2007 Redux: Stock Market Parties——Even As Junk Debt Sounds The Alarm, by Pater Tenebrarum

From Pater Tenebrarum at davidstockmanscontracorner.com:

While the Stock Market is Partying …

There are seemingly always “good reasons” why troubles in a sector of the credit markets are supposed to be ignored – or so people are telling us, every single time. Readers may recall how the developing problems in the sub-prime sector of the mortgage credit market were greeted by officials and countless market observers in the beginning in 2007.

At first it was assumed that the most highly rated tranches of complex structured products would be immune, as the riskier equity tranches would serve as a sufficient buffer for credit losses. When that turned out to be wishful thinking, it was argued that the problem would remain “well contained” anyway. After all, sub-prime only represented a small part of the overall mortgage credit market. It could not possibly affect the entire market. This is precisely the attitude in evidence with respect to corporate debt at the moment.

A weekly chart of high yield ETF HYG (unadjusted price only chart)

The argument as far as we’re aware goes something like this: there are only problems with high yield debt in the energy and commodity sectors. This cannot possibly affect the entire corporate credit market. We should perhaps point out that in spite of this sectoral concentration, problems have recently begun to emerge in other industries as well (a list of recent victims can be found at Wolfstreet).

The argument also ignores the interconnectedness of the credit markets. Once investors begin to lose sufficiently large amounts of money in one sector, the more exposed ones among them (i.e., those using leverage, a practice that gains in popularity the lower yields go, as otherwise no decent returns can be achieved), will start selling what they can, regardless of its relative merits. This will in turn eventually make refinancing conditions more difficult for all sorts of industries.

It also overlooks that energy and commodities-related debt is simply huge and the losses are really beginning to pile up by now. The junk bond market has grown by leaps and bounds during the echo bubble, so a lot of money has become trapped in it. Many low-rated borrowers need to continually refinance their debt, otherwise they will simply fold. Once liquidity for refinancing dries up – and this is what growing losses in a big market segment will inexorably lead to – it will be game over.

To continue reading: Junk Debt Sounds The Alarm

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