. 

The IMF, in its own report, pressed for urgent actions from policymakers, noting that the current period of stability does not need much to be disturbed. Many things could happen to tighten credit access, which in turn will cause severe shocks to companies that have previously been able to borrow with little or no consequence. 

"A number of events could trigger a sharp tightening in financial conditions at the current conjuncture, including an intensification or broadening of trade tensions, a faster-than-expected slowdown in global growth, a sudden market reassessment of the outlook for monetary policy (especially if there is a gap between market expectations and central banks’ communications), or the crystallization of political and policy risks (for example, a geopolitical event that leads to contagion and capital flow reversals from emerging markets, renewed concerns about fiscal challenges in highly indebted countries, or a no-deal Brexit)," said the IMF report. 

Policymakers in particular were asked to address rising corporate debt burdens, increased holdings of riskier and more illiquid securities by institutional investors, and increased reliance on external borrowing by emerging and frontier market economies. 

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