How crisis in the energy sector could spark a repeat of the subprime bust

The oil and gas industry is in crisis. But while $50 oil might be good for America, is there a chance that a fever in the oil patch could cause the rest of the U.S. economy to catch a cold? It’s possible, and here’s why. Oil companies are on the hook for nearly a quarter of the overheated $1.2 trillion high-yield and leveraged loan market.

Nothing to worry about, says Fed Chairwoman Janet Yellen, who has concluded the effect will likely be “transitory.” That’s kind of like how the problems in subprime were “contained” in 2007, according to then-Chairman Bernanke. Coincidentally, the subprime mortgage market was $1.2 trillion at the time.

Human beings are hardwired to be optimistic. No one at the Fed or on Wall Street wants to acknowledge a parallel. But a default cycle in energy may well force a retrenchment in risk appetite with wide-ranging and perilous consequences for markets trading near all-time high valuations, all-time tight credit spreads, and all-time low yields across industries and asset classes.

Subprime was totally different, pundits say with the benefit of hindsight. Housing underpins consumer confidence and the residential mortgage values on which our banking system is grounded. The beginning of a broad decline in home prices in 2006 spelled crisis. Construction employed nearly 10% of the labor force then, whereas oil and gas is a small part of banking assets and employment today. A problem in housing evidently would lead to a crisis, the thinking goes, but there’s nothing so threatening afoot now.

Rather than being a danger, most people see the plunge in oil prices as a “tax break” for consumers and a definitive positive for the U.S. economy. Economists reason that the benefits of lower prices at the pump are widespread and particularly boost cash-strapped low-income consumers, who will go spend savings at restaurants and retailers. Lower prices will also reduce the tab for the country’s net imports of oil, alleviating the trade deficit and further bolstering GDP. By contrast, declining house prices would of course reduce spending and GDP.

Except it wasn’t so clear at the time. In 2006, then-Fed Governor Susan Bies asserted to the FOMC that a decline in home prices and homebuilding could actually invigorate the economy by redirecting households’ money to more productive investment. Not one of the 57 other Fed governors, secretaries, economists, and advisers present laughed or objected to her thinking – it was viewed as a credible argument. In mid-2007 three hedge funds owning subprime mortgages had collapsed, and Chairman Ben Bernanke delivered his line that the “impact on the broader economy and financial markets of the problems in the subprime mortgage area seems likely to be contained”. Even after Bear Stearns failed in early 2008, by which point house prices had fallen meaningfully across the country for over a year, few banking analysts or Wall Street strategists envisioned losses or consequences beyond the subprime and alt-A mortgage markets and CDOs built on the same underlying securities.

We know now that subprime mortgages were just the tip of the iceberg, one of the earliest and most acute symptoms of a broad underpricing of risk to bubble up in the $14 trillion mortgage debt market. Recognition of underpricing in that narrow part of the market led to admission of underpricing elsewhere, too, and with it tightening of credit and an accompanying reduction of economic activity.

Today, the beginning of a default cycle in high-yield bonds issued by energy companies similarly may be the first recognition of a broad underpricing of risk, whose locus is in the massive $12 trillion corporate debt market. Lending at 5% to cash flow-negative companies whose future depends on stable prices of a notoriously cyclical commodity may seem more than a bit optimistic, in retrospect, and may catalyze retrenchment elsewhere. As realization of the over-optimism dawns on market participants and losses mount, they may begin to mark down low-interest loans to other highly levered, potentially not-so-stable high-yield issuers, and be forced to sell.

Many Wall Street and Fed economists who are currently thinking only about the pain from oilfield job losses and decreased investment in the oilfields of Texas and North Dakota may be missing the point. Just like economists who thought most mortgages were OK because they still showed solid credit performance and reasonable loan-to-values in 2007. Optimists today point to healthy credit metrics and improving economic fundamentals for most corporate issuers outside oil and gas. They may not remember that markets can often lead and effect fundamentals – the tail can wag the dog. Construction may have employed 8 million Americans in 2007, which is more than energy does now, but most of the job losses in construction only occurred in 2009, after markets had already cracked.

As credit spreads widen, over-leveraged companies outside the oil patch will likely have trouble refinancing. Reduced credit would batter business activity. The unwinding cycle could gain steam as the specter of widening default leads investors to pare back further their high-yield holdings, increasing spreads and the incidence of default.

Now is not the time to be sanguine about these risks. Confidence ballooned over the past six years, as valuations rose and capital became readily available on ever more favorable terms. But the deflation of that confidence — even if initially confined to the oil and gas sector — could end up sucking far more air out of the balloon than expected, and help trigger our next major financial crisis.

http://www.forbes.com/sites/christopherhelman/2015/04/22/how-crisis-in-the-energy-sector-could-spark-a-repeat-of-the-subprime-bust/2/?ss=energy