Debt excess, GameStop turbulence, zombie companies and future (Corona) crises

Last week there was short-term turbulence on the stock markets due to the GameStop event. Actually, apart from a few slumps, the price trends on the stock markets have only known one direction in recent years, namely upwards. If, due to the low interest rate policy, investors or you investors get almost no more interest for borrowing or for their savings accounts in the long run, a shift takes place, especially into the investment of real estate and shares. The time horizon of equity and real estate funds as well as stock indices is stretchable, insofar as there is a constant exchange between the shares of companies that are disappearing and those that are newly coming onto the market.

With regard to the central banks’ low interest rate policy, its proponents now argue that it would encourage borrowing by companies and consumers. This has demonstrably failed to happen after the 2008 financial crisis; instead, this policy continues to increase demand for companies, securities, stocks, real estate, etc., and thus asset prices. Low interest rates generally reverse the relationship between incentives to save and incentives to borrow: Those who save money receive low amounts of money, those who take out loans, for example to speculate, receive “cheap money” and at least the option of high returns. Interest rates and prices of securities behave inversely to each other. The asset price increases resulting from the low interest rate policy make precisely those richer who already hold enough assets, thus favouring above all those who invest their assets in companies, securities, shares, real estate and derivatives. This in turn benefits the financial industry, which not only collects fees, bonuses and commissions from the trading of assets, but also creates credit and realises returns by buying securities.

How could this happen? Since the beginning of the financial crisis of 2007, the money supply in the developed countries has increased dramatically, also as a result of central bank policies; the Fed has increased the money supply ninefold since 2007, the ECB sevenfold and the Bank of England also ninefold. This was mainly done in two eruptions, the first to mitigate the effects of the 2007 financial crisis, the second to begin to address the economic consequences (unemployment and decline in growth) of the 2020 pandemic and lockdowns. The low interest rate policy and the purchase of securities by the central banks lead to an increase in the liquidity of private banks and also of companies, some of which remain on the market as non-profitable zombie companies.

At the same time, the private debts of companies and households as well as the debts of states have also increased enormously, mainly because of the 2020 pandemic. The increase in debt globally from the third quarter of 2019 to the third quarter of 2020 is about $20 trillion. There is hardly any chance that the debts will ever be paid off; rather, there will certainly be large debt defaults. While it is mainly the debt of private companies that is being hedged today, this only brings further risks into play.

After the 2007 financial crisis, bank demand shifted to another risky asset, collateralised loan obligations (CLOs). A CLO is structured similarly to a CDO, but instead of loans to homebuyers, loans are made to companies – especially troubled companies. CLOs bundle and structure leverage loans, the subprime mortgages of corporations. These are loans to companies that have reached their borrowing limit and are no longer able to sell bonds directly to investors or qualify for a traditional bank loan. There are currently more than $1 trillion worth of leveraged loans outstanding in the US, with the majority held as CLOs.

While banks have held more capital to protect against a downturn since 2008, and their balance sheets are less leveraged today than in 2007, last year the Financial Stability Board estimated that for the 30 “global systemically important banks” the average exposure to leveraged loans and CLOs was about 60 per cent of existing capital. Citigroup reported $20 billion worth of CLOs as of 31 March; JPMorgan Chase reported $35 billion. Some mid-sized banks – California Banc and Stifel Financial – have CLOs worth more than 100 per cent of their capital. If the market for CLOs were to implode, their liabilities could quickly become larger than their assets.

When you own a security, you assume that you will realise the money later and you can buy something with it. Assets and loans are based on promises to pay and on trust, but this can prove illusory. This can be seen, among other things, in the fact that the increase in money supply and debt is not matched by rising economic output; for example, real economic output fell by about 4.4 per cent in 2020.

Modern Money Theory, for example, maintains that central banks could continue to issue unlimited amounts of money and simply leave the key bank interest rates at zero for the next few decades, which would not strengthen the real economy, but rather further fuel the stock and real estate markets. If the interest rate remains at or near zero for a long time, then the value of shares and real estate could continue to rise, driven by the issuance of cheap money. Accordingly, with few exceptions, share prices and real estate prices have continued to rise in recent years, even in times of the Corona lockdown. This forces the central banks to keep interest rates so low. However, this leads to bubbles forming in the stock markets, debt defaults on derivatives such as CDLs, because zombie companies cannot be propped up forever, and in the real estate markets, property prices keep rising, but so do rents, which many of the lower income classes can barely afford.

The central banks’ long-term zero interest rate and bond-buying policies inevitably fuel new financial crises. If we now end the low-interest-rate policy, which also leads to an increase in real interest rates, many companies, households and many countries, including some of the industrialised countries, will become insolvent. Even the state cannot create debt at will, as it is constantly valued on the secondary markets. Even cancelling the debt does not solve the problem, as the ECB has increased the liquidity of private banks by buying up government and corporate bonds in order to drive their power to create credit, thus creating giro money. This fiat money circulates even if the bonds are derecognised. A debt cut, in turn, would entail a reduction in wealth, which the rich will not easily put up with. And inflation, while it would reduce debt in real terms, brings new problems, and is also difficult to achieve given weak mass purchasing power and high excess capacity in industry.

More realistic will be a wave of bankruptcies and insolvencies, sovereign insolvencies and mass unemployment, and new uprisings on a global scale. For the economy, the coronavirus pandemic has already brought disrupted supply chains, record unemployment, failed small businesses and further poverty for the masses. And there is just one more threat to the economy. It lurks in the balance sheets of the big banks, and it could be catastrophic for the entire economy. It is the possibility of a new financial crisis, because the banks have learned little from the last financial crisis, and the new decrees and laws that were supposed to stop them from taking on too much risk have had little effect so far. As a result, we may be on the precipice of another crisis, different from the 2008 financial crisis less in kind than in magnitude.

A brief turbulence was heard in the financial markets last week around the events of GameStop. One can speculate on a price rise without owning the security, for example through the futures or options market. Financial operations,including the buying and selling of assets, short or otherwise, are an important part of the mechanism of modern capital.

The fact that regulators, brokers and government officials are taking to the barricades in the face of the GameStop events is hypocritical, since they of all people have always defended such markets. In the “free market”, governments have always tried to prop up stock prices and keep money market interest rates low, zero or negative. As we have seen above, such policies lead to numerous zombie companies that would have failed long ago without government help. GameStop was on the verge of failure, and a number of hedge funds sold short its shares, fully expecting that government aid would not save GameStop.

A key point that doomed these hedge funds is that information about extreme short positions is easier to come by these days. What started as a great speculative idea led to big losses. They had the so-called “fundamentals” on their side, but ignored another fundamental fact of the financial market: extreme exposure, this time it was an association of small investors via the internet platform reddit, can lead to extreme vulnerability and large swings. A large part of GameStop’s shares had been sold short by various funds, which meant that they would have to buy them back at some point. The question was at what price, and the answer came unexpectedly when many small, mainly US-based investors started buying GameStop. Prices soared and then soared even further as short positions were unwound, resulting in billions of dollars in losses for these hedge funds.

This was touted as some kind of victory of the small investor over Wall Street. It merely reflects a case of prices running against large market speculators. But no doubt other hedge funds could have joined in the buying to weaken their competitors. After all, a large group of small speculators won against a small group of large speculators in this one case. Nevertheless, it will remain an exception, because financial capital, continues to dominate the financial markets and thus the world economy. However, large losses could force the sale of other assets, leading to the decline of positive developments in the stock markets.

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