Home > Uncategorized > The New Subprime

The New Subprime

The front page of this weekend’s Wall Street Journal bears the headline: “‘Junk’ Bonds Hit Record.”  So let’s think back to 2008 and remember some of the things that led up to this depression.  The combination of the Fed keeping interest rates low and the government subsidizing home loans for those who would have otherwise been considered too risky pumped up a real estate bubble.  Everyone said “hey look prices are going up faster than interest rates, I can just buy houses with practically no down payment and then sell them six months later and make a big profit without doing anything.  It’s easy money!”  So naturally everyone started doing this and eventually we ended up with too many houses and not enough buyers and prices had to come down.  When prices came down, everyone who’s house was highly leveraged (which was just about everyone with a house…) found themselves owing more than it was worth.  This meant people started to default on their loans which meant the securities which were backed by those loans fell dramatically in value causing widespread losses throughout the financial sector of the economy.

Now look at what is going on in the bond markets.  In order to keep prices propped up in the broader economy, the Fed has had to lower interest rates to near zero levels.  And just holding short-term interest rates low hasn’t been enough, so they have started buying longer term securities driving those yields down as well.  So if you want a safe investment, you can pretty much forget about getting any return on it.  You might as well put your money in your mattress.  But wait, if you just buy some slightly riskier bonds, you can actually get a yield and after all, they’re not defaulting at a very high rate right now….

‘Even though high-yield bond yields have come [down], versus other asset classes, they’re still comparatively attractive, especially when you consider the direction of default today,’ says Darin Schmalz, a director in leveraged finance at Fitch Ratings.  ‘When you take into account other investment options for investors, and a benign default rate, the high-yield asset class is still pretty attractive.’

So the Fed’s monetary policy is chasing people into junk bonds, and people are going willingly because after all the default rate is pretty “benign” right now.  But it’s not about right now!  This is the same mistake the market made (I know, I don’t like accusing the market of making mistakes but it happens) with real estate.  People thought since prices were going up at the time that they would go up forever.  By the way, it’s the same thing that happened with the stock market in 1929.  Stocks were going up and you could just open a margin account and ride the wave with practically no real investment.  That worked well…

So ok, this probably isn’t as bad as all that because people don’t buy bonds on margin typically and there’s no Fannie and Freddie being forced by the government to sell junk bonds to poor people and then shirking the liability onto said government.  But the pattern is the same.  The Fed pumps up price bubbles and then deflation comes in a wave. 

The refinancings, on the whole, are positive for the economy, because they help companies with too much debt avoid default or bankruptcy.  But they do little to create new economic growth, and in some cases simply delay an inevitable reckoning.

The default rate is low right now because they are able to get cash in large quantities at low rates due to the Fed’s monetary policy.  But this won’t turn a bad business into a good business and it won’t keep them alive indefinitely.

Advertisements
Categories: Uncategorized
  1. No comments yet.
  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: