Are the days of easy credit nearly over?
Ever heard of the ‘Altman Z-score’?
It’s a statistical formula that uses income and balance sheet values to calculate the chance of a company going bust. The Z-score was first published in 1968 by Edward Altman, then Assistant Professor of Finance at New York University.
That’s almost 50 years ago. But Dr Altman is still around. He’s still a Professor at NYU. And he’s just issued a stark warning to those borrowers, lenders and investors who expect easy money to go on for ever.
Maybe the best description of present borrowing conditions comes from a decade before the Z-score was developed.
In 1957, Prime Minister Harold Macmillan – the original SuperMac – told fellow Conservatives that “most of our people have never had it so good”. He claimed that Britain was enjoying unprecedented levels of prosperity. But his quote could easily be applied to the current state of the credit cycle.
Interest rates are seriously subdued. In fact as the chart below shows, these are now at their lowest for some 5,000 years!
This has set the scene for borrowers, lenders and investors everywhere.
Ultra-low long-term yields mean that well-respected governments can fund their pet projects for next to nothing. And corporate spreads – the difference between government and company debt costs – have compressed, allowing many businesses to borrow at very low interest rates. Meanwhile there’s plenty of liquidity sloshing around, indicating that credit is not only cheap, it’s been easy to get.
From a bondholder’s perspective, it’s been a great time too. On the vast majority of bonds, the coupon (the payment to the lender) is fixed. So it becomes more valuable as other interest rates fall. Britain’s 10-year government bond index hit an all-time high of 16% in November 1981. It’s now yielding 1.2%. Net result: huge profits for people who’ve owned bonds over the long run.
But this happy state of affairs could soon change.
Credit change is on the way
For one thing, here in the UK the Bank of England has just tightened mortgage rules. It says that lenders have been using different ways of testing affordability, leading to a lack of consistency. Lenders have been told by the Bank to check whether borrowers could cope with a 3% hike in standard variable home loan rates.
In addition, other UK borrowing is set to get tougher. Britons’ consumer credit has been expanding at around 8% year-on-year for the last 18 months, according to today’s Bank of England data. With pay packets growth by just 2% annually, overdraft, loan and credit card debts are clearly growing too fast for comfort.
This week’s Bank of England Financial Stability Report showed that the Financial Policy Committee soon wants to tighten lending standards for unsecured personal debt. “A more effective and focussed policy intervention to address the rapid growth of consumer credit looks likely in September”, says Andrew Wishart at Capital Economics.
What about the lenders?
But the real focus of this article is the other side of the balance sheet. That’s where the lenders and investors are.
Back to Dr Altman: “it’s been a terrific market for investors for quite a long time and if anything is concerning it’s that we are more than eight years into a benign credit cycle,” he tells Yahoo Finance. “We’ve never had such a long benign cycle. And just that is something we should be concerned about because… it could come to an end very dramatically.”
Why should we listen? Altman has good form. In mid-2007 he warned about a “Great Credit Bubble” that would create major problems. Sure, his initial fear at the time was a potential surge in company failures (though this did eventually happen) rather than the implosion in US mortgage-backed securities that sparked the 2008/09 financial crisis. But he was right to be worried about the system as a whole.
American mortgages aren’t a problem at the moment – at least they aren’t yet. But there are other echoes of a decade ago.
“Prior to the crisis in ’08 and ’09, the fundamentals of credit risk of companies issuing bonds and taking out loans were quite low,” he says. “I see between 2007 and 2016 very similar fundamentals, quite a bit of high risk. And it doesn’t seem to bother the market because it’s the only game in town in terms of getting yield greater than what you can get for low-risk securities like governments and high-grade corporates.”
“In other words, investors aren’t buying junk bonds just because the risk-reward balance is favourable”, says Julia La Roche for Yahoo Finance. “They’re buying because the rewards of investing in lower risk bonds just aren’t cutting it anymore.”
Since Altman created his Z-Score formula, he’s clocked that bankruptcies have kept getting larger. While inflation has been a factor, companies have been borrowing ever-more because of those low interest rates.
So what’s the Z-Score saying today? Remember, the smaller the number, the worse the company situation. In fact the US average Z-score for 2016 was actually lower than in 2007. And 2008/09 saw a huge surge in corporate bond defaults and loans.
We don’t know what 2017 will throw up on the Z-score front. Although I’d hazard a guess that it’ll be an even worse reading than last year. And interest rates are quite a bit lower than they were in 2007. Even quite a small rise in borrowing costs could prompt a tsunami of American corporate bankruptcies.
In turn, that would freak out both lenders and investors who would become more risk averse. Put another way, they’d be much less willing to advance loans. Credit might stay relatively cheap, but it could also become scarce. And the effect on bond and stock markets – both in the US and around the globe – wouldn’t be at all pretty.
Somehow, this doesn’t feel like it will end well.