22/10/17: Leverage risk and CAPE: Why Rob Shiller Might Be Wrong

Rob Shiller recently waxed lyrical about the fact that - by his own metrics - the markets are overpriced, yet no crash is coming because there is not enough 'leverage in the system' to propagate any shocks to systemic levels.

The indicator Shiller used to define overpricing is his own CAPE - Cyclically Adjusted PE Ratio - and the indicator does indeed flash red:

CAPE is defined by dividing the S&P 500 index by the 10-year moving average of index components' earnings. The long-run average of CAPE is 16, and the index currently sits above 31, making the current markets valuations trailing those of the dot.com bubble peak (using recent/modern comparatives).

So the markets are very expensive. But what Shiller says beyond this mechanical observation is very important. His view is that these levels of valuations are 'sustainable' in the medium term because there is very little leverage used by investors in funding these levels of stock prices. In the nutshell, this says that if there is any major correction in the markets, investors are unlikely to be hit by massive margin calls, triggering panic sell-offs. So any correction will be short-lived and will not trigger a systemic crisis.

All fine with the latter part of the argument, if we only look at the stock market brokerage accounts leverage, ignoring other forms of leverage.  And we can only do this at a peril.

Investor is a household. Even an institutional one, albeit with a stretch. When asset prices correct downward, income received by investors falls (dividends and capital gains are cut) and investor borrowing capacity falls as well (less wealth means lower borrowing capacity). But debt levels remain the same.  Worse, cost of funding debt rises: as banks and other financial intermediaries see their own assets base eroding, they raise the cost of borrowing to replace lost income and capital base with higher earnings from lending. Normally, the Central Banks can lower cost of borrowing in such instances to compensate for increased call on funds. But we are not in a normal world anymore.

Meanwhile, unlike in the dot.com bubble era, investors/households are leveraged not in the investment markets, but in consumption markets. Debt levels carried by investors today are higher than debt levels carried by investors in the dot.com and pre-2007 era. And these debts underwrite basics of consumption and investment: housing, cars, student loans etc (see https://www.bloomberg.com/view/articles/2017-10-18/don-t-rely-on-u-s-consumers-to-power-global-growth). Which means that in an event of any significant shock to the markets, investors' debt carry costs are likely to rise, just as their wealth is likely to fall. This might not trigger a market collapse, but it will push market recovery out.

An added leverage dimension ignored by Shiller is that of the corporates. During the crises, cash-rich and/or liquid corporates can compensate for falling asset prices by repurchasing stocks. But corporates are just now completing an almost decade-long binge in accumulating debt. If the cost of debt carry rises for them too, they will be the unlikely candidates to support re-leveraging necessary to correct for an adverse asset prices shock.

I would agree with Shiller that, given current conditions, timing the markets correction is going to be very hard, even as CAPE indicator continues to flash red. But I disagree with his view that only margin account leverage matters in propagating shocks to a systemic level.

5/10/17: Leverage Risk, Credit Quality & Debt Tax Shield

In our Risk & Resilience class @ MIIS, we cover the impact of various aspects of the VUCA environment on, amongst other things, the Weighted Average Cost of Capital. One key element of this analysis - the one we usually start with - is the leverage risk. In practical terms, we know that the U.S. (bonds --> intermediated bank debt) and Europe (intermediated debt --> bonds) are both addicted to corporate leverage, with lower cost of capital attributable to debt. We also know that this is down not to the recoverability risks or credit risks, but to the asymmetric treatment of debt and equity in tax systems. Specifically, leverage risk is driven predominantly by tax shields (tax deductibility) of debt.

In simple terms, tax system encourages, actively, accumulation of leverage risks on companies capital accounts. Not only that, tax preferences for debt imply distorted U-shaped relationship between credit ratings (credit risk profile of the company) and the cost of capital, whereby top-rated A+, A and A- have higher cost of capital (due to greater exposure to equity) than more risky BBB and BBB- corporates (who have higher share of tax0deductible debt in total capital structure).

Which brings us to one benefit of reducing tax shield value of debt (either by lowering corporate tax rate, which automatically lowers the value of tax shield) or by dropping tax deduction on debt (or both). Here is a chart showing that when tax deductibility of debt is eliminated, companies with lowest risk profile (A+ rated) enjoy lowest cost of capital. As it should be, were risk playing more significant role in determining the cost of company funding, instead of a tax shield.

Simples. com

19/5/17: A Reminder: Social Security is Only Getting More Insolvent...

On foot of my earlier post on U.S. household debt, it is worth mentioning another, much-overlooked in the media, fact concerning U.S. real economic debt crisis. This fact is a staggering one, even though it has been published a year ago, back in April 2016.

Based on the 2016 OASDI Trustees Report, officially called "The 2016 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds" (see link here: https://www.ssa.gov/oact/TR/2016/index.html).

• U.S. Social Security's total income will exceed total cost of Social Security payouts through 2019. However, beyond 2019, interest income and money taken out of reserves will have to cover the funds required to offset Social Security's annual deficits until 2034.
• Assuming the U.S. Presidential Administrations and the Congress continue business as usual approach to Social Security, the federal government payroll taxes will only be able to cover roughly 75% of scheduled retirement benefits until 2090
• As the result, the Social Security Administration now projects that unfunded obligations will reach USD 11.4 trillion by 2090 or some $700 billion higher than the USD 10.7 trillion shortfall projected a year ago
• Worse:  on an "infinite horizon" basis (netting Social Security expected future liabilities from forecast revenues) Social Security will face a USD 32.1 trillion in unfunded liabilities by 2090, or staggering USD 6.3 trillion more than 2015 projection

Chart below plots forecast Social Security unfunded liabilities corresponding to each forecast year:

The above clearly shows that the Social Security 'stabilisation' achieved in 2014-2015 is now not only erased, but is set back to what appears to be a rapid acceleration in liabilities back to 2008-2014 trend.

Yes, Social Security is a system in which people pay in taxes for an 'allegedly' ringfenced program that is supposed to supplement retirement. No, Social Security is not a program that is actually contractually ringfenced to provide anything whatsoever to those who pay into it. Which, really, means that the default on Social Security is looming large for the millennials and subsequent generations. And this raises the issue of what will happen to pensions provision across the entire U.S. Currently, even public sector pensions (across states and municipalities) are facing severe uncertainty and, in an increasing number of cases, actual cuts. Which raises public reliance on Social Security just at the time that the Social Security system is facing higher threats of insolvency. 

Meanwhile, household debt situation is getting from bad to awful (see this post: http://trueeconomics.blogspot.com/2017/05/19517-us-household-debt-things-are-much.html). 

The status quo is a prescription for a social, economic and political disaster. No medals for guessing what the Congress is doing about it all.

8/5/16: Leverage and Management: Twin Risks or Separate Risks?

A new paper “How Management Risk Affects Corporate Debt” by Yihui Pan, Tracy Yue Wang, and Michael S. Weisbach (NBER Working Paper No. 22091 March 2016) looks at the role management risk (uncertainty about future managerial decisions) plays in increasing overall firm-wide default risk.

Specifically, the paper argues that “management risk is an important yet unexplored determinant of a firm’s default risk and the pricing of its debt. CDS spreads, loan spreads and bond yield spreads all increase at the time of CEO turnover, when management risk is highest, and decline over the first three years of CEO tenure, regardless of the reason for the turnover.”

The authors also show that a “similar pattern but of smaller magnitude occurs around CFO turnovers.”

Overall, “the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of prior uncertainty about the new management.”

Which means that leverage risk and management turnover risk can be paired.


In some detail, as authors note, “firm’s default risk reflects not only the likelihood that it will have bad luck, but also the risk that the firm’s managerial decisions will lead the firm to default”. In other words, while leverage risk matters on its own (co-determining overall firm risk), it also runs coincident and is possibly correlated with management turnover risk. “Management risk occurs when the impact of management on firm value is uncertain, and, in principle, could meaningfully affect the firm’s overall risk.”

This is not new. Empirically, we know that management risk is “an important factor affecting a firm’s risk. However, the academic literature on corporate default risk and the pricing of corporate debt has largely ignored management risk. This paper evaluates the extent to which uncertainty about management is a factor that affects a firm’s default risk and the pricing of its debt.”

Using a sample of primarily S&P 1500 firms between 1987 and 2012, the authors “characterize the way that the risk of a firm’s corporate debt varies with the uncertainty the market likely has about its management. The basic pattern is depicted in [the chart above]… The announcement of a CEO’s departure is associated with an increase in the firm’s CDS spread, reflecting an increased market assessment of the firm’s default risk. The CDS spread declines at the announcement of the successor, and further declines during the new CEO’s time in office, approximately back to the pre-turnover level after about three years.”

Quantitatively, the effect is sizeable: “the 5-year CDS spread is about 35 basis points (22% relative to the sample mean) higher when a new CEO takes office than three years into his tenure. Spreads on shorter-term CDS contracts exhibit an even larger sensitivity to CEO turnover and tenure. Spreads on loans and bond yield spreads also decline following CEO turnovers. These patterns occur regardless of the reason for the turnover; changes in spreads following turnovers that occur because of the death or illness of the outgoing CEO are not economically or statistically significantly different from changes in spreads in the entire sample.”

Dynamically, the results are also interesting: the process of risk pricing post-CEO exits is consistent with information updating / learning by markets. “The observed decline in default risk over tenure potentially reflects the resolution of uncertainty about management and hence a decline in management risk. …Bayesian learning models imply that if the changes in spreads around CEO turnover occur because of changes in management risk, then when ex ante uncertainty about management is higher, spreads should increase more around management turnover and decline faster subsequently. Consistent with this prediction, our estimates suggest that the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of uncertainty there is about the new management. For example, the increase in CDS spreads at the announcement of a CEO departure when the firm does not have a presumptive replacement is almost three times as high as when there is such an “heir apparent.” The revelation of the new CEO’s identity leads to smaller declines in spreads prior to the time when he takes over if the new CEO is younger than if he is older; presumably less is known about the young CEOs ex ante so less uncertainty is resolved when they are appointed. But once a younger CEO does take over, the market learns more about his ability from observing his performance, so the spreads decline faster.”

Fundamentals that may signal CEO quality ex ante also matter: “…when the CEO has an existing relationship with a lender before he takes his current job, the lender is likely to know more about the CEO’s ability and future actions, leading to lower management risk. Consistent with this argument, we find that the sensitivity of interest rates to the CEO’s time in office is 39-57% lower for loans in which the CEO has a prior relationship with the lender compared to those without such a relationship. This relation holds even if the CEO is an outsider and the relationship was built while he worked at a different firm, so the existence of the relationship is exogenous to the credit condition of the current firm.”

What about cost of debt and risk pricing? Some nice result here too: “Since uncertainty about management is likely to be idiosyncratic rather than systematic, it theoretically should not affect a firm’s cost of debt (i.e., the expected return on debt). Accordingly, firms should not adjust the cost of capital they use for capital budgeting purposes because of management-related uncertainty. In addition, since variation in management risk appears to be relatively short-term, it is unlikely to affect firms’ long-term capital structure targets. However, since management risk increases the volatility of cash flows, it should increase the demand for precautionary savings. Consistent with this idea, we find that firms facing higher management risk tend to have higher cash holdings. In particular, cash holdings decline with executive tenure, but only for firms for which management risk is likely to be high.”


Overall, an interesting set of results - highly intuitive and empirically novel. One thing that is missing is control for quality of governance within the firms, e.g.
- CSR
- ERM
- Board and C-level quality metrics
Avenue for future extension of the study…

27/4/16: The Debt Crisis: It Hasn't Gone Away

That thing we had back in 2007-2011? We used to call it a Global Financial Crisis or a Great Recession... but just as with other descriptors favoured by the status quo 'powers to decide' - these two titles were nothing but a way of obscuring the ugly underlying reality of the global economy mired in a debt crisis.

And just as the Great Recession and the Global Financial Crisis have officially receded into the cozy comforters of history, the Debt Crisis kept going on.

Hence, we have arrived:

Source: http://www.zerohedge.com/news/2016-04-27/debt-growing-faster-cash-flow-most-record

U.S. corporate debt is going up, just as operating cashflows are going down. And so leverage risk - the very same thing that demolished the global markets back in 2007-2008 - is going up because debt is going up faster than equity now:

As ZeroHedge article correctly notes, all we need to bust this bubble is a robust hike in cost of servicing this debt. This may come courtesy of the Central Banks. Or it might come courtesy of the markets (banks & bonds repricing). Or it might come courtesy of both, in which case: the base rate rises, the margin rises and debt servicing costs go up on the double.

18/4/16: Leverage Risk, the Burden of Debt & the Real Economy

Risk of leverage has been a cornerstone of our recent lectures concerning the corporate capital structure decisions in the MBAG 8679A: Risk & Resilience:Applications in Risk Management class at MIIS. However, as noted on a number of occasions in both MBAG 8679A and other courses I teach at MIIS, from macroeconomic point of view, corporate leverage risks are just one component of the overall economic leveraging equation. The other three components are: household debt, government debt, and the set of interactions between the burden of all three debt sources and the financial system at large.

An interesting research paper by Mikael Juselius and Mathias Drehmann, titled “Leverage Dynamics and the Burden of Debt” (2016, Bank of Finland Research Discussion Paper No. 3/2016: http://ssrn.com/abstract=2759779) looks that both leverage risk arising from the U.S. corporate side and household side.

Per authors, “in addition to leverage, the debt service burden of households and firms is an important link between financial and real developments at the aggregate level. Using US data from 1985 to 2013, we find that the debt service burden has sizeable negative effects on expenditure.” This, in turn, translates into lower economy-wide investment and consumption - two key components of the aggregate demand. Debt “interplay with leverage also explains several data puzzles, such as the lack of above-trend output growth during credit booms and the depth and length of ensuing recessions, without appealing to large shocks or non-linearities. Using data up to 2005, our model predicts paths for credit and expenditure that closely match actual developments before and during the Great Recession.”

With slightly more details: the authors found that “the credit-to-GDP ratio is cointegrated with real asset prices, on the one hand, and with lending rates, on the other. This implies that the trend increase in the credit-to-GDP ratio over the last 30 years can be attributed to falling lending rates and rising real asset prices. The latter two variables are, moreover, inversely related in the long-run.”

In addition and “more importantly, we find that the deviations from the two long-run relationships - the leverage gap and the debt service gap henceforth - have sizeable effects on credit and output. …real credit growth increases when the leverage gap is negative, for instance due to high asset prices. And higher credit growth in turn boosts output growth. Going beyond the existing evidence, we find that the debt service gap plays an additional important role at the aggregate level that has generally been overlooked: it has a strong negative impact on consumption and investment. In addition, it negatively affects credit and real asset price growth.”

The link between leverage gap and debt service gap:

In summary, “The leverage and debt service gaps hold the key for explaining the divergence of credit and output in recent decades. For instance, in the late 1980s and mid 2000s both gaps were negative boosting credit and asset price growth. This had a positive effect on output, but not one-to-one with credit, which caused the credit-to-GDP ratio to rise. This in turn pushed the debt service gap to positive values, at which point it started to offset the output effects from high credit growth so that output growth returned to trend. Yet, as the leverage gap remained negative, credit growth was still high, ie we observed a “growthless” credit boom. This continued to increase the debt-service gap, which had a growing negative effect on asset prices and expenditure, driving the leverage gap into positive territory. And once both gaps became positive they worked in the same direction, generating a sharp decline in output even without additional
large shocks or crises-related non-linearities. The subsequent downturns were deep and protracted, as the per-period reduction in credit had to be faster than the per-period decline in output in order to lower the credit-to-GDP ratio and thereby close the two gaps. This also implied that the recovery was “creditless”.”

Highly intuitive and yet rather novel results linking leverage risk to debt financing costs.

19/09/2011: Highly Leveraged Banks' real impact on economy

An interesting paper from CEPR sheds some (largely theoretical) light on the real side of the current global financial crisis.

CEPR DP8576 titled "Financial-Friction Macroeconomics with Highly Leveraged Financial Institutions" by Sheung Kan Luk and David Vines (September 2011: available here) models the current crisis by adding "a highly-leveraged financial sector to the Ramsey model of economic growth". The paper shows that the presence of high leverage in financial sector "causes the economy to behave in a highly volatile manner" and thus exacerbate the macroeconomic effects of aggregate productivity shocks.

The model is based on the mainstream financial accelerator approach of Bernanke, Gertler and Gilchrist (BGG). The core BGG model assumes leveraged goods-producers are subjected to idiosyncratic productivity shocks, inducing them to borrow from a competitive financial sector.

Luk and Vines, by contrast, assume that "it is the financial institutions which are leveraged and subject to idiosyncratic productivity shocks." As the result of this, leveraged financial institutions "can only obtain their funds by paying an interest rate above the risk-free rate, and this risk premium is anti-cyclical [ in other words the premium is higher at the time of adverse productivity shock, i.e. during the recession], and so augments the effects of shocks."

Luk and Vines parameterise the model to US data under the assumption that "the leverage of the financial sector is two and a half times that of the goods-producers in the BGG model". The assumption is relatively robust for the current environment in the US. It is probably less robust in the case of the EU where financial sector leverage is likely to be higher in a number of countries due to:

1. Traditional over-reliance on debt financing of the banking sector
2. Lower rates of deleveraging in the banking sector than in the US, and
   
3. Greater deposits attrition during the crisis.
   

The study finds that the presence of leveraged financial institutions "causes a much more significant augmentation of aggregate productivity shocks than that which is found in the [traditional] BGG model."

In the nutshell, this provides a plausible explanation as to the channels through which financial sector funding and operational strategy risks (leading to higher leverage) transmit through to real economy. It also links more directly monetary policy to the real economy as well. Ben, keep that printing press running... nothing can possibly go wrong with negative interest rates, mate.