What to Expect When You’re Expecting… Massive Defaults on Multiple Scales  

“…When Silenus had finally fallen into his clutches, the king asked him what was best
and most desirous thing of all for mankind. The daemon stood silent, stiff and
motionless, until at last, forced by the king, he gave shrill laugh and spoke these
words:
‘Miserable, ephemeral race, children of hazard and hardship, why do you forced me
to say what would be more fruitful for you not to hear? The best of all things is
something entirely out of your grasp: not to be born, not to be, to be nothing. But
the second best for you—to die soon.”
-F. Nietzsche, The Birth of Tragedy

This write-up is in response to a question regarding what would happen if both the stock
market and the bond market were to blow up at the same time. I’m assuming the only way
this happens is via massive bond defaults. Certainly not saying this is necessarily going to
happen, but it is worthwhile to think through extreme events. And it’s not a stretch to think
that Greece, a Baltic country with a debt-to GDP ratio of around 500%, and many US states
are expecting. Defaults, that is. It is worth understanding how people and institutions
respond to an unsustainable debt burden on a societal scale, and how to make money on it.
The unexpected results of a promiscuous consequence-free debt binge will have extreme
consequences for shaken money-makers.

Take-Aways

 Pervasive reduction of leverage. Syndicated loans and dependence on short-term

bank financing will be reduced. Longer term financing (bonds) will be viewed as less
risky.

 Deleveraging means retained earnings will be an increasing source of financing. As a

result of dividend reduction, equity issuance will be a funding source for few
companies. This will be harsh on equities.

 Big changes in the M&A landscape. Disintermediation will place companies with
pricing power in an enviable position. They will create integrated conglomerate
industries that pair businesses that throw off cash with other less profitable
complimentary business lines.

 Household, business and central bank behavior will innovate to survive. Firms will
fragment their risk exposures. Household strategically default will become rather
common. As far as central banking, it may not be legal for the Fed to purchase
corporate debt, but there are no current restrictions on purchases of credit-linked
obligations (CLOs, CBOs).

 Securitization is a powerful cipher of decontrol. Securitization is going nowhere.

Due to large liability overhangs, intractable government commitments far in excess
of tax outlays, and a desire for institutional portfolios to off-load exposures,
securitization arranger and originator businesses will endure. Future securitization
will bundle new raw material (e.g. bundled tax/payment arrears). This is the ancient
practice of tax farming in new clothes.

 Unwinding securitization is a powerful cipher of disintegration. Expect securitization

unwinds of some existing product. Toxicity going forward will be controlled by more
stringent collateral standards and aggressive discounting.
Where we are, where we go

The set up is a hang-over from a liquidity binge. Sovereign bond issuance will drive
sovereign govvie yields up, and weaker sovereign credits are going to get the divine
hammer. Corporate credits, both IG and HY will follow as taxes rates rise. Any
improvement in top line will likely be insufficient to avoid higher default rates. There will be
little residual earnings, so equities will get the crushed.

This is a well-known story, agree or no. How people and organizations behave in such an
extreme environment is the unknown issue. It is important to anticipate the strategies that
the creative pilots of Slaveship Earth develop to enhance survivability.

There is an entrenched insolvency problem in the United States, and a picture is worth a
thousand words. Insolvency is not illiquidity; insolvency is about income that can’t service
debt burden. Notice where things fall off the cliff: I believe we are getting close to this
point. Just need a catalyst. Sequential bond auction failures here, a sov default there,
massive liquidity drain all around, worse… whatever. The fumes running the engine (QE, or
credit easing) are dwindling.

Don’t Go Chasing Waterfalls…

Asset Price Melt-Up Until QE ends.

Then Crowding-out effect Dominates.
Asset Valuations Become Uneasy

Sovereign Bond
Yields go
Parabolic. Profits
and Income
Tax Revenues Collapse. Asset
Decline, Massive Deflation, Default
Sovereign Debt and Deleveraging
Buildup, leading to on Multiple Scales
QE
Over the top and
down...

Liquidity Vanishes. Either cash-flow recovers or QE starts

up again.
The ingredients are already in place for a much-needed solution to hubris. One can already
observe top-down government economic reengineering interacting with moral-hazard
induced behavior adaptation in bad ways.

The outcomes… well there is any range of outcome. But I can assure you that good
intentions mean nothing where survival of the fittest is explicitly written into the cosmic
gene code. History does provide a template for how this sort of political reengineering will
shape the next few years. Buckle up!

Exhibit A:  Good Intentions Mean Nothing  
The Intention Method Implementation Adverse Effect
Direct Stimulus (expanded unemployment
benefits, Food stamps, other transfer
Firm and Taxpayer Payment
payments)
Arrears

Direct Industrial Subsidies (GM, AIG)

Fiscal Policy

Financial System Capital Injection

Ambiguous Property Rights

Government Intervention
to Mitigate Deleveraging Monetary Policy:
and Insolvency Collapse of asset
prices destroys Liquidity Injection
balance sheets.
Excess liabilities force Creates Zombie Banks
everyone to go into
debt minimization
mode. Monetary policy Geopolitical Risk: Import
becomes largely capacity is suppressed
useless, no matter how
Weaker Dollar
much money is
Reserve Currency Risk:
printed. OPEC rejects denomination
of oil price in dollars

A powerful neutralizer of nihilism is data that looks at how these adverse policy effects—
payment arrears, ambiguous property rights, zombie banks ‘n such—reconfigure society. It
may take years to work through, but this is nothing new under the sun.

The data suggests something of note. Humans can slip out of the noose for some time
through innovative behavior. In meltdown situations, liquidity is generated when firms and
households adapt and develop work-arounds to an unsustainable debt burden. Government
turning a blind eye and ignoring basic corporate law (creditor rights) is more inflationary
than any fiscal or monetary policy. However, it is unsustainable and only magnifies
systemic risk. When chaos dominates order, things fall apart. Illusions must burn away
and all things must live within their means.

I found an out-of–the-way laboratory to observe these rules. My lab has a certain back-to-
basics charisma: Romania. After all, Transylvania is an ideal place to study undead
zombies. The time: right after a real vampire, Vlad Ceaucescu, ate bullets.

Indeed, there are few more glamorous locales for a Lovecraftian scene. Sure the United
States is different. But note that there is a global dynamic going on bigger that any single
country: a dynamic of decontrol. Political and social structures are all in flux. The
ascendant autonomy of the individual to act in his or her best interests independent of other
considerations (globalization) is the decisive element of contemporary history. Where
better to observe this dynamic than at a punctuated equilibrium point between communism
and capitalism?

What enterprise arrears were to a smokestack satrap economy churning out wholesome
proletarian smoke is what mortgage squatters are to a blood-sugar-sex-magic financial
economy.

For example, Romanian corporations under the pressure of unsustainable debt levels,
declining revenue, and threats of bankruptcy broke their firms up along divisional or factory
lines. It was an effective way to both avoid balance sheet stresses and increase autonomy
against government regulators. How is this different from a Wall Street SIV? Human
systems and human nature have changed little since Athens and Ur.

So let’s start with the disintegration of the existing Romanian government in 1991, resulting
in a stop-go approach to law and order. Then observe a demand implosion and a massive
unemployment spike. Then prices were liberalized, meaning basic goods prices went
through the roof. Monetary policy in the sense we understand it didn’t exist. Banks were
accounting entities commanded by the Center, not mechanisms that profited from taking
credit risk.

So… government was in severe shock, and there was no existing financial structure to
administer conventional fiscal and monetary policy. How could real wages—the most
reliable measure of household well-being in command society—possibly hold together and
even increase in 1995 and 1996 as well as shown below?

Real wages:  No Sign of Apocalypse in Collapse. 

Because people and social phenomena survive extreme limit situations by 1) fragmenting
risk exposures and 2) searching intensely for better options outside the box.

Risk Management by Risk Fragmentation: What Liquidity Injection Really Does

Capital infusions by purchase of preferred stock (note that this purchase was diluted to
common stock in due time), liquidity injections, and organized MBS purchases enable an
entire financial system to hunker down in extremes. The entire system reorganized assets
in a decentralized way to SIVs or other off balance-sheet conduits outside of regulator
purview while liabilities were managed at the on-balance sheet center to create a “Too Big
Too Fail” entity. This created an utter mess of independent legal entities whose status is
only semiautonomous in practice. By design.

It is this attempt to hold liabilities on balance sheet that enabled banks to enjoy “too big too
fail” status using one standard of measurement. At the same time, holding assets that can
be measured money good using another valuation method are moved out of reach of
regulators. I know, I know FASB may change this…only to change again should need arise.

So the best case in both Romania and Wall Street is they got a bailout. Socialized versus
private enterprise distinctions are meaningless when the state holds a big equity stake. It
may be true that the government will not exercise its right over disposal of property, but
they could. And they do have rights over residual income streams and business decisions.

On the other side are fortunate businesses that have cash flow when others don’t. In this
case, risk fragmentation combined with illiquidity creates interlocking business
conglomerates. If a business can’t collect on receivables, then cash rich businesses will
exchange debt for equity, creating conglomerates whose center generates cash. This isn’t
about Wall Street. This is nothing new under the sun.

Thinking Outside the Box…Strategic Mass Default

Outside the box in Romania meant ceasing payment of interest and principal. Not paying
interest and principal as a debtor’s unilateral decision independent of legal recourse is what
makes a payment arrear. And it explains how businesses kept going and employing people.
Remember that rising real wage in 1995-1996? State and firm arrears exploded in 1995-
1996.

Capital and liquidity injections to banks in the US create incentives for bank forbearance of
mortgage delinquencies. Delinquency is just a type of payment arrear. Whether this is an
intended transfer payment or an unintended consequence of a direct subsidy, the result is
disturbing if it becomes a perceived free ride. How pervasive could arrears become?
Business and state/local government arrears approached 50% of GDP in Romania.

Unpaid Arrears as a % of GDP, Romania 1993‐2003 
Source:  IMF Statistical Annex, various issues 

Arrears created a new and persistent dynamic for business funding in Romania. Tax and
payment arrears still accounted for over twenty percent of the total financing for corporates
almost ten years after the arrears problem first presented. Note also that retained earning
financing formed a growing share as equity financing declined. This should be expected in
any deleveraging context.

Sources of Funds for Romanian Firms, % of Total Financing 
   1999 2000 2001
Retained Earnings   6.8 8.9 11.9
Company Reserves  0.6 1.1 0.9
Equity Capital  35.6 29.2 28.3
Bank Credit  23.2 22.6 24.2
Tax Arrears  19.2 22.6 15.2
Payment Arrears  6 5.7 7.2

Endgame

I don’t fault these “Romanian” behaviors. They kept possibly solvent businesses under
intense liquidity pressure from buckling entirely. They kept people employed. They kept
household wages supported. They kept people from starving and freezing in the streets.
However, it becomes negative when the behavior becomes entrenched and incentives to
downsize living standards are negated by a government sponsored sense of entitlement.

If mortgage delinquencies become a bigger source of financing for the unemployed than
bank credit or transfer payments, then enforcing payment discipline will require more
spending on transfer payments. Debt issuance needed to finance government spending on
transfer payments will crowd out business and household credit needs, making profitability
and asset devaluations even worse. This will magnify the extent of payment and tax arrears
even more.

This is really about the dangers of direct government intervention outside of the parameters
of established law, coupled with the lack of control in other areas. Such folly only makes
the environment more perverse, and for investors more volatile. The trigger to arrears is a
liquidity squeeze combined with ambiguous property rights.

Further, it will be difficult for government to disentangle itself from direct subsidies and bail-
outs of favored industries because of the special interests that profit from them. At the
extreme margin, further difficulties accompanied with fiscal inability to act could pressure
the Fed to make monetary policy an even greater socializing mechanism. We are already
on this track. The purchasing of treasuries is a relatively impartial method of reflation. The
purchase of MBS is credit easing that favors the financial system in general and the weakest
links in particular. The logical conclusion of credit easing is purchase of corporate debt via
CLOs and CDOs. Note that this policy would be different from AIG and GM capital injections
only in scale and method.

As with all such activities, current government policies will screw government in the end.
They enable unprofitable businesses to continue cash-burn. The implicitly approved
payment arrears will inevitably lead to explicit tax arrears of both businesses and
households. As a massive source of corruption and fraud, it is only a matter of time before
arrears manifest themselves as tax evasion.

The positive spin on this is how resilient people are in the face of shocks. They become
tough and resolute when it is needed.