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Gundlach: Corporate Credit Meltdown May Spark the Next Financial Crisis, Pt. 1

GuruFocus.com

On the surface, everything seems to be going swimmingly for capital markets. After a brief flirtation with tipping into bear market territory early in the year, U.S. stocks have surged to all-time highs as 2019 approaches its close.

Yet, as billionaire bond investor Jeffrey Gundlach observed in a Dec. 4 interview with Yahoo! Finance, the renewal of market strength was only possible thanks to a phenomenal amount of government intervention, with the Federal Reserve "battling tooth and nail" to prevent a tip into economic recession:



"The Fed has done, and the central banks, everything they can to avert the next recession. But a recession will come."



While these actions may stave off a downturn in the short-run, they run the risk of sowing the seeds of a far more serious crisis down the line. According to Gundlach, increasing levels (and deteriorating quality) of corporate debt may be the spark that sends the bull market - and economic expansion - down in flames.

Credit rating bubble inflates again

Anyone who has read the book (or watched the film) "The Big Short" knows all too well how credit rating agencies were complicit in inflating the subprime bubble. All of the "Big Three" credit rating agencies, Moody's Corp. (NYSE:MCO), Standard & Poor's and Fitch Ratings, demonstrated a willingness to inflate ratings for corporate clients. Eventually a reckoning came, as they always do. The bubble burst into full-blown financial crisis, leading to the worst recession since the Great Depression.

In the aftermath of the Great Recession, federal regulators and legislators worked to prevent such an eventuality from occurring again. Their favored solution was to promote competition, fostering the development of a host of new ratings agencies to compete head-to-head with the incumbents, all of whom had seen their reputations painfully tarnished in the wake of the crisis. Yet, according to a Wall Street Journal study published in August, this has backfired spectacularly:


"The challengers tended to rate bonds higher than the major firms. Across most structured-finance segments, DBRS, Kroll and Morningstar were more likely to give higher grades than Moody's, S&P and Fitch on the same bonds. Sometimes one firm called a security junk and another gave a triple-A rating deeming it supersafe."



In other words, rather than spurring improvements in rating methodology and quality, competition and fragmentation of credit rating agencies has allowed companies to game the system and win high ratings for low quality credit securities. As some agencies won more issuer clients thanks to laxer standards, others followed suit in order to win business. As the Wall Street Journal's Jason Sweig opined on Aug. 7, competition has proven to be a failed experiment, since "rate inflation is back, as issuers cherry-pick ratings."

Eerie reminders of the subprime bubble

Jeffrey Gundlach, who famously foresaw and warned markets about the impending subprime crisis, told Yahoo! Finance on Dec. 4 that, while "you never have the same crisis twice," corporate bonds are "probably significantly overrated, which sounds a lot like subprime in 2006."

Not everyone is sleepwalking toward another financial disaster, of course. For example, a federal advisory panel - evidently fearful of the visible resurgence of widespread credit rating inflation - submitted a recommendation last month to the Securities and Exchange Commission calling for an overhaul of ratings agencies business models (i.e., debt issuers paying for ratings, as has always been the case). Unfortunately, this looks like it may prove to be a case of "too little, too late" in light of the corporate bond market's frightening state. With more than one-third of corporate bonds deserving of junk ratings based purely on their leverage ratios, it is clear that the contagion has spread widely already.

When the economy eventually tips into recession, Gundlach warned, it will send shockwaves across the entire corporate credit market:


"There won't be any idea of addressing these leverage ratios. They're just going to get a lot worse when the recession comes. And you're going to see en masse downgradings of the investment-grade corporate bond market."



Gundlach's prognosis is for investors to employ extreme caution in these unsettled times, recommending defensive strategies.

Disclosure: No positions.

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This article first appeared on GuruFocus.