As the stock markets struggle—so far without much success—to recover from an astoundingly quick rout that has lopped off nearly 30% from the Dow Jones Industrial Average in a month's time (you may recall that the all-time high on the Dow, 29,551, was February 12), the action on Wall Street is moving quickly to the credit markets, and that's when things can begin to get really scary.
The vicissitudes of the stock market get all the attention of course: the ticker at the bottom of the CNBC screen, the chyrons announcing the latest bombshell moves up or down, the headlines on the Wall Street Journal, the inane presidential tweets. But the credit markets are where the rubber meets the road for capitalism. If businesses can't get access to the capital they need to finance payroll, to pay their bills, to make expenditures on new projects, or to simply run things on a daily basis, then the economic consequences get dire. If companies with debt coming due can't refinance that debt with banks or public investors, then the economic consequences become dire. If companies can't issue new debt at acceptable rates of interest, or at any rate of interest, then the economic consequences become dire. If the credit markets freeze up, as they did in the fall of 2008, as they did for the about three years after Citibank in 1989 failed to syndicate the loan that was to be used to finance the management buyout of United Airlines, then the economic consequences become dire.
We're not there yet. But we are, sadly, heading in that direction, and quickly. According to my Wall Street sources, companies of all stripes are drawing down the lines of credit that they have from their banks. This is, of course, a "better safe than sorry" course of action—take the money down whether you need it or not because otherwise when you really need it you might not be able to get it. But it's also a leading indicator of extreme financial and economic nervousness. Before it collapsed 12 years ago, Bear Stearns drew down the full amount of its credit facilities too. Companies such as Boeing, Hilton, and Wynn Resorts will draw down their credit lines, according to reports earlier this week. Bloomberg reported that big private-equity firms such as the Blackstone Group and the Carlyle Group were encouraging some of their portfolio companies to draw down their credit lines too. ("There is no firm-wide directive to our portfolio companies to draw upon credit lines," a Blackstone representative said in a statement. "We are evaluating the financing needs of a small number of companies directly impacted by COVID-19.")
While this will put more risk assets on the balance sheets of the big Wall Street banks that made these lines of credit available in the first place, it is important to note that this financial crisis is very different than the one that occurred 12 years ago. That one was caused by a systemic breakdown inside the Wall Street banks at the heart of the capitalist system. They had made the classic banking mistake of borrowing for short periods of time and lending for long periods of time. They did that—and continue to do that—because short-term financing is generally (but not always) much cheaper than long-term financing. So by borrowing short-term and lending long-term the difference between what they pay for the raw material—money—and what they receive by lending it out is their profit, or much of their profit. (Fees are an important source of profits too.) That works just fine, until it doesn't. What happened 12 years ago to Bear Stearns—almost to the day—was that it could no longer finance itself in the short-term markets, even on a secured basis. It could no longer pay its bills as they became due. It was bankrupt. The same thing, more or less, happened to both Merrill Lynch and to Lehman Brothers, and was about to happen to Morgan Stanley (and many think to Goldman Sachs too).
This time is different. Thanks to the reforms in the wake of 2008 financial crisis—reforms that Donald Trump is eager to try to continue rolling back—Wall Street banks are much better capitalized now than they were then. The Washington regulators have also greatly curtailed the kinds of loans they can keep on their books and their ability to make markets in certain kinds of debt and equity securities. In short, the good news is that the banking system is much more secure today than it was 12 years ago.
But risk doesn't just disappear because it's not housed inside the Wall Street banks. The risk still exists, and plenty of it. Nowadays it's contained in what's known on Wall Street as the "shadow banking" system, inside relatively less regulated financial players who buy and sell packages of loans and other risky debt securities. These companies, which most people haven't heard of, have names such as Ares Capital Corporation, Antares Capital, Golub Capital, and Owl Rock Capital, and have been buying and selling the risk that Wall Street has been prevented from doing by its regulators. There are also big credit funds that have sprung up inside any number of private-equity firms and hedge funds. They are also players in this market.
There is now what's been described to me as a rare opportunity for firms such as these to step up and to provide capital to companies that are struggling to refinance their debts. Wall Street's clients are seeking its help to get capital from the shadow banking sector, which so far seems to be rising to the task, although they are charging higher rates of interest on the money than what most companies have been used to paying. And that's if they are lucky enough to get the money they need. It's definitely become a buyer's market virtually overnight. "They have huge capacity," one Wall Street senior banker tells me about the shadow bankers. What's currently being proposed widely is that a distressed company's refinancing be carved up into two pieces: a "senior," or less risky, piece that the Wall Street bank will provide and a "junior," or more risky, piece that a shadow banking group, hedge fund or private-equity fund will provide. "Of course, if the entire world turns upside down," the banker continues, even the shadow players won't have enough money.
Richard Farley, a partner at the law firm of Kramer Levin and the chairman of its Leveraged Finance Group, tells me that just like in 2008, there are rumors of some hedge funds—"weak sisters," he called them—that are selling the higher quality debt in their portfolios to raise much-needed capital and to remain "liquid." He says the these "sisters" are not getting as much for these securities when they sell them because the buyers "smell blood in the water." But, he continues, the "rumors of trouble" have not yet hit the Wall Street banks or the shadow players. They are still allowing companies to draw down on their lines of credit, even if the drawdown might trip a covenant. "In fact, some private credit firms are viewing this as a once-in-a-decade opportunity to buy loans or refinance existing facilities at extremely attractive rates," he says. "Of course, there will certainly be other firms who were over their skis with loan books full of ill-conceived loans before the coronavirus crisis and for whom this will not end well."
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