August 09, 2018
Prior to the collapse of the housing bubble and the resulting financial crisis there was little interest in major news outlets in pieces warning about the bubble and the risks it posed to the economy. These days there seems to be a large demand for such pieces. Unfortunately, in choosing these pieces, news outlets seem little better informed today than they were in the housing bubble years.
Today’s contribution comes from William D. Cohan and appears in the New York Times. The center of his story is corporate debt. The argument is that we have a large amount of debt that has been taken on at very low interest rates. If interest rates go up, then many debtors will be unable to pay their debts and we will be back in the 2008 financial crisis.
To get the ball rolling, Cohan pulls off one of the best bait and switches I have seen for a long time. He tells readers:
“The $30 trillion domestic stock market seems to get all the attention. When the stock market sets new highs, we instinctively feel things are good and getting better. When it tanks, as happened in the initial months of the 2008 financial crisis, we think things are going to hell.
“But the larger domestic debt market — at around $41 trillion for the bond market alone — reveals more about our nation’s financial health.”
This is a great bait and switch because he uses the $41 trillion figure for the bond market, but the rest of the piece is essentially devoted to corporate debt. Most of the $41 trillion in bonds either comes from the federal government ($17 trillion), Fannie and Freddie ($6.7 trillion), and state and local governments ($3.1 trillion). The portion that is attributable to non-financial corporations, which is the focus of the piece, comes to $6.2 trillion.
While that is still a considerable chunk of change, with interest rates at historically low levels and after-tax profits now exceeding $1.5 trillion, don’t anticipate any mass defaults any time soon. In fact, historically low interest rates gave companies an incentive to take on debt, as opposed to equity financing.
If we look at debt service, instead of levels, we find that interest payments were equal to 23.1 percent of after-tax profits in 2017, compared to more than 25 percent in the late 1990s, not a period we associate with a corporate debt crisis.
It is also worth thinking about what happens if some companies do run into problems paying off their debt. First, many would be able to issue more stock, to get cash. That certainly would be true for most companies as long as the stock market remains near its current level, or even if it fell 20 percent.
But even in the case of companies that are unable to meet their debt payments and can’t issue shares, we will not see the value of their debt fall to zero. In most cases, these companies will still have assets that can be sold off to allow bonds to repay 70 to 80 cents on the dollar.
If we take what would undoubtedly be a really really bad story, in which 25 percent of the debt goes bad, and companies can only repay 75 cents on the dollar, we’re talking about losses of less than $400 billion. This is less than 2.0 percent of an economy that is now over $20 trillion. Are you scared yet?
Just to remind people who were too young to remember, the 2008 crisis was first and foremost about a crash of a housing bubble, the financial crisis was secondary. Furthermore, it can be traced to the collapse in the value of a highly leveraged asset (housing).
Even in normal times, it is standard to buy a house with 10 to 20 percent down, but in the bubble years, it was common for people to buy homes with zero or near zero down. As a result, when prices fell 40 or 50 percent, as they did in many areas, the mortgages became nearly worthless as the cost associated with repossessing and selling the home could be very close to the amount of money from the sale of the house.
But skipping the financial aspects, the loss of real demand associated with the collapse of the bubble was enormous. The shift from boom to bust caused residential construction to drop by four percentage points as a share of GDP. That is equivalent to a loss of $800 billion in annual demand in today’s economy.
In addition, the wealth effect from the run-up in house prices led to a consumption boom, as the savings rate hit a record low of just over 3.0 percent in 2005. When the bubble generated housing wealth disappeared, so did the consumption it was fueling. By 2010, the saving rate was back over 6.0 percent, roughly its current level, costing the economy an additional two percentage points in lost demand, or $400 billion in today’s economy.
There is no story in today’s economy that can give you a picture anything remotely like the collapse in 2008. It’s nice that papers like the NYT want to print scare stories like this one produced by Cohan, but serious people should recognize them for the fiction they are.
Note: An earlier version had wrongly spelled “Cohan” as “Cohen.” Thanks to several comentators for calling this to my attention.
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