Creating the Zombie Apocalypse. Fed Chair Jerome Powell is doing an admirable job of playing the action hero in “2012 Zombie Apocalypse,” a 2011 film about a fictional virus, VM2, that causes a global pandemic. He is doing whatever it takes to stop the zombies from killing us by ruining our economy and way of life. In my recently released book Fed Watching for Fun & Profit, I defined the zombies as living-dead firms that continue to produce even though they are bleeding cash. In a purely capitalist system, they should go out of business and be buried. However, these firms survive only because they are kept on life support by government subsidies, usually because of political cronyism, which corrupts and undermines capitalism. In recent years, the Fed’s ultra-easy monetary policies have
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In my recently released book Fed Watching for Fun & Profit, I defined the zombies as living-dead firms that continue to produce even though they are bleeding cash. In a purely capitalist system, they should go out of business and be buried. However, these firms survive only because they are kept on life support by government subsidies, usually because of political cronyism, which corrupts and undermines capitalism. In recent years, the Fed’s ultra-easy monetary policies have created and exacerbated the zombie problem. I wrote:
“And why are lenders willing to lend to the zombies? Instead of stimulating demand by borrowers, historically low interest rates incite a reach-for-yield frenzy among lenders. They are willing to accept more credit risk for the higher returns offered by the zombies. Besides, if enough zombies fail, then surely the central banks will come up with some sort of rescue plan.”
Now consider the following developments just before the Great Virus Crisis (GVC) significantly increased the odds of a zombie apocalypse:
(1) The IMF’s script. In my book, I wrote: “If you want to read a very frightening script of how this horror movie plays out, see the October 2019 Global Financial Stability Report prepared by the International Monetary Fund (IMF). It is titled ‘Lower for Longer’ but should have been titled ‘Is a Zombie Apocalypse Coming?’ Here is the disturbing conclusion: ‘In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that cannot cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies, and above post-crisis levels.’”
(2) The Fed’s script. Also in my book, I observed that the Fed’s second Financial Stability Report was released in May 2019. It had the same don’t-worry-we-are-on-it tone as the first report released during November 2018. However, credit quality had clearly eroded in the corporate bond market. The second report observed: “[T]he distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion.”
The report also raised concerns about leveraged loans, as follows:
“The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody’s Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.”
(3) The man who saw it coming. During his October 30, 2019 press conference, Fed Chair Jerome Powell was asked about financial stability. He responded: “Obviously, plenty of households are not in great shape financially, but in the aggregate, the household sector’s in a very good place. That leaves businesses, which is where the issue has been. Leverage among corporations and other forms of business, private businesses, is historically high. We’ve been monitoring it carefully and taking appropriate steps.” He didn’t specify those steps. However, the Fed’s three interest-rate cuts during 2019 undoubtedly kept lots of zombies alive and fed their appetite for more debt.
Containing the Zombie Apocalypse. On March 11, the World Health Organization declared that the COVID-19 outbreak had turned into a global pandemic. The pandemic of fear spread just as rapidly in the US capital markets, especially in the bond markets, which seized up as credit-quality yield spreads soared. The zombie apocalypse had arrived.
On Sunday, March 15, the Fed responded by cutting the federal funds rate by 100bps to zero and announcing a $700 billion QE4 program of Treasury and mortgage-backed securities purchases. That week, the governors of California and New York issued executive orders requiring nonessential workers to stay home. Credit-quality spreads continued to widen significantly. So on March 23, the Fed introduced QE4ever and posted term sheets on five major credit facilities.
Three of the new facilities dated back to the Great Financial Crisis and were reactivated. The big shockers were the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). For the first time ever, the Fed was going to lend a hand to the investment-grade corporate bond market. Here are the specifics from their term sheets:
(1) PMCCF. The Fed is prohibited by law from purchasing corporate bonds. To get around this restriction, the Fed will lend to a special purpose vehicle (SPV) on a recourse basis. “The SPV will (i) purchase qualifying bonds directly from eligible issuers and (ii) provide loans to eligible issuers.” This backstop for investment-grade corporate bonds and loans (with maturities of four years or less) will be backstopped by $10 billion in equity provided by the US Treasury’s Exchange Stabilization Fund. Borrowers may defer paying interest for six months (extendable at the Fed’s discretion), but they must not pay dividends or buy back shares during the period they aren’t paying interest. The facility is scheduled to be terminated on September 30 of this year.
(2) SMCCF. This facility is structured in the same way as the PMCCF, but it purchases eligible individual corporate bonds as well as eligible corporate bond portfolios in the form of exchange-traded funds (ETFs) in the secondary market with maturities of five years or less. Both programs set limits per issuer and ETF.
(3) Another round of drinks for my friends. On March 27, President Donald Trump signed the CARES Act, which gave the US Treasury $450 billion to invest in the Fed’s SPVs, thus effectively converting the Fed into the Bank of the United States, or “T-Fed” as I call it. On April 9, the Fed announced how it would leverage up all that capital, initially up to $2.3 trillion in loans and possibly up to $4.0 trillion in total.
That sum includes $750 billion in lending by the two corporate liquidity facilities leveraging up (on a 10-to-1 basis) the Treasury’s $75 billion in capital from the original $20 billion. The ironic shocker was that the eligible bonds now included those BBB-rated bonds that the Fed had warned about in its FSR (cited above) less than a year ago. If those dicey bonds dropped below that rating after March 22, they could still be purchased by both facilities, according to the updated term sheets of the PMCCF and the SMCCF. The Fed opened up these two liquidity facilities for homeless investment-grade corporate bonds to the so-called fallen angels as well.
Now what will the Fed do about all the junk bonds issued by zombie energy companies that are about to blow up? Probably nothing. Large oil companies and distressed asset funds are likely to scoop up all the frackers, who can’t service their debts, at big discounts. Some portfolio managers will have to take big hits in their junk-bond portfolios. That’s the downside of associating with zombies.