International -- Special Report
Prosperity under Siege (int'l edition)
Global markets are sinking. The Mideast is boiling. Japanese firms are collapsing. It's scary out there
Hear that roar? That's the sound of global stock market value going down the drain--some $5 trillion of it since the start of the year, estimates Morgan Stanley Dean Witter. What's that snap? An overloaded world bond market splintering. Oh, and that thud was another large Japanese financial institution collapsing.
Led by Wall Street, global markets are down an average 17% since the start of the year, as shown by the Dow Jones World Index. In dollar terms, Europe is off 21%, Japan's Nikkei is down 25%, South Korea is off 51%--and none seems ready to hit bottom. The risk premiums over government debt that investors demand for even good corporate issues are at their widest since the Russian debt default in August, 1998, and in both the U.S. and Europe, the market for new issues of junk bonds is effectively closed. America's ranking bond guru, William H. Gross of Pacific Investment Management Co., warns that he wouldn't touch even a high-quality corporate bond in this climate.
Following the collapse of the Chiyoda Mutual Life Insurance Co. in mid-October--Japan's largest bankruptcy ever--Japanese market watchers have been warning that there may more large financial collapses in the weeks ahead. On Oct. 17, Tokyo authorities were preparing for the liquidation of one of the country's largest leasing companies. There have been warnings that other mid- to large-size financial, construction, and retail enterprises are likely to be liquidated.
What's going on here? Just a month ago, the world economy looked pretty safe. Sure, corporate debt was at high levels, and there had been a dot-com crash starting from last April, but markets kept shrugging off those warnings. Revenues and profits in the U.S. looked healthy, and growth was especially encouraging in both the U.S. and Europe--3.7% for the U.S., 3.5% for Europe.
Japan and the troubled Asian countries were said to be slowly recovering, and investors were beginning to hope that Federal Reserve Chairman Alan Greenspan was done with interest-rate hikes and that the miracle of a soft landing was in sight.
It's true that oil prices were continuing to push up inflation rates across the developed world. But after subtracting energy prices, core inflation was moderate, meaning that oil prices weren't hiking costs across the board. The bitter, violent blowup in the Middle East was and remains a big worry. But short of an oil embargo or a war that shut down the oil fields, that danger too was contained, wasn't it?
Adding it up, the big change that's taking place is that investors everywhere are casting a cold eye on risk. Until recently, U.S. and European investors were spending profligately, throwing the old profit standards out the door and embracing unproven dot-com business models as the next great thing in finance. Now, all of that is over. Risk matters again. Oil, the Middle East, bonds, stocks, Japan, dot-coms--what seemed like discrete concerns have been thrown together in a volatile stew. The idea that the economies of Europe and Asia could accelerate--always a myth--while the U.S. slowed has been demolished. In a world more closely linked than ever, the danger is that once a financial cycle turns for the worse, it will go too far. Global prosperity, a given just a few weeks ago, is now seriously threatened.Return to top
The Big Squeeze in America (int'l edition)
The markets and banks are turning off the spigots
To hear Federal Reserve Chairman Alan Greenspan tell it, the U.S. owes a lot of its economic success over the past decade to the flexibility of its financial system. When U.S. banks savagely cut back on credit in 1990 following a collapse in property prices, American companies were able to turn to the capital markets for the financing they needed. That helped keep the last recession short and mild. And when the financial markets seized up in late 1998 after Russia's debt default, companies turned around and tapped banks for money, letting the economic expansion continue uninterrupted.
But don't look now. The twin financing faucets that have kept the U.S. economy afloat are both drying up. Since hitting a record high in March, the Standard & Poor's 500-stock index has dropped 13.5%, while the Nasdaq stock index has plunged by nearly 60%, with no firm bottom in sight. The bond market, too, is tightening; indeed, the junk-bond market has collapsed, with yields at their highest level in a decade. The combined turmoil is making it harder and costlier for companies to raise money through new issues of stocks and bonds. At the same time, banks are getting stingier with credit. Faced with mounting bad debts, they're raising interest rates on their loans, demanding more collateral, and in some cases cutting off business borrowers completely.
It's a nightmare scenario for many an executive and investor: a corporate credit crunch that, together with soaring oil prices and higher interest rates, could slow growth to a crawl and rob companies of the capital needed to fuel America's productivity miracle. "We'll be lucky if we get a soft landing," says Jason R. Trennert, managing director of ISI Group economic consultants. "The risks of a recession are rising."
What's happening is a fundamental reassessment of risk throughout the economy. And the growing evidence of a potential liquidity crunch seems to be everywhere. On Oct. 16, Bank of America reported that its third-quarter net income fell 15%, to $1.83 billion, as nonperforming assets jumped nearly 50%. The next day, Chicago's Bank One Corp. reported a 37% drop in earnings, also in part because of bad loans. On the same day, bond guru William H. Gross, who manages the world's largest bond investments at Pacific Investment Management Co. (PIMCO), declared that he would avoid corporate bonds "at any cost" because of a deterioration of credit quality leading to more "debt defaults" in the future.
The situation is just as bad for equities, where the rout in the market, especially in technology company shares, is wreaking its own havoc with corporate financing plans. The IPO pipeline has shrunk dramatically. On Oct. 16, Verizon Wireless Communications pulled its widely anticipated initial public offering, citing poor market conditions. Since the start of October, 15 companies have postponed IPOs--more than double the amount delayed in the same period last year. Plunging stock prices have also put an end to the heady stock-financed M&A deals common earlier in the year and have called into question several pending pacts. "M&A activity in September was the lowest since November, 1996, in terms of number of deals," says Richard Peterson, chief market strategist of Thomson Financial Securities Data in Newark, N.J. "Year over year, the numbers are off by 12%."
What's behind the shift? As growth slows sharply under the impact of Fed-engineered interest-rate hikes and OPEC-induced oil-price rises, investors and bankers alike are being forced to radically rethink their overly rosy scenarios. That's true even though GDP growth, which should slow to about 3% in the third quarter from 5.6% in the second, still is strong by historical standards.
Nevertheless, the slowdown is already weakening corporate profits--and the fear is that they will continue to erode. "American business capitalized itself for a state of continuing and bountiful prosperity," says James Grant, editor of Grant's Interest Rate Observer newsletter. Corporate debt as a percentage of net worth rose to nearly 83% in the second quarter, according to Moody's--meaning making debt payments could quickly get tough if earnings dry up. That's the highest level in more than seven years. There's "very little room for error," says Grant. "When error is introduced, investors run for their lives."
The same worries have also sent psychology in the stock market south. "We've gone from rampant complacency to where we're beginning to see signs of panic," says Bank of America Securities LLC market strategist Thomas M. McManus. That's why investors are suddenly filled with "fear that the underpinnings of the bull market will disappear," says Joseph Battipaglia, strategist at Gruntal & Co.FUTURE SHOCK. The angst among equity investors is clearly spilling over to the bond market. One reason: More bond dealers and institutional investors are using equity-linked computer models to estimate credit risk. The models derive asset value, leverage, and likelihood of default from the market value and volatility of a company's share price. So if the price drops precipitously, dealers and investors quickly mark down the value of its bonds as well. That hurts liquidity, since few investors want to hold bonds whose prices are falling.
Add it all up and U.S. companies can kiss goodbye to free-flowing, cheap money. Telecom investors got a terrifying glimpse of the future back in May, when GST Telecommunications Inc. filed for bankruptcy and defaulted on its bonds. Now, other telecoms that have tapped the bond and equity markets for tens of billions of dollars to finance their expansion plans face shakeouts of their own. With brutal competition undermining earnings throughout the sector, fears of more defaults are on the rise.
The most recent bad news came on Oct. 17, when Covad Communications Co., the leading independent broadband provider of digital subscriber lines, announced that some customers had not paid their bills. The stock dropped nearly 60% on the news, to $3.56, while its bonds plummeted 20 points. Covad recently raised $500 million in a convertible debt offering, but a day before its earnings announcement, Goldman, Sachs & Co. telecom analyst Frank Governali warned that debt and equity markets for upstart telecom carriers like Covad will remain largely closed through the end of the year. "If the availability of capital remains limited," says Governali, expect "additional bankruptcies." For weaker or risky companies, the credit crunch is already here. The yield on U.S. issued junk bonds now averages 13%, their highest level since the end of 1991. And new issuance is drying up.MORE HEADACHES? Behind the market meltdown has been a gradual deterioration in credit quality that investors are just noticing. Diane Vazza, head of global-fixed-income research Standard & Poor's, a unit of BUSINESS WEEK parent McGraw-Hill Companies, says corporate debt downgrades have outnumbered upgrades for nine straight quarters. So far this year, S&P has lowered credit ratings on 325 bond issues, with a face value of $218 billion. That compares with 78 issues, or $62.3 billion, that have been upgraded.
The turmoil in the bond market has been made worse by a drying up of liquidity. The ongoing consolidation in the banking industry means that there are fewer and fewer bond dealers for investors to trade with. Investors wanting to sell bonds--especially junk issues from smaller companies--are having trouble doing so. That's feeding the sense of panic in the market.
With access to the financial markets closing down, where will companies turn for money? "More companies will be dropping in to renew relations with their bankers," quips Grant. But they may not get a warm welcome. The banks are facing problems of their own. Losses from large syndicated loans held by U.S. banks more than tripled to $4.7 billion this year. That's higher than in the last recession. And banking regulators think there are more headaches to come. "We do expect them to go up for a while," says Deputy Comptroller of the Currency David D. Gibbons.
It's not as if the banks didn't know what was coming. Regulators began warning them about the need to tighten up on their lending a couple of years ago. If banks had listened, much of the current crunch might have been avoided. Instead, bankruptcies are sure to rise as cash-strapped companies seek protection from their creditors. And cutbacks in capital investments to conserve precious cash may wind up slowing the economy far more than anyone had ever intended.By Rich Miller in Washington, with Debra Sparks, Heather Timmons, and Steve Rosenbush in New York, Geoffrey Smith in Boston, and Joseph Weber and Roger O. Crockett in ChicagoReturn to top