Is the U.S. Building a Debt Bomb?
U.S. corporate and consumer borrowing has hit worrisome levels
Everybody has a favorite economic doomsday scenario. Some worry that the stock market could collapse tomorrow; others fear that irrational exuberance will continue--postponing, but intensifying a market meltdown. Is there too much growth, or is the nation on the brink of a deep slowdown? Will inflation reignite? Or will corporations that are unable to raise prices see their profits evaporate?
With the economy still growing rapidly, perhaps none of these fears should keep anyone up at night. But here's something that should: Even as the federal government has gotten its borrowing under control, the debt load on the U.S. economy is bigger than it has ever been. And such a burden makes even a thriving economy much more vulnerable to any kind of shock.
While the boom lasts, leverage can help companies and individuals make the most of their money. But if rates rise much more or if growth slows appreciably, once-manageable debts can quickly become a strain. Faced with big debt payments, companies are forced to cut back on capital investment and consumers pull back on spending. Without much warning, a mild downturn can turn into a surge of defaults, leading to a drying up of liquidity and a credit crunch. Says John Lonski, chief economist at Moody's Investor Services. 'That's where the risk of recession comes from.'
Consider this: Total household debt is now perilously close, at 98%, to total disposable annual income. At the end of the famously debt-happy 1980s, consumer IOUs stood at only 80% of total household earnings (chart). Corporate debt has also spiked, and borrowing by financial institutions as a percent of gross domestic product has doubled from a decade ago. 'This is historically unprecedented,' says Jane D'Arista, director of programs at Virginia-based think tank Financial Markets Center. 'We're in territory where no one knows what will happen.'
OMINOUS WARNING. And going deeper. Companies and individuals continue to borrow at an ever-accelerating rate--despite the ominous warning of last fall when the emerging-markets meltdown caused a near paralysis of debt markets and led to the emergency bailout of Long-Term Capital Management. All told, domestic debt, other than that issued by the federal government and financial institutions, adjusted for inflation, rose by 8% over the past four quarters, a pace matched only during the savings-and-loan-financed spree of the mid-1980s.
So far, most debtors have had little trouble shouldering the load, thanks to low interest rates, a strong stock market, and powerful wage and profit gains. Indeed, the Information Revolution driving the economy rides on the assumption that corporations can borrow money to buy productivity-enhancing technology and earn a quick payback. Even as long-term interest rates have risen from 5% to 6.3% in just a year, nobody is panicking. 'Rates are up a bit, but if you look at them over 10 or 20 years, we're still at a pretty good place,' says Continental Airlines Inc. President Gregory D. Brenneman.
TROUBLESOME TILT. But the perception could change quickly if rates continue to climb. 'History tells us that sharp reversals in confidence occur abruptly, most often with little advance notice,' Federal Reserve Chairman Alan Greenspan said in an Oct. 14 speech. 'These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short period.'
The most alarming sign of trouble ahead may be what's happening to corporate balance sheets. Despite the huge gains in the stock market, there is a pronounced tilt in corporate financing toward debt and away from equity. Even at today's prices, companies are buying back far more stock than they are issuing. Over the past 12 months, an eye-popping 3.6% of gross domestic product went into stock buybacks, and even with the IPO boom, nearly $500 billion in equities have been taken off the market since 1997.
Making the situation even worse, some companies are borrowing to finance buybacks. EDS just borrowed $1.5 billion on the bond market, nearly doubling its long-term debt, to fund its stock-repurchase program. With aggressive buyback programs prevalent across the whole market, the question is whether stock prices would fall if the buybacks slowed or ceased.
At the same time, companies have been issuing more and more debt to finance acquisitions and expansion. DuPont (DD), for example, sold $2 billion in bonds on Oct. 13 to replenish its coffers after spending $7.7 billion to purchase Pioneer High-Bred International Inc. earlier in the month. And Williams Communication Group Inc. (WCG) raised $2 billion in debt--an amount that about tripled the proceeds from its Oct. 1 IPO--to expand its fiber-optic networks.
High-tech companies justify their accelerated borrowing by pointing to prospects for exceptional growth. Software maker Computer Associates International Inc. (CA) went from $50 million in long-term debt in 1995 to almost $5 billion in the latest quarter, but revenues rose as well, from $2.6 billion to a $5.6 billion rate today. 'Our customers can see value beyond just saving on costs,' says CEO Charles B. Wang, whose company just reported a 32% increase in revenues in the latest quarter. Still, what happens if sales don't continue to grow?
The belief in growth prospects is strongest in the telecom industry, where deregulation, new technology, and intense competition have unleashed massive spending. AT&T (T), MCI WorldCom (WCOM), and Bell Atlantic (BEL) alone have piled on more than $30 billion in long-term debt over the past two years (table, page 42).
Problem is, not all these bets pay off. The most notorious dud to date is satellite-phone service Iridium LLC (IRIQE). With too few customers willing to pay for its pricey service, Iridium couldn't meet interest payments on its huge loans used to buy satellites. The company is now in bankruptcy, owing billions to banks and bondholders.
All told, in the first half of 1999, there were $20 billion in corporate defaults worldwide, according to Standard & Poor's, with 85% of the losses coming in the U.S. Add in $10 billion in defaults in the third quarter, and this is looking like the worst year since the 1991 recession, says Nicholas Riccio, managing director at S&P.
Despite their big debts, most consumers face less risk of default--at least for now. The tremendous surges in stock and home prices have kept households flush, even as they continued to take on debt. Since 1997, households have sold $1.3 trillion in stocks, including exercised stock options. After reinvesting nearly half in mutual funds, $700 billion in cash was left to fund a buying spree. Meanwhile, proceeds from mortgage refinancing and home equity loans--over and above the amount used for home purchases and renovations--were used to pay off $34 billion in credit-card debt in 1998, estimates SMR Research Corp.
But with rates rising, refinancing can't be used as readily by families to reduce their debt burdens and 'the chickens are coming home to roost,' says Stuart A. Feldstein, president of SMR. He predicts that personal bankruptcy filings in 2000 will rise 8% to 15% over 1999. Mortgage delinquencies could also climb, thanks to rising rates on adjustable mortgages and the recent explosion of high-risk mortgage lending (those with downpayments of 10% or less). Owners' equity as a percentage of residential real estate now stands at 56%, down from 66% in 1989.
Consumers are not just borrowing for homes. Even more dangerous is the quadrupling of margin debt--borrowing to fund stock purchases.
In only five years, that has tripled, to $179 billion. If the market plunges, much of that debt will immediately have to be paid back. The result: an immediate hit to the economy.
The least-understood factor in the debt explosion is borrowing by the financial institutions themselves. Although consumers know banks and financial institutions as lenders, they are also huge borrowers. Banks, finance companies, mortgage companies, and other so-called lenders repackage the loans they make and sell them as bonds and notes--creating debts of their own. The amount of direct borrowing by financial institutions plus securitized lending held by investors has soared from $2.4 trillion in 1989 to $7 trillion today, bigger than household debt and almost double the size of nonfinancial corporate debt. 'The worry is that we might become too efficient at creating debt,' says Lonski.
Securitization has the advantage of spreading risk over a lot of investors. In good times, that means lenders are able to make more loans. In bad times, it may become difficult for the lenders to place their securities. The U.S. got a small taste of this effect last fall during the LTCM crisis. As investors got more conservative, the lenders making the riskiest loans--such as subprime home loans--were the ones cut off.
OUTSIZE EFFECT. Last fall's crisis quickly abated. But one unanswered question is what a sustained slowdown, combined with higher rates, would do to the residential mortgage lending market, which totaled a massive $400 billion over the past year. To be sure, mortgage lenders have taken steps to lower the risks. For example, Freddie Mac, which buys mortgages either to hold or repackage for sale, has reduced its exposure to defaults by requiring more mortgage insurance. As a result, 39% of Freddie Mac's loan purchases have some form of insurance or other 'credit enhancement.'
Nevertheless, any disruption in the flow of funds through the mortgage market could have an outsize effect on the economy. 'You don't need a lot of volatility in mortgages to cause a disaster,' says SMR's Feldstein.
And of course, there is the menace of external debt, which is still rising. With the U.S. running an enormous trade deficit, it has become the world's major borrower. According to Credit Suisse First Boston, the U.S. is now using 72% of net global savings, an amazingly high percentage. But that flow of overseas funds could be diverted by any negative shock, including a stock market decline or an economic slowdown. The result would be a less violent version of what happened in Asia a couple of years ago: soaring interest rates and a sharp drop in the dollar. 'We're in a dangerous situation,' says D'Arista of Financial Markets Center. 'As the level of external debt grows, the vulnerability of the dollar is much higher.'
The U.S. still has the world's deepest financial markets and its most productive economy. But even a paragon of economic virtue can go too far into debt.
By Michael J. Mandel in New York, with bureau reports
BUSINESSWEEK ONLINE : NOVEMBER 1, 1999 ISSUE
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