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Is The Surge In Corporate Borrowing Sowing Seeds Of Next Crisis?

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    July 16, 2014

    Since the beginning of the year there has been an ongoing hope that businesses were on the verge of a capital expenditure cycle that would boost economic growth. The primary supporting evidence of this hope was contained within the surge of corporate business loans and leases as shown in the chart below.


    This is an issue that I addressed previously asking some basic questions:

    “Is this spurt in activity historically relevant? Have such increases previously led to surges in economic activity or inflation? Or, is this activity just an anomaly that will rectify itself in the months ahead?”

    The answer is “not really.”  As shown in the chart below, surges in bank loans and leases are more a lagging indication to economic growth rather than a predictor of it. When put into this “context” the surge isn’t nearly as impressive.


    Businesses respond to changes in “demand.”  When the economic is weak, and demand slows, businesses move into a defensive position and reduce costs in order to preserve profitability.  As economic activity and demand increases enough to restore “confidence”to businesses, they will begin to increase production, expand facilities and increase employment. As confidence increases in the sustainability of the underlying economic growth, they will access loans and leases to further expand operations.  This is why bank loans lag changes in economic growth.

    The problem is, as shown in the recent National Federation Of Small Business survey, confidence by businesses in the economy and plans to increase capital expenditures remains extremely muted and at levels more consistent with economic recessions than expansions.



    As Bill Dunkleberg, NFIB Chief Economist, stated:

    “The latest Reuters/University of Michigan poll shows 10 percent of consumers characterizing government policy as ‘good’ and over 50 percent say ‘poor’.Other than ‘economic conditions’, the ‘political climate’ is the most frequently cited reason for not expanding businesses. This is the major impediment to a stronger recovery. Owners are experiencing far too much uncertainty and no sign that the powers that be will get any of it resolved.”

    So, if businesses aren’t running out to borrow money to expand production and increase capital expenditures then what is the surge in borrowing be used for?  That question was answered by Camilla Hall via the Financial Times:

    Much of the corporate lending is going to fund payouts to shareholders, finance acquisitions and fuel the domestic energy boom, bankers say, rather than to support companies’ organic growth.

    ‘Loan growth doesn’t seem to be driven by the underpinning of an economic recovery in terms of new warehouses and [capital expenditure],’ said one senior corporate banking executive at a large US bank. ‘You don’t see the foundation, the real strong demand.’

    ‘The larger part of the usage in the market right now are loan refinancings where companies are paying dividends back out.’ He added: ‘They’re requesting increased loans or usage under a lien in order to pay a dividend or equity holders of a company. Traditionally banks have been very cautious of that.’”

    With the interest environment so low it is not surprising that companies are using debt to fund shareholder payouts and repurchase company shares. In fact, according to a recent Bank of America survey, companies have been a primary buyer of stocks since the beginning of the year in order to boost earnings per share as top-line revenue growth remains extremely weak.


    Furthermore, according to a just released report by Murray Devine, leverage for the purpose of merger activity has exploded in recent months.

    “Cheap credit is having a significant impact on the deal-making environment. As mentioned previously, the median debt percentage for 2014 deals has hit 72%, a six-percentage-point jump from 2013’s 66%. Leverage use has skyrocketed since 2011, when the median debt percentage for PE deals was around 55%. Median debt percentages in 2013 and the first half of 2014 both outpaced the percentages seen during the buyout boom; for context, the median only reached 63% in 2007.

    Analysts have noted recently that PE firms, armed with cheap debt financing, have been pushing purchase price multiples beyond what many strategic acquirers are willing to pay.

    To win those deals, PE investors have pushed valuations (11.5x) to historically high levels and have added an extra turn of debt to their transactions. Last year’s median debt-to-EBITDA multiple ballooned to 6.9x, a big jump from the 4.9x median in 2012. Through the first two quarters of 2014, debt multiples are even higher at 8.2x. Part of those high debt multiples, according to some, is tied to a resurgence in cash-flow lending in the industry.”


    The reality is that the surge in bank loans and leases in recent months has very little to do with economic recovery expectations. In fact, it is more of a sign of a late stage economic cycle where companies scramble to “buy” revenue through mergers and acquisitions as the ability to generate organic revenue wanes.

    This kind of activity is not new or unusual other than the current record magnitudes. While not identical, this type of activity has been witnessed near every major market peak in history. As discussed yesterday, as market environments become “exuberant”the view of “risk” is grossly diminished. The belief that what happened “before” can not happen again as this “time is different.” 

    However, as Tyler Durden recently penned:

    “What the FT is effectively saying is that unlike before when companies would issue unsecured debt (i.e. General Unsecured Investment Grade bonds) for the purpose of funding buybacks and dividends, which is perfectly in the company’s right to do…what companies are doing now is taking on secured debt and using the proceeds to fund buybacks of their stock or fund dividends!

    It is here that the hair of anyone who has ever underwritten any debt, secured or unsecured, should stand on end. Because this revelation shows that unlike the last bubble, when levered buybacks once again went through the roof, at least they were unsecured, and the bank did not have a lien on any assets should the company ultimately file bankruptcy as a result of a debt issuance spree.

    This time, however, in order for shareholders to cash out, existing bondholders will be primed by the bank when the rate cycle finally turns and all the companies that were scrambling to reward investors now and up going tits up. It also means that banks effectively become lienholders in companies without having any actual collateral backing their loans…

    In simple terms: instead of indicating a recovery, any recovery, the only thing the recent surge in loans and leases indicates is that companies are increasingly more desperate to cash out their shareholders, and are completely oblivious of what form of debt they use to fund such shareholders friendly activities as stock buybacks and dividends. It certainly means that instead of using the liened cash to invest in growth, or even maintenance, CapEx, so critical for the non-recovering economy, the only thing that is happening is that banks are effectively funding corporate shareholders with secured debt, in the process collateral-stripping the intermediary companies which with every such incremental deal have less and less recourse to unencumbered assets.”

    The important point contained within that statement is that the seeds of the next credit related crisis have been sown. While I am not suggesting that the economy and markets are set to plunge into the abyss today, tomorrow or even next week; what I am suggesting is that we are very late in the game.

    For all those that believe we currently have a “one-way ticket to ride” in the current bull market, here is a question for you to ponder:

    “If the current bull market cycle is currently supported by low interest rates and liquidity, what happens when the Fed raises interest rates and begins to extract liquidity from the markets?”

    Here is the answer.

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    Lance Roberts

    Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of “The Lance Roberts Show,” Chief editor of the X-Factor Investment Newsletter and the Streettalklive daily blog. Follow Lance on FacebookTwitter and Linked-In

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.


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