By Howard Schneider
Thursday, July 15, 2010; A14
It has been dubbed the "wall of debt."
A massive wave of borrowing will start cresting this year when the U.S. and European governments sell an estimated $4 trillion in new bonds. The surge will course through the world financial system for several years as countries, corporations and banks borrow record amounts of money to repair the damage from the financial crisis and pay back loans from the boom that preceded it.
One crucial concern about the nascent economic recovery is whether markets can smoothly absorb that new debt, or whether it will force less-creditworthy governments into a Greek-style crisis, push weaker banks and corporations into default, and possibly trigger another downturn.
Analysts are split on the prospects. Large amounts of cash around the world and the expectation of continued low interest rates have some predicting a trouble-free outcome, while the sheer level of debt involved has others spooked about a destructive competition for credit. But that wall of debt has become a source of concern among economists at the International Monetary Fund and others who are trying to anticipate where the next crisis might arise.
"There will be a tightening of financial conditions," said Mohamed El-Erian, chief executive at bond-fund manager Pimco. He said his company expects that governments, corporations and leveraged buyout firms will all have to cope with stiffer requirements as they refinance maturing bonds, "some of which will not be refinanced on any terms."Warnings are there
In a series of recent reports, the IMF questioned the ability of governments and banks to raise the money they need as both collide in the markets with multitrillion-dollar tabs -- a dynamic of supply and demand that could raise interest rates as those selling bonds bid up the rate they are willing to offer investors. That potential for high levels of government borrowing to raise rates or even displace corporate bond sales -- depriving companies of an important source of financing -- is a key reason for the agency's call on governments to trim deficits.
Ratings agencies such as Standard & Poor's already have begun warning of problems, particularly as bonds used to fund corporate takeovers during the boom years start to mature.
Standard & Poor's said some $1.7 trillion in bonds are due in the next three years or so among the non-financial companies it rates. Much of that debt is below-investment-grade junk bonds that pay a high interest rate but might be difficult to refinance in an economic climate wary of risk.
"Companies at the low end of the ratings scale may find it difficult to refinance at the rates they'll need for long-term survival, if they can find financing at all," Standard & Poor's wrote in a recent study.
The issue is affecting firms large and small. The ratings agency recently downgraded the Great Atlantic & Pacific Tea Co. over doubts about its ability to refinance $188 million in debt next year. It also cautioned about the prospects for the holding company of Texas energy giant TXU. The subject of the largest-ever leveraged buyout, TXU faces a $20 billion balloon payment in 2014 on $40 billion in outstanding bonds.
"The dollar amounts around the world that we are looking at are unprecedented," said Standard & Poor's Managing Director John J. Bilardello. "It was debt issued during the peak years [that] . . . originated in a fairly strong market" but is coming due in a much weaker one.
The IMF, for example, has estimated that banks will need to sell about $5 trillion in bonds in the next three years, particularly in Europe, where the agency said the need for long-term financing is "bearing down" on a sector overly reliant on short-term cash from central banks. That amount is an increase of $2 trillion -- 66 percent -- over the value of bonds sold by financial firms from 2007 to 2009, according to data provided by the Securities Industry and Financial Markets Association.
Between the money needed for its annual deficit and the refinancing of maturing debt, the U.S. government is expected to sell more than $2 trillion of bonds annually for at least the next two years -- about double its usual amount. Over the next six months, that will be part of what the IMF anticipates as a crush of government financing that includes Japan and heavily indebted countries in Europe.
The United States, as a classic safe-haven investment, has benefited from the current caution in the market, as investors plow money into U.S. Treasury securities and help keep interest rates at historic low levels.
Other countries don't enjoy the same confidence. According to the IMF, a handful of the economically weakest European countries, including large nations such as Spain and Italy, will need to sell some $360 billion in bonds during the rest of this year, at the same time stronger nations such as the United States are crowding the market with their own sales. Greece's large refinancing needs this year sparked its recent crisis -- and threatened a larger and potentially global financial seizure when the country appeared at risk of default. Although the European Union and the IMF have set up a fund to guard against a recurrence of that sort of problem, the actual mechanism has not been tested, and the IMF noted that interest rates had begun rising again for Spanish, Italian and some other European government debt.Further ahead
Some analysts play down the risk, arguing that the low-interest-rate policy pursued by the U.S. Federal Reserve effectively pulls down rates across a variety of markets -- including for some corporate debt. Corporations and banks have comparatively large cash reserves, they note, and investors who shun equity markets may put money into well-rated corporate, government or financial bonds.
Even with the large amounts of government bonds to be sold, it was unlikely that the total demand for credit would outstrip supply by so much that interest rates are forced appreciably higher, said Larry Kantor, head of research for Barclay's Capital.
"I am not saying some borrowers won't be squeezed, but how it turns out will turn on a bunch other factors -- what the Fed is going to do, whether economic conditions become more favorable," Kantor said.
But it is the next few years -- not the next few months -- that the IMF is concerned about. Markets might cope with the current level of refinancing, but if economic growth rebounds -- if Europe recovers and its slower-growing nations start expanding -- then the private demand for financing will also increase. In its recent forecasts for the U.S. economy, the IMF even factored in a full percentage-point rise in Treasury rates -- an expensive proposition for the United States, in terms of its borrowing costs, and a sign that it expects credit markets to tighten.
"The concern comes more when we get to the point where private-sector demand picks up and there is true competition," said David Robinson, deputy director of the IMF's Western Hemisphere department. "Then there will be pressure . . . and it could be quite substantive."