How the Debt Bubble Burst in 2018: Hidden Risks in the Global Financial System
While the holiday season unfolds, global stock markets are cratering around the world, led by sharp declines in the US. Since October, when the Dow Jones Industrial Average (DJIA) peaked at 26,951.81, it has lost nearly 4,000 points, down 15.1%. The S&P 500 has lost even more: 15.8%.
The red ink in share prices has erased trillions of dollars from global balance sheets, with the stocks comprising the S&P 500 losing $2.39 trillion in December alone.
Stock Market Crashes in 2018: The Role of Debt
When asked why stock prices are falling, the talking heads on TV and the internet blame the Fed’s rate hikes and the trade war with China. Those factors are important, but there’s another component that gets less attention: soaring levels of debt. Much of this debt is of questionable quality, creating systemic risks.
In early December 2018, the International Monetary Fund reported that global debt is an incredible $184 trillion. This staggering figure surpasses the combined GDP of the world’s largest economies, emphasizing the unsustainable nature of global debt. It’s 225% of the entire world’s GDP and nearly double what it was in 2007, at the eve of the last financial crisis.
From Subprime Mortgages to Corporate Debt Bubbles
You may recall that the 2007 to 2008 financial crisis was set off by excessive debt. The crisis began with a series of interest rate hikes by the Fed. Homeowners with adjustable mortgages, tied to interest rates, started to default in droves.
Many of the mortgages that defaulted were “subprime.” They were given to borrowers with poor credit or who weren’t asked to prove their creditworthiness. In many cases, the mortgages were for more than 95% of the value of the home, leaving minimal equity. Meanwhile, the financial wizards on Wall Street turned subprime mortgages into mortgage-backed securities called collateralized debt obligations, greedily lapped up by individual investors, hedge funds, and even pension funds.
Would you lend 95% or more of the value of a home to someone with bad credit? I wouldn’t, and no less an authority than Warren Buffett once called derivatives, including mortgage-backed securities, “financial weapons of mass destruction,” a warning that remains relevant today.
Why BBB-Rated Bonds Could Spark the Next Financial Crisis
However, with the help of global credit rating agencies, the purveyors of mortgage-backed securities were able to do something roughly akin to “converting lead into gold.” Credit rating agencies reasoned that owning a collection of subprime mortgages was much safer than owning just one. After all, it was unlikely that all the mortgages would default simultaneously. On this theory, instead of rating the collection of subprime mortgages as junk bonds, they gave them the highest possible ratings.
We all know what happened next. Millions of borrowers defaulted on their mortgages. The value of collateralized debt obligations collapsed. Then, the banks and insurers backing those securities began to collapse. So did stock markets worldwide.
Now it’s happening again. Credit rating agencies, despite the lessons of 2008, continue to inflate the ratings of trillions in risky debt, ignoring the potential consequences. Ratings agencies assign credit ratings based on a sliding scale ranging from AAA to D (Standard & Poor’s) or Aaa to D (Moody’s). The lowest rating for supposedly “investment-grade” debt is BBB- or Baa3.
How to Protect Your Wealth in an Unstable Market
Since 2007, corporations worldwide have been borrowing money at a dizzying pace. Like homebuyers a decade ago, they are fueled by the zero interest rate policy at the world’s central banks. And the volume of debt rated BBB- has ballooned from $700 billion in 2008 to $3 trillion today.
Drilling down into these numbers, there are some alarming statistics. In 2007, companies rated BBB- had an average net debt of 2.1 times earnings. Today, that ratio is 3.2. Moreover, over one-third of companies with a BBB- rating have a debt-to-earnings ratio exceeding five.
I won’t be surprised if a large chunk of supposedly investment-grade debt is effectively junk and written off if the correction we’re now experiencing in the stock market turns into a recession. And that could trigger a financial crisis that dwarfs the one we experienced a decade ago.
Simply put, it’s time to get defensive. I’ve already liquidated virtually every stock in my portfolio and currently hold most of my assets in gold and US Treasuries. Yes, the Treasury will default on its debt obligations someday, but probably not in the next few months. And since stock prices started falling in early October, the price of gold has risen 6.4%, even in the face of rising interest rates. Remarkably, gold prices have defied the usual trend of declining during such periods.
