Companies these days are borrowing at unprecedented rates, although the real threat here isn’t so much default as it is sacrificing future profits for shorter-term stock love.
If you are holding stocks these days, which a lot of people are, you just have to love what companies are doing with their balance sheets in this very low rate environment. The lure of profits from driving stock prices higher and higher just doesn’t tempt shareholders, it also tempts corporate leaders as well, perhaps even more so, and this all bears close watching at the very least.
When we look back upon the 2008 financial crisis, there is no question that this was driven by what we could call corporate greed, with greed here being defined as seeking to profit short-term with little or no regard to longer-term risks. The pull here was so strong that the world’s largest financial institutions became so excited to cash in on this that they completely set aside risk concerns, even those of the most extreme variety.
We all know what happened, but if we were sitting in judgement of this before things blew up, and we had a good understanding of what was really going on, as the banks did, what happened should not have come as a surprise. This really was a Ponzi scheme of sorts, and one on a scale that completely dwarfed anything that Mr. Ponzi himself could have ever dreamed about.
People rail against these individual Ponzi operators, and just putting them in jail and throwing away the key doesn’t even serve as much consolation when your life savings are taken from you from these fraudulent schemes. It’s not that people didn’t get upset about the conduct of banks during this crisis as well, but comparatively speaking, they got off very easily indeed, and even got rewarded for their utter disregard of the welfare of the companies that they were managing.
If Bernie Madoff scares us, this should have scared us at least a thousand-fold more, and in comparison, Madoff was like an individual terrorist with rocket-propelled grenades, where the financial crisis used nuclear warheads. We avoided the worst of this nuclear attack as this really could have escalated into a financial World War 3, and we have recovered since and then some, but we at least need to come away with a much better taste of the danger inherent in today’s corporate structure and what motivates them.
The uninitiated might think that the primary responsibility of corporate leaders is to promote the long-term interests of their companies, but this is truly a naïve view. This is much more like putting wolves in charge of the livestock pen than we realize, for better or worse, but for worse if we don’t get this properly.
The biggest problem with this is when we invest in their securities longer-term with the illusion that the longer-term view is some sort of priority in business, and while it might be in word, it certainly may not be in action.
It’s not hard to figure out why this does not end up being the priority we think it is, and this is not some sort of fringe conspiracy theory, it’s the main theory. It’s not even a theory, it’s what happens in practice every day, for reasons that should be very obvious.
It is not that this approach is in any sense wrong in itself, aside from avoiding the systemic perils that we saw during the collapse of credit markets over 10 years ago now, which we truly need to avoid. While we can say with some confidence at least that the prospects of such a thing are behind us due to better oversight, where there is at least a shepherd on duty now to keep the herd from being decimated like this, the desire for companies to cannibalize is as strong as ever, if not stronger.
What we have done since is choose a different whipping boy, moving from the riskier world of collateralized debt obligations to a company’s bond issues. Make no mistake though, bond defaults are nothing to mess with, and while a company can go down from taking on too much risk, this is the point where the game is over by definition, when a company becomes insolvent.
This is nowhere near any sort of crisis level, as this cannibalization goes on more behind the scenes and while it does pack a payload, as long as rates remain on the lower side, we can sustain this impact and if things do go south, we’ll have plenty of warning, much more than we did in 2008.
That bomb caused a massive explosion, but this one will be much more of a slow bleed where those who don’t like getting cut by this will be able to dance to the music along with the CEOs while the music is still playing, and follow them with their briefcases of money out the door when the music does stop.
Stocks Are Being Pumped Up in a Way that Would Make Mr. Ponzi Proud
To get a perspective of what actually goes on behind these doors, we need to realize that the priority for both corporate leaders and shareholders is to expand the value of their stock. Neither care about the future very much, and business leaders care even less about this than shareholders do, when they can make enormous sums of money for themselves by flying high in the near term while keeping their parachutes on.
Millions more in your pocket is a powerful incentive indeed, and while some may object to the way that we compensate our top executives, this is how companies choose to do it and they are entitled to do so as long as they do not take on so much risk that they need to be bailed out or the whole house of cards will collapse.
As long as transparency is maintained, there is nothing that terrible with taking a company and looking to whack this horse to make it run faster now even though we know this will tire it out. It is their horse after all, so if people want to hire jockeys that will ride too hard and everyone makes a lot more money now, that’s a preference that needs to be respected as long as it does not result in a track full of fallen horses like we saw not long ago.
This is not as transparent as it needs to be though, and both bondholders and long-term investors can become deceived, and in some ways at least, this does share some characteristics with Ponzi schemes. The difference here is what happens when the music does end, where Ponzi schemes completely crash and reveal the utter fraudulence involved, where our Ponzi-like company management with its prodigal stock management involves much more survivable outcomes.
Economist Hyman Minsky used the term Ponzi in his characterization of the cycle of debt markets, although it took 40 years for people to really start paying attention to his theories. His work is much better known today, after the 2008 collapse, and we now describe these things as Minsky moments.
A Minsky moment describes the sudden reversal of a financial market once its growth phase ends, which we sure had then, and although the collapse of the housing market certainly did come to an abrupt end, the debt problem didn’t collapse under its own weight in the way that Minsky describes. Something else collapsed instead, housing prices, so this wasn’t an authentic Minsky moment.
The current situation matches Minsky’s theories much better though, which should at least concern those who have plans on staying around past the Minsky moment that we may be headed for once our current growth peaks. While we definitely need to be worrying about bonds being devalued and even defaulting in some cases, this also has the potential to bring down stocks, and ultimately, this might even be inevitable.
According to Minsky, these moments are created by companies relying on borrowing too much to fuel their growth, and the more they borrow, the more fragile the situation becomes. Finally, when credit markets start to tighten, this debt fueled growth can no longer be sustained in its present form and we see a collapse of some magnitude.
He describes the final stage of this rise before the fall as a “Ponzi market.” We might initially think that this is using the term Ponzi pretty loosely, but this term actually describes what is going on in the stock market right now surprisingly well once we take a close look at how this is playing out right now.
Companies may borrow to expand their businesses, which is the traditional reason, and as long as their projections are correct, this can build long-term value where companies can achieve good returns on investment with their borrowed money.
When they instead borrow not to grow their companies but to instead just grow their company’s stock, this is a different story altogether, where the focus isn’t just no longer on the long term, the long term ends up getting cannibalized by the short-term.
Buying back your stock can be in itself a good idea if this involves taking profits and reinvesting them in the company. While spending the money on company growth needs to be in the conversation as well, and promotes a company’s future, with some companies, there’s only so much expanding you can do, and you need to do something with the extra cash that may be left over once you saturate these opportunities.
If we are being responsible about the long-term health of the companies that we are running, we will need to resist the temptation to reinvest profits in the stock when investing it in the company’s business would provide more value overall. If not, we have a little Ponzi action going on already, when we sacrifice long-term health for shorter term gains in the value of our stocks.
Overborrowing and Ponzi Schemes Both Seek to Misrepresent the Truth
The real Ponzi element of this really comes home to roost when we are willing to borrow to fuel our lust for higher stock prices, as this borrowed money does not grow the business at all but will have to be paid back from future profits. This puts down future earnings at best, and can place companies in danger if taken too far.
The final piece of the puzzle kicks in when the low rates that have fueled this frenzy start to rise, where the costs of this borrowing go up and eat up even more future profits. However, we do not want to make the mistake of thinking that this only goes wrong when rates rise quite a bit, otherwise we may be lulled into a false sense of security if we think that this won’t happen for quite a while or maybe not for a long time.
What makes all of this really Ponzi-like is the cannibalization of future profits to keep propping up stock prices that otherwise would be quite a bit lower. Few people realize just how powerful buybacks really are, and the fact that this cannibalization causes the overall value of the company going down can be easily offset by these buybacks, and then some, where long-term company value and stock price can move in different directions for quite a while.
Even being fully aware of this should not cause us to want to be off this ride on the stock side at least, and in fact, this all going on is specifically designed to benefit the stocks of companies. If we like to party, this is one we definitely want to be at, and the music certainly is still playing very loudly at the one going on now.
There may indeed come a time when our stocks can’t be propped up like this anymore, when we see the ability to maintain the level of borrowing that we need to maintain to keep this party going becoming diminished. In the corporate bond world, we don’t need monetary policy tightening to see this happen, as declining business performance in itself is enough to cause rates to climb just from credit downgrades.
We do not want to be in the room next door, the bond room, where they have been living it up as well, although this is a party that can and will end without any help. Corporate bond ratings overall have been declining and continue to do so, and although their value has increased considerably over the last 15 months, this trend will not last because it is simply market driven, which just can’t last because you hit a ceiling, and we have already. With corporate bonds, the fundamentals end up speaking against this by way of downgrades which do put bond prices down very reliably over time.
The bond market is not only the front line of this Ponzi war, it is the one that we are taking so many troops from and moving them to the rear where the stocks are standing. When the real firing starts, bonds will be the first to take the hit from this and fall.
It should be enough just to know that bonds are being cannibalized to fuel stock growth to know which side we should be on here. It surely is better to hang with Ponzi himself than with his victims. Unlike Ponzi, we can just walk away when he gets busted, so all this is not a bad thing at all for investors provided that they hang with the right crowd at the right time.
This is what investing is all about anyway. Given that it is what running corporations are all about as well, regardless of what we think about this strategy, it does cause the skies to rain money for a time, and it’s just better to be one of those who pick it up rather than being one of the people throwing it out of the window.