Credit Cycles: Historical Lightning Round
We post an event checklist used in a recent presentation on credit market history for the Wharton Executive Education program.
We already posted some of our handout materials from a recent presentation for the Wharton Executive Education program as part of the Aresty Institute of Executive Education. The 4-day session was run by Wharton Finance Professor Michael Roberts with his guest star Wharton Fellow and Rutgers Professor, Fred Hoffman. I worked or interacted with Fred as a colleague or client since the 1980s during his buy side years and hedge fund adventures. I weighed in during a session on the history of the credit markets.
A separate, chart-heavy handout called Credit Markets Across the Decades was already posted to the Macro4Micro Substack. The text below covers (at least my) winding trail since the public credit markets were born and boomed in the 1980s. For those entering the credit markets in some capacity in current times, you might find it interesting (or perhaps horrifying).
A look back across the decades…
For the credit markets, life began in the 1980s as growth in debt products and systemic corporate sector leverage outpaced a doubling of nominal GDP. Corporate financial policies were redefined in the interest of shareholders with interest rates moving lower from the early 1980s and activism rising.
Credit cycles get warmed up in early/mid 1980s…
The deregulation wave from the late 1970s brought both credit expansion and disintermediation of the banks by the over-the-counter corporate bond markets and mutual funds.
More credit brings more growth but also the challenge of framing when too much credit compromises quality and risk pricing.
The aging of the population and basic demographics were flowing into asset allocation in public sector and private sector pension funds, setting the stage for rising demand for bonds and credit risk as a source of diversification from equities.
Lending was constrained by Glass-Steagall since the New Deal and FDR with insurance company private placement departments dominating bonds for riskier corporates including LBOs in the early 1980s.
The Volcker victory over inflation could be declared by 1982 or was certainly complete by 1986 with the oil price collapse and 1% CPI as the UST downshift set off waves of refinancing, encouraged more debt-financed M&A and recapitalization deals, and created more avenues to shareholder rewards.
Banks ruled the loan markets while securities firms underwrote and traded bonds with the “bulge bracket” driving breakneck expansion in bond origination across the tiers.
Deregulation in financial services and the rise of mutual funds created the demand with Wall Street generating plenty of supply.
The rise of Drexel saw HY bonds soar in the 1980s and drove deal flow and leveraging as the phrase “greenmail” joined in with hostile takeovers, special dividends, and recapitalizations in the routine dialogue. Drexel was in Chapter 11 by early 1990.
The arrival and expansion of private equity firms went hand in hand with HY bonds as the KKR model trumped the Forstmann Little model in LBOs.
Life with Reg Q and the rise of money market funds saw asset-liability mismatches fuel trouble via deposit outflows.
The oil price collapse in1986 brought regional economic stress for the oil patch and generated widespread regional bank and thrift collapses, driving numerous merger rescues (notably Texas Banks).
Seeds were planted for the rise of the Super Regionals (NCNB=NationsBank=Bank of America)
Deposit flight to money markets and the collapse of the S&Ls accelerated to a peak in 1988-1989.
The world of credit cycles and market volatility arrives and never looks back…
1987-1988: Texaco bankruptcy in 1987 on Pennzoil litigation. Stock market crash Oct 19, 1987 (-22.6%). Increasingly aggressive leveraged structures in LBOs and bridge loans (example: the RJR LBO by KKR in 1988. Barbarians at the Gate). LBO quality risk and the zero- sum battle of “loans vs. bonds” in financial restructuring.
1987 and years to follow: Bank and intermediary realignment starts and continues for years. Primerica buys Smith Barney (1987) and then Commercial Credit (Sandy Weill) buys Primerica in 1988 (Note: Primerica later is on the Weill acquisition trail of Travelers, Salomon Brothers, and Citibank in the 1990s). This is just the start of the process.
1989: The Brady Bond program starts to free up liquidity and bank system balance sheets as legacy Emerging Market sovereign debt finds a secondary market.
1989: The credit cycle peaks and starts to unravel. Hung bridge loans plague securities firms. Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). Train wrecks unfold for securities firms and thrifts. LBO deals fall through, market anxiety rises.
1990: Drexel Chapter 11, Shearson Lehman bailout by Amex, First Boston rescued by Credit Suisse, Kidder by GE. Iraq invades Kuwait August 1990. Oil spike in late 1990 rattles markets. Recession begins. Chrysler bonds from par-plus in June 1990 down into the 50s in late 1990 before later seeing a round trip to well above par. Coupon step-up bonds rose by over 100 points. A testament to an illiquid OTC market and a HY market-making vacuum in 1990.
1991: Jan-Feb 1991 Desert Storm in Iraq begins and ends quickly. Default spike (13% Jan 1991). HY dollar price lows of 69 in Jan 1991. Greenspan runs wild in easing. “Soft bailout” of bank system by Fed. Citibank under the microscope.
1992: Regional bank crisis, stress in commercial real estate, thrift crisis continues in California and various. Consolidation in the bank system continues across the decade. Chemical Bank/Manufacturers Hanover merger gets the ball rolling with a Chase merger later and then by 2000 with JP Morgan. Real estate stress and low fed funds set off a chain in the 1990s fueling more acquisition such as Primerica (Sandy Weill) buying Travelers (1993), Travelers (Weill) acquiring Salomon Brothers in 1997, and Citibank announcing merger in 1998 (Weill on top yet again).
1992: The rebirth of HY business lines at the securities firms as risky credit commitments rise from the ashes with new leveraged finance expansion. The market sees more than a few Drexel alumni (notably at DLJ) driving initiatives. Private equity firms collect an exceptional Drexel talent pool to ramp up leveraged finance operations.
1990s: Deregulation of banks kick into gear, the rise of Section 20 brokerage units within banks brings more capital to the securities markets, more consolidation across banks and securities firms, and the rise of derivatives and counterparty risk. Waves of European and Japanese banks look to expand in the US markets. Bidding wars for talent.
1994-1995: Fed tightening ambush sees a painful bear flattener and upward shift of the UST curve despite low inflation. Curve shift rattles mortgage markets (“toxic waste” headlines), and fledgling derivative markets (“inverse floaters”). Orange County collapses on overexposure and “picking off” unsophisticated asset manager. The lack of inflation (2.5% to end 1995) then saw a major downshift in the UST curve and bull flattener alongside the best performance of the S&P 500 during 1995 across the bull market 1990s (NASDAQ best was 1999).
Dec 1994 to March 1995: “Tequila Crisis” (Mexico peso crash), some near death experiences in market on Mexico exposure (Lehman overexposed). Congress rejects bailout for Mexico, but Clinton/Robert Rubin (UST) circumvented Congress and provide a massive loan through the Exchange Stabilization Fund. Mexico gets past crisis and Lehman lives to fight another day.
1996-1997: Major risk rally in credit in 1996-1997 with material UST curve downshift from 1996 across 1997 and again in 1998 when the Fed eases on Emerging Market turmoil and LTCM (Long Term Capital) late in 1998. HY market demand growth in 1996 fed into cyclical lows in credit spreads in Oct 1997 for both IG and HY. Boom in Yankee bond issuance (dollars) from Asian corporates and EM broadly. Asia crisis (Thailand, South Korea, Indonesia, Malaysia, etc.) was percolating and grew worse by late 1997 into a full-blown EM crisis in 1998. Asset-liability mismatches with dollar debt made life harder for Asian issuers and increased counterparty risk on hedges.
1998: Russia defaults in August, LTCM crisis prompts a Fed-engineered bailout deal from the major banks/brokers (ex-Bear, smaller slice from Lehman). LTCM was a textbook example of poor counterparty risk management (including minimal haircuts on collateral) by Wall Street to generate trading volumes and curry favor. 1998 saw a dry run for subprime mortgage excess (lessons not learned) ahead of the later housing bubble and RMBS crisis of 2005-2007.
1999: Eurozone currency was launched, and € based credit origination soars. TMT was hitting peak valuations globally, the HY default cycle already began in late 1999, but the equity market stayed hot (+86% total return for NASDAQ in 1999).
2000-2002: Reg FD (Fair Disclosure) was approved over Wall Street opposition. March 2000 NASDAQ peak, risk was repricing dramatically into 2001-2002. TMT drives HY default cycle (longest – not highest – default cycle in history), double dip default cycle 2001-2002. Headlines from Enron (2001) to WorldCom (2002) cause a crisis of confidence in underwriter due diligence and auditing quality. Arthur Andersen collapsed in 2002 on criminal prosecution and the loss of SEC qualifications for audits.
2001-2002: US defaults spiked to 11.6% in Jan 2002, defaults stay at or above 4% for almost 5 years. The European HY market was TMT heavy at its highs (74% TMT) as Euro HY defaults peaked at over 17% in Sept 2002 on an issuer-weighed basis with volume-weighted defaults at 58%. US HY dollar price lows “double dip” at a 75 dollar-price in late Sept/early Oct 2021 and revisited in July 2002 (post-WorldCom).
2001: The events of 9/11 are remembered by all. The Fed continued to ease after that shock, but the Fed had already been easing frantically and posted 7 easing moves before 9/11 and 4 more right after. The 2001 economic downturn (peak was March 2001, recession trough Nov 2001) was the mildest in postwar history. The real “recession” was a capital market recession as banks/brokers worked through a long default cycle and litigation on bad underwriting in equities.
2002: The long tail of Washington investigations and hearings seemed to be nonstop with so many different committees piling on. Sarbanes-Oxley (“SOX”) signed in July 2002. Credit rating agency review was mandated by SOX and eventually NRSRO reform was initiated (not completed for years with the 2005-2006 legislation process). The eventual Global Research Analyst Settlement with Wall Street in April 2003 changed the street business model and reduced research and information flows in equities and credit. Less information, less efficient information flows, but less temptation to engage in conflicts of interest. A few “banned for life” decisions in the mix. The sad reality of ratings reform was that “the worst was yet to come” with structured credit ratings and subprime RMBS fallout. Tag team of Wall Street and the rating agencies created all new products. Very lucrative.
2003-2007: Greenspan moved to 1% fed funds into early 2004 (well into the expansion) as the housing bubble inflates along with subprime RMBS excess (125% LTVs etc.). Despite a tightening cycle from 2004 to 2006 (17 hikes from June 2004 to June 2006), the market experienced a structured credit binge (SIVs, CLOs, CDOs, etc.), record asset backed commercial paper, and de facto unlimited “counterparty lines” on derivatives exposure and notably CDS. The market saw record-sized LBOs into 2006 and 2007. Transparency in the financial system of counterparty exposure was limited, opaque, measurement inadequate, and in substance useless. Dec 2007 was the cyclical peak (recession begins).
2008-2010: Crisis time from 2008 to 2010 and Dodd-Frank. In early 2008, BofA closed Countrywide merger after taking de facto bailout stakes during later 2007, and Bear Stearns was part of a Fed-orchestrated bailout merger (March 2008). During Sept 2008, Paulson pulls plug on Lehman hopes for support, bails out AIG in coordination with the Fed, BofA hugs Merrill, and the automotive sector stress was spiking on a collapse in production and funding. TARP was not adequate to the task in size or execution to solve the crisis, and Fed programs proliferate to support viable securitization. SEC structured credit and NRSRO/rating agency reform revisited in 2009. Dodd-Frank and Volcker Rule in 2010.
Bank defaults and seizures, bailouts in credit crisis 2008-2009: Bush bails out autos as lame duck using TARP. Obama bailout of GM and Chrysler came in shifts including using loans and Section 363 under Chapter 11, creating new entities. Dec 2008 saw a US HY dollar price low of 54. Issuer default rates serve as a lagging indicator with US HY default rates at 14.6% in Oct 2009. March 2009 was the stock market low and June 2009 the recession trough (Dec 2007-to June 2009).
Late 2008 to Dec 2015: ZIRP and QE fuels refinancing volumes (corporate and household), record commercial paper refinancing and extension into bonds, maturity extension of bank holding company debt, waves of overhauls in banking regulations, what’s left of major brokers become bank holding companies (Goldman, Morgan Stanley). The crisis period continued de facto bank system rescue with extended ZIRP, credit and loan markets reprice favorably and rally. Bond origination booms. Leveraged Lending Guidance was issued by bank regulators in 2013 (Fed, OCC, FDIC), but was later killed by Congress and GAO as a “rule” needing Congressional review and not just regulatory “guidance.”
2010-2011: Sovereign crisis starts with Greece and Ireland 2010, peaks in 2011 with Spain and Italy in market crosshairs, and the systemic risk whipsaw infects US and European banks and notably subordinated paper. Aug 2011 US downgrade by S&P from AAA to AA+ on default threat and balance sheet. Oct 2011 peak in HY spreads.
2012-2013: Major HY and bank bond rally. “Whatever it takes!” by Mario Draghi in July 2012 rallies risk. The 2013 Taper Tantrum and UST steepening under ZIRP saw duration punished and risk (equities and HY) rewarded. Record CCC issuance and major spread compression wave in 2012-2013.
2014: Cyclical low in HY spreads in June. Saudis and OPEC start market share price war in late summer to break US shale sector. Oil prices collapse in Sept to Dec 2014. HY bond market hit hard with its #1 sector (Energy) facing a cash flow crisis and excessive debt after years of debt-financed expansion and capex.
2015-2016: Oil crisis peaks 4Q15/1Q16. China systemic nerves in summer/fall of 2015. Upstream oil and gas exposure and “face value at risk” was very high in US HY. Fear of HY fund redemptions sent HY price action plunging into Feb 2016 lows with some headlines showing single digit recoveries in unsecured E&P bankruptcies. The E&P index with a weighted credit rating of B priced at 38 on 2-11-16 while the BB tier Oilfield Equipment and Services at a dollar price of 42. By 12-31-16, E&P traded at 98 and Oilfield Equipment at 89 in a big rally from late spring through year end in credit risk.
2017: Trump arrives in White House after 2016 election. Record tax cuts by Dec 2017. HY returns modest at +7.5% while IG posted +6.5%. Equities win the year with Emerging Markets and NASDAQ leading the way on optimism around tax cuts and investment looking ahead.
2018: Tariffs and trade worries dent investment and capex sentiment. Chamber of Commerce and various business interest clash with White House over tariff policies. Corporate fixed investment stayed weak relative to tax cut expectations. Oil has a 4Q18 minicrash. The 2018 results show a very poor asset performance year for an expansion with cash at #1 under 2% while the S&P 500, NASDAQ, Midcaps, Small Caps, US HY, and US IG all in negative return range. The 2018 “winners” posted the worst top quartile asset class performance numbers since bond indexes started in the 1980s.
2019: 2019 is a generally misunderstood year in economic performance but was a good year for risky assets. The Fed eased with 3 cuts in 2019 to relieve the effects of weak corporate investment and defensive capex planning. The Fed executed three 25 bps cuts with one after the July meeting to 2.0-2.25%, a mid-Sept cut to 1.75-2.0% and finally, at the end of October, down to 1.5-1.75%. 2019 saw a rally year for HY on the back of the Fed actions and weak numbers to start the year with a “par plus” HY index by the end of 2019 after ending 2018 at a 92 dollar price.
2020: COVID arrives, and the Fed moves back to ZIRP in March while teaming up with the UST to reopen some of the crisis-era playbook in supporting refinancing and credit market confidence. The supplier chain crisis starts, the vaccine is ready by early Nov, the boom in refinancing for corporate debt and household mortgages continues. “Flight to the suburbs” and housing starts soar. The HY index hit 78 on 3-23-20 but soars to almost a 105 dollar price by year end 2020. The market benefited from a masterful job done by Powell and Mnuchin in 2020.
2021: Biden takes office. Post-COVID rebound is underway in tech equities and growth stocks. The yield curve steepened while ZIRP remained in place despite high GDP growth, a rally in risky assets, and signs of inflation. This is where the accusation of the Fed moving too slow to tighten are legitimate.
2022: Inflation soars to June high for CPI of 9.1% after ZIRP ended in March 2022 (effective 3-17-22). The market sees the first mega-tightening cycle since Volcker (excluding a mini fed funds shock in 1994). Equities and growth stocks get clobbered, and duration is hammered by UST curve shift. Second worst year in history for US HY.
2023: A lot of crosscurrents on how Fed will proceed given the fears of recession. Growth stocks rally and a lack of breadth for much of the year. Interest rates peak in Oct 2023 with UST 10Y around 5% in week 3 of Oct. Monster rally of UST and risk assets (equities, HY, etc.) to close out 4Q23 in Nov-Dec. Very strong performance for fundamental risk pricing brings solid numbers for the full year with some asset subsectors generating almost all of their returns in the last two months. All equity benchmarks do well in the end. HY a major winner with over 13% total return and IG performed well in high single digits over 8%.
2024 YTD: The year begins with duration bets and a consensus on bullish UST curve view. The year continues with mixed results on the sustained handicapping of Fed cuts. Year to date the UST curve is higher in contrast with original consensus forecast. The debate will continue on, “How many, how much, and when?” around Fed cuts and easing game plan. Expectations of a steady rise in coupons on refinancing and “new money” deals (notably in M&A) will be a key influence on asset allocation actions by pensions and savers.
2024 and into the future: Asset allocation can refocus on fixed income as new issue coupons rise, private credit providers and BDCs expand, and more retail product evolution is seen via ETF’s. The Fed is looking to take back some hikes and slow QT in 2024 and into 2025. More disintermediation of banks will be a trend with major decisions to be made by retirement fund asset allocation around private credit. New asset allocation frameworks to consider, and that comes with new fees, new accounting quality questions, and new measurement challenges for risk monitoring.