What to Expect When You’re Expecting… Massive Defaults on Multiple Scales  

“…When Silenus had finally fallen into his clutches, the king asked him what was best and most desirous thing of all for mankind. The daemon stood silent, stiff and motionless, until at last, forced by the king, he gave shrill laugh and spoke these words: ‘Miserable, ephemeral race, children of hazard and hardship, why do you forced me to say what would be more fruitful for you not to hear? The best of all things is something entirely out of your grasp: not to be born, not to be, to be nothing. But the second best for you—to die soon.” -F. Nietzsche, The Birth of Tragedy This write-up is in response to a question regarding what would happen if both the stock market and the bond market were to blow up at the same time. I’m assuming the only way this happens is via massive bond defaults. Certainly not saying this is necessarily going to happen, but it is worthwhile to think through extreme events. And it’s not a stretch to think that Greece, a Baltic country with a debt-to GDP ratio of around 500%, and many US states are expecting. Defaults, that is. It is worth understanding how people and institutions respond to an unsustainable debt burden on a societal scale, and how to make money on it. The unexpected results of a promiscuous consequence-free debt binge will have extreme consequences for shaken money-makers.

 Pervasive reduction of leverage. Syndicated loans and dependence on short-term bank financing will be reduced. Longer term financing (bonds) will be viewed as less risky. Deleveraging means retained earnings will be an increasing source of financing. As a result of dividend reduction, equity issuance will be a funding source for few companies. This will be harsh on equities. Big changes in the M&A landscape. Disintermediation will place companies with pricing power in an enviable position. They will create integrated conglomerate industries that pair businesses that throw off cash with other less profitable complimentary business lines. Household, business and central bank behavior will innovate to survive. Firms will fragment their risk exposures. Household strategically default will become rather common. As far as central banking, it may not be legal for the Fed to purchase corporate debt, but there are no current restrictions on purchases of credit-linked obligations (CLOs, CBOs). Securitization is a powerful cipher of decontrol. Securitization is going nowhere. Due to large liability overhangs, intractable government commitments far in excess of tax outlays, and a desire for institutional portfolios to off-load exposures, securitization arranger and originator businesses will endure. Future securitization will bundle new raw material (e.g. bundled tax/payment arrears). This is the ancient practice of tax farming in new clothes. Unwinding securitization is a powerful cipher of disintegration. Expect securitization unwinds of some existing product. Toxicity going forward will be controlled by more stringent collateral standards and aggressive discounting.

Where we are, where we go
The set up is a hang-over from a liquidity binge. Sovereign bond issuance will drive sovereign govvie yields up, and weaker sovereign credits are going to get the divine hammer. Corporate credits, both IG and HY will follow as taxes rates rise. Any improvement in top line will likely be insufficient to avoid higher default rates. There will be little residual earnings, so equities will get the crushed. This is a well-known story, agree or no. How people and organizations behave in such an extreme environment is the unknown issue. It is important to anticipate the strategies that the creative pilots of Slaveship Earth develop to enhance survivability. There is an entrenched insolvency problem in the United States, and a picture is worth a thousand words. Insolvency is not illiquidity; insolvency is about income that can’t service debt burden. Notice where things fall off the cliff: I believe we are getting close to this point. Just need a catalyst. Sequential bond auction failures here, a sov default there, massive liquidity drain all around, worse… whatever. The fumes running the engine (QE, or credit easing) are dwindling. Don’t Go Chasing Waterfalls…
Asset Price Melt-Up Until QE ends. Then Crowding-out effect Dominates. Asset Valuations Become Uneasy

Tax Revenues Decline, Massive Sovereign Debt Buildup, leading to QE
Over the top and down...

Sovereign Bond Yields go Parabolic. Profits and Income Collapse. Asset Deflation, Default and Deleveraging on Multiple Scales

Liquidity Vanishes. Either cash-flow recovers or QE starts up again.

The ingredients are already in place for a much-needed solution to hubris. One can already observe top-down government economic reengineering interacting with moral-hazard induced behavior adaptation in bad ways. The outcomes… well there is any range of outcome. But I can assure you that good intentions mean nothing where survival of the fittest is explicitly written into the cosmic gene code. History does provide a template for how this sort of political reengineering will shape the next few years. Buckle up! Exhibit A:  Good Intentions Mean Nothing  
The Intention Method Implementation
Direct Stimulus (expanded unemployment benefits, Food stamps, other transfer payments) Direct Industrial Subsidies (GM, AIG)

Adverse Effect
Firm and Taxpayer Payment Arrears

Fiscal Policy

Financial System Capital Injection Ambiguous Property Rights

Government Intervention to Mitigate Deleveraging and Insolvency

Monetary Policy:
Collapse of asset prices destroys balance sheets. Excess liabilities force everyone to go into debt minimization mode. Monetary policy becomes largely useless, no matter how much money is printed. Liquidity Injection Creates Zombie Banks

Geopolitical Risk: Import capacity is suppressed Weaker Dollar Reserve Currency Risk: OPEC rejects denomination of oil price in dollars

A powerful neutralizer of nihilism is data that looks at how these adverse policy effects— payment arrears, ambiguous property rights, zombie banks ‘n such—reconfigure society. It may take years to work through, but this is nothing new under the sun. The data suggests something of note. Humans can slip out of the noose for some time through innovative behavior. In meltdown situations, liquidity is generated when firms and households adapt and develop work-arounds to an unsustainable debt burden. Government turning a blind eye and ignoring basic corporate law (creditor rights) is more inflationary than any fiscal or monetary policy. However, it is unsustainable and only magnifies systemic risk. When chaos dominates order, things fall apart. Illusions must burn away and all things must live within their means. I found an out-of–the-way laboratory to observe these rules. My lab has a certain back-tobasics charisma: Romania. After all, Transylvania is an ideal place to study undead zombies. The time: right after a real vampire, Vlad Ceaucescu, ate bullets. Indeed, there are few more glamorous locales for a Lovecraftian scene. Sure the United States is different. But note that there is a global dynamic going on bigger that any single country: a dynamic of decontrol. Political and social structures are all in flux. The ascendant autonomy of the individual to act in his or her best interests independent of other considerations (globalization) is the decisive element of contemporary history. Where

better to observe this dynamic than at a punctuated equilibrium point between communism and capitalism? What enterprise arrears were to a smokestack satrap economy churning out wholesome proletarian smoke is what mortgage squatters are to a blood-sugar-sex-magic financial economy. For example, Romanian corporations under the pressure of unsustainable debt levels, declining revenue, and threats of bankruptcy broke their firms up along divisional or factory lines. It was an effective way to both avoid balance sheet stresses and increase autonomy against government regulators. How is this different from a Wall Street SIV? Human systems and human nature have changed little since Athens and Ur. So let’s start with the disintegration of the existing Romanian government in 1991, resulting in a stop-go approach to law and order. Then observe a demand implosion and a massive unemployment spike. Then prices were liberalized, meaning basic goods prices went through the roof. Monetary policy in the sense we understand it didn’t exist. Banks were accounting entities commanded by the Center, not mechanisms that profited from taking credit risk. So… government was in severe shock, and there was no existing financial structure to administer conventional fiscal and monetary policy. How could real wages—the most reliable measure of household well-being in command society—possibly hold together and even increase in 1995 and 1996 as well as shown below? Real wages:  No Sign of Apocalypse in Collapse. 

Because people and social phenomena survive extreme limit situations by 1) fragmenting risk exposures and 2) searching intensely for better options outside the box.

Risk Management by Risk Fragmentation: What Liquidity Injection Really Does

Capital infusions by purchase of preferred stock (note that this purchase was diluted to common stock in due time), liquidity injections, and organized MBS purchases enable an entire financial system to hunker down in extremes. The entire system reorganized assets in a decentralized way to SIVs or other off balance-sheet conduits outside of regulator purview while liabilities were managed at the on-balance sheet center to create a “Too Big Too Fail” entity. This created an utter mess of independent legal entities whose status is only semiautonomous in practice. By design. It is this attempt to hold liabilities on balance sheet that enabled banks to enjoy “too big too fail” status using one standard of measurement. At the same time, holding assets that can be measured money good using another valuation method are moved out of reach of regulators. I know, I know FASB may change this…only to change again should need arise. So the best case in both Romania and Wall Street is they got a bailout. Socialized versus private enterprise distinctions are meaningless when the state holds a big equity stake. It may be true that the government will not exercise its right over disposal of property, but they could. And they do have rights over residual income streams and business decisions. On the other side are fortunate businesses that have cash flow when others don’t. In this case, risk fragmentation combined with illiquidity creates interlocking business conglomerates. If a business can’t collect on receivables, then cash rich businesses will exchange debt for equity, creating conglomerates whose center generates cash. This isn’t about Wall Street. This is nothing new under the sun.

Thinking Outside the Box…Strategic Mass Default
Outside the box in Romania meant ceasing payment of interest and principal. Not paying interest and principal as a debtor’s unilateral decision independent of legal recourse is what makes a payment arrear. And it explains how businesses kept going and employing people. Remember that rising real wage in 1995-1996? State and firm arrears exploded in 19951996. Capital and liquidity injections to banks in the US create incentives for bank forbearance of mortgage delinquencies. Delinquency is just a type of payment arrear. Whether this is an intended transfer payment or an unintended consequence of a direct subsidy, the result is disturbing if it becomes a perceived free ride. How pervasive could arrears become? Business and state/local government arrears approached 50% of GDP in Romania. Unpaid Arrears as a % of GDP, Romania 1993‐2003 

Source:  IMF Statistical Annex, various issues  Arrears created a new and persistent dynamic for business funding in Romania. Tax and payment arrears still accounted for over twenty percent of the total financing for corporates almost ten years after the arrears problem first presented. Note also that retained earning financing formed a growing share as equity financing declined. This should be expected in any deleveraging context.

Sources of Funds for Romanian Firms, % of Total Financing     1999 2000 2001 Retained Earnings   6.8 8.9 11.9 Company Reserves  0.6 1.1 0.9 Equity Capital  35.6 29.2 28.3 Bank Credit  23.2 22.6 24.2 Tax Arrears  19.2 22.6 15.2 Payment Arrears  6 5.7 7.2

I don’t fault these “Romanian” behaviors. They kept possibly solvent businesses under intense liquidity pressure from buckling entirely. They kept people employed. They kept household wages supported. They kept people from starving and freezing in the streets. However, it becomes negative when the behavior becomes entrenched and incentives to downsize living standards are negated by a government sponsored sense of entitlement. If mortgage delinquencies become a bigger source of financing for the unemployed than bank credit or transfer payments, then enforcing payment discipline will require more spending on transfer payments. Debt issuance needed to finance government spending on transfer payments will crowd out business and household credit needs, making profitability

and asset devaluations even worse. This will magnify the extent of payment and tax arrears even more. This is really about the dangers of direct government intervention outside of the parameters of established law, coupled with the lack of control in other areas. Such folly only makes the environment more perverse, and for investors more volatile. The trigger to arrears is a liquidity squeeze combined with ambiguous property rights. Further, it will be difficult for government to disentangle itself from direct subsidies and bailouts of favored industries because of the special interests that profit from them. At the extreme margin, further difficulties accompanied with fiscal inability to act could pressure the Fed to make monetary policy an even greater socializing mechanism. We are already on this track. The purchasing of treasuries is a relatively impartial method of reflation. The purchase of MBS is credit easing that favors the financial system in general and the weakest links in particular. The logical conclusion of credit easing is purchase of corporate debt via CLOs and CDOs. Note that this policy would be different from AIG and GM capital injections only in scale and method. As with all such activities, current government policies will screw government in the end. They enable unprofitable businesses to continue cash-burn. The implicitly approved payment arrears will inevitably lead to explicit tax arrears of both businesses and households. As a massive source of corruption and fraud, it is only a matter of time before arrears manifest themselves as tax evasion. The positive spin on this is how resilient people are in the face of shocks. They become tough and resolute when it is needed.

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