When things go great, the winners go into debt. Sometimes they go too far.
With the American economy in its longest period of expansion ever, the news for corporate America has been as good as it can be. Profits have soared and are at or near record levels by almost any measure — in dollars, as a percentage of revenues or as a portion of national income. Investors eagerly paid unprecedented multiples of those profits when they bought shares.
And yet, with profits pouring in and investors eager to buy stock, corporate America is deeper in debt than ever before. Corporate debt now equals 46 percent of gross domestic product, up from 38 percent five years ago.
One might expect companies to pay down debt in good times, and they tend to early in an economic recovery, when the bad times are still fresh. Corporate debt fell in 1991, after the last recession.
But as the economy continues to grow, such conservatism comes to appear foolish as people grow more confident that good times are here to stay. "It's the perception of certainty that causes so many prosperous companies, individuals and companies to get in over their heads," says James Grant, the editor of Grant's Interest Rate Observer.
The result is that the richest of one era can end up in deep trouble when times change. Mexico raked in the cash when oil prices soared during the 1970s and could not pay its debts in 1982. Japanese corporations seemed to conquer the world in the 1980s and could not pay their bank loans a decade later.
In the current corporate borrowing spree, the money borrowed has been far in excess of what was needed for capital spending, notes Paul Kasriel, the chief economist of Northern Trust. Much of the money went to buy back stock — in large part to offset the shares that were issued to executives when they cashed in stock options. Corporate America has bought back more shares than it issued in recent years.
None of this is unprecedented. The two longest periods of expansion before the current one were in the 1960s and 1980s. In each case, corporate debt rose rapidly in the final years of the expansion. In the 1980s, Drexel Burnham Lambert, the leader in junk-bond underwriting, came up with a new measure — the "MAD ratio" — to reassure investors that debt levels were not excessive. That stood for market-adjusted debt, and it showed that many companies were not really very far in debt, considering the market value of their stock. That was great, until share prices fell.
Now, evidence is growing that the economy is slowing, and worries are picking up that corporate profits may not be as robust as expected. Credit markets are growing tighter. The junk bond market is reluctant to finance many companies, and banks are growing more cautious.
If those trends continue, some companies that assumed they could refinance debt when it came due will find that they cannot. And then we will see corporate defaults and bankruptcy filings rise to a level much higher than might be expected even if there is only a modest slowing in economic growth.
Inevitably, some of the companies that default will be ones that need never have borrowed money, given how eager investors were to buy their shares. But the managers feared that issuing too many shares would depress the stock price, and they knew that their duty was to maximize shareholder value. So they took on debts that did not look dangerous — but that proved to be fatal.