DH and I watched the movie, “The Big Short,” last night. Somehow I hadn’t gotten around to it after all these years. (Amazon Prime Video.)
I found the movie riveting. The script, acting and editing were designed to increase the excitement of a potentially dull subject, the subprime mortgage and derivatives market before the 2008 financial crisis. Frankly, I can’t imagine how the average person would be able to understand the movie – it reminded me of a movie that was incomprehensible to DH since he hadn’t previously read the book (“The Girl With The Dragon Tattoo.”)
“The Big Short” reminded me of how Mike Shedlock (who founded this board which he named after himself, “Mishedlo”) continually discussed the worsening conditions in the mortgage marketplace in 2004-2007 since he had worked at a bank and understood the fundamentals. Mish saw this coming years in advance. I owe him a lot in his generous sharing of his experience and understanding.
“The Big Short” movie reminded me of “the big one that got away” in my own investing history. During those years, there were two or three companies which issued portfolio insurance. Their stocks were highly valued. I remember thinking, “If this disaster plays out the way Mish thinks it will, there’s no way that these portfolio insurance companies will be able to pay off their customers. They will go bankrupt.” I had the idea of shorting the portfolio insurance companies but I didn’t know how to do it. During the crisis, they did indeed go bankrupt and their stock prices plunged to zero. Meanwhile, I played it safe.
“The Big Short” is relevant to the time we are living through right now.
While I was watching, I had the same feeling as I did when thinking about the portfolio insurance companies. Except this time I got the feeling about zombie companies.
The Federal Reserve is laser-focused on consumer price inflation. In the same way that they ignored the problem of subprime mortgages in 2004-2007, I think they may be ignoring the problem of how rising interest rates will impact zombie companies.
The root cause of zombie companies is the financialization of business due to the ultra-low interest rates maintained by the Fed for the past 20 years. (cf. “The Lords of Easy Money.”)
Like the meme “House prices always go up,” a similar meme of “Interest rates always go down” was fundamental to implementing this business strategy. In fact, a typical moderate to weak-rated company would have been pretty correct in assuming this.
The long-term chart shows that corporate bond yields usually rise during a recession, especially if there is also a crisis at the same time. But companies are carrying far more debt now than they were in 2008 since they have used ultra-cheap money to buy back stock shares.
Corporate bond yields have more than doubled in less than a year. If inflation doesn’t subside quickly the Fed could hold rates high for a fairly extended period. Zombies could begin to default in large numbers.
The Fed would be caught between a rock and a hard place. Their mandate is price stability. They are specifically forbidden to buy any debt weaker than AAA by law (except in an emergency like Covid, which took an act of Congress). Would they abandon their tightening campaign to bail out the zombies which they fostered by their ZIRP in the first place?
I don’t think so. But it’s hard to say.