I have never claimed to be a market historian, but the obvious similarities of the Subprime and Junk Bond crises are staggering even to the casual observer. Maybe it is a confluence of my recent reading of Sorkin’s “Too Big to Fail”, Lewis’s “The Big Short”, and Klarman’s “Margin of Safety” that brings the parallels into clear focus, but I am floored by our ability to have two vastly identical crises in the course of two decades.
While reading chapter 4 of “Margin of Safety” I turned to my disinterested wife after each page and proclaimed, “this junk bond thing is almost identical to the subprime crisis.” The narrative is plagiarism of the same financial horror story (see the chart below). In the search for higher yields, investors relax standards and issue debt to people (subprime) / companies (junk bond) that have no ability to pay back their obligations. Diversification and low correlation amongst low-quality borrowers was used as a justification for reducing the risk inherent in individual risky loans. Due to the demand for higher yielding assets, investment banks concentrated human and financial capital at staggering rates into packaging and selling subprime / junk bonds.
Capital available to finance these shaky deals increased with the ability to resell structured products like mortgage-backed securities and collateralized debt obligations (subprime) / collateralized bond obligations (junk bond). Retail banks and institutional investors (subprime) / thrifts and savings and loans (junk bond) created ready capital sources to soak up the buy side of any high yielding deals. CDO-focused funds (subprime) and high yield mutual funds (junk bond) added additional fuel to growing capital being given to undeserving borrowers.
An escalation of creative financing was needed to allow lower and lower quality standards including Pick-a-Pay, Alt-A, No Doc, Interest-Only (subprime) / zero-coupon and pay-in-kind (junk bond). The ratings agencies had to play dumb or be dumb to allow packaged subprime mortgages and packaged junk bonds to be magically rated investment grade. To justify these ratings they used historical models that assumed house prices could not fall (subprime) or historical junk bond default rates and no refinancing issues (junk bond). Finally, all of these lending machines were picking up speed as the empirical evidence was flying in the face of all that were willing to look as illustrated by subprime defaults growing from 2005 on and MBS, CDO, and CDS prices staying stable (subprime) / junk defaults rising in the late 80s at the same time the pace of new junk deals was accelerating.
Is our memory so short that we cannot remember the financial chaos created by the junk bond market in the 1980s? Some remembered because there were many smart investors that made the connection and made substantial bets on how the subprime story was going to end. Many issues coalesced to allow both bubbles to form and I certainly do not have the prescription to prevent it from happening again, but the first place I would focus my attention is the flawed incentive structure that paid the participants of the junk bond market to make foolish bets. The incentive to take outsized risk for short-term gain has not changed substantially in the past 20 years and has probably even become more acute with the increase of financial engineering and the repeal of Glass-Steagall in 1999. As my friend Dr. Art Laffer says, “Incentives are the key to understanding economic behavior.” Maybe we should stop paying bonuses on this year’s returns and instead pay a three or five-year rolling percentage of returns. That could discourage some of the short-termism that manifests financial crises.
We are just fortunate the Credit Default Swap market was nascent in the 80s or the Junk Bond crisis would have been compounded like the Subprime Crisis of this decade. Will we ever learn?
|Similarities of the Subprime and Junk Bond Crises|
|Junk Bond Market (1980s)||Subprime Market (2000s)|
|Search for higher yielding assets||Search for higher yielding assets|
|Issuance of debt to companies that did not have the cash flow to pay back obligations||Issuance of debt to people that did not have the cash flow to pay back obligations|
|Thrifts and Savings and Loans willing to invest in junk bond backed obligations (over 1000 banks failed1)||Retail banks and institutional investors willing to invest in subprime backed obligations (230 banks have failed to date2)|
|Investment banks deploy substantial human and financial capital towards junk bond market||Investment banks deploy substantial human and financial capital towards subprime market|
|Hypothetical diversification and low correlation of underlying loans created perception of lower risk securities||Hypothetical diversification and low correlation of underlying loans created perception of lower risk securities|
|Structured products like collateralized bond obligations (CBO) to finance further investment||Structured products like mortgage-backed securities (MBS) and collateralized debt obligations (CDO) to finance further investment|
|High yield mutual funds created additional liquidity||MBS and CDO focused funds created additional liquidity|
|Disregard for empirical evidence: junk default rates increasing while new issuance of junk bonds accelerating||Disregard for empirical evidence: sub-prime default rates increasing but MBS, CDO, and CDS prices remaining stable|
|Creative financing: Zero Coupon and Pay-in-Kind||Creative financing: Pick-a-pay, Alt-A, No Doc, Interest Only, Option ARMs|
|Issuers paying ratings agencies for ratings on new issues||Issuers paying ratings agencies for ratings on new issues|
|Ratings agencies allowing junk bonds to be packaged together to create investment grade securities||Ratings agencies allowing subprime to be packaged together to create investment grade securities|
|Ratings agencies used historical models without a scenario for weak economy, no refinancing, and default rates higher than historical levels||Ratings agencies used historical models without a scenario of declining house prices|
1 Many of the bank failures of the 80s and 90s were due to bad commercial and real estate loans, not just junk bonds
|2 The full impact of commercial loan losses have not been realized at this point|