Excessive Leverage: The Root of All Financial Crises

Today’s European sovereign-debt crisis has much in common with other seemingly unrelated crises of the past decade. The common element? Too much leverage.

Let’s take a look at the last three major crises we’ve faced. First came the technology, media and telecom bubble of the early 2000s, when corporations took on excessive leverage. We all know how that ended. Next came the overleveraging of financial firms and consumers that led to the unraveling of the US subprime market in 2007 and 2008. And today, we are faced with a sovereign-debt crisis caused by a period of overleveraging by governments.

There are three ways in which an entity can deleverage:

  • First, they can pay the debt back, which is generally the preferred choice (especially of debt holders).
  • Second, they can default, or as the Greeks have called it, “voluntarily restructure.” Some people, including the economist Carmen Reinhart, include “financial repression” as a form of debt restructuring. This is where a country takes various measures to keep nominal interest rates below what they would otherwise be, effectively coercing captive investors such as savers and pension funds to accept lower returns.
  • Third, they can inflate their debt away.

The first road—paying back debt—requires a sustained period of deleveraging, as we’ve seen in the past. Japan’s private sector has been deleveraging since the late 1980s. In the US, companies have taken action to reduce their leverage in the years following the corporate crisis of 2001. In fact, US investment-grade companies today have more free cash on their balance sheets than ever before. Of course, the most highly leveraged entities don’t have the luxury of repaying their debt. Hence, the European high-yield market’s default rate of nearly 40% in 2002.

We’ve seen a similar process at work since the 2008 financial crisis. US consumer debt has come down slightly, and the debt-service ratio—the ratio of debt payments to disposable income—has declined at a more rapid rate thanks to very low interest rates and write-offs. US financial firms, too, have been deleveraging. Many have raised fresh capital, and Tier 1 capital ratios—a measure of capital adequacy—have risen well above precrisis levels.

So, US corporations, consumers and financial firms, in aggregate, are all in better shape today than they were three years ago. European institutions have not fared quite as well, although private sector credit growth is contracting. But government debt growth has been rapidly accelerating. That brings us back to the current European sovereign-debt crisis.

If governments do nothing, debt-to-GDP levels will likely increase. An escalating debt burden can be very detrimental. A study by Reinhart and another economist, Kenneth Rogoff, suggests that once a debt/GDP ratio exceeds 90%, growth tends to fall off meaningfully. Many European countries—most notably as Greece and Italy—have debt levels in this vicinity (Display).

Sovereign Debt Is Very High in Much of EuropeThe problems of Europe are complex because of the one-size-fits-all nature of monetary policy in the euro area, but in the end, there are still three potential options with respect to the debt overhang. Two of these—debt repayment and default—will no doubt choke off economic growth. The inflation option appears to be a near-zero probability, because it is anathema to the European Central Bank.

So don’t expect rapid growth in Europe any time soon.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Head of Fixed Income at AllianceBernstein

Douglas J. Peebles

Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer of AB Fixed Income. In this role, he supervises all of the Fixed Income portfolio-management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within the fixed-income division, having served as director of Global Fixed Income from 1997 to 2004, and then co-head of AllianceBernstein Fixed Income from 2004 until August 2008. He earned a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

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4 thoughts on “A Municipal Bond Cliffhanger

  1. I personally believe you are way off base here. Are you looking out for the clients or the brokerage firm and it”s reps. I have been dealing in Muni bonds for about 40 years and there has always been a segment of the political jerks trying to do away with the nature of the tax free status. Sure, they have come in the back door and made the tax free income effect the taxability of other income based on amounts of income a person has, but to change the tax free status would take an act of Congress. Now, with what we have as a congress at this time that could happen, but before it is approved I am sure some of them would realize the effect on their own pocketbooks…higher infrastructure rebuilding costs, same for schools, hospitals and any public paid project for the good of the people in the area(there are standards here) Your doom and gloom approach would be a definite high cost to the consumer or investor who would be using short term investing and multiple purchases over the intermediate to long term, making some sales people and firms happy to receive multiple commissions and concessions. Not so good for the client. I have never seen where the knee jerkers win over the patient believers. Have a good day.

    • Personally, I hope you are correct—that Congress sees the benefit of tax exemption for municipal issuers and maintains the current tax status of municipal bond interest. However, that is far from certain. In fact, the President has proposed limiting the benefit of tax-exempt interest in his budget, which would effectively tax municipal bond interest for some investors. Interest rates are incredibly low and any change to the tax status of municipal interest would probably impact the longest-maturity bonds the most. As such, for those concerned about changes to the tax code and the potential impact on municipal debt, their focus should be on their longest holdings, and not their entire municipal portfolio. In this way, our advice is anything but a knee-jerk reaction to uncertainty, but rather a prescription to get the biggest benefit for the least number of transactions.

  2. Good information here. Here in California we have high taxes and our clients are concerned about the effect of Prop 30. Thanks for your comments.

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