Are Debt Problems Lurking Below the Surface?

A decade ago, concerns that companies and individuals had borrowed too much money toppled the stock market from what was then its all-time high.

Now, with stocks again tumbling from record levels, are debt problems rumbling beneath the surface of what seems like a strong economy? The short answer is that, in most places in the world, the reckless borrowing that led up to the financial crisis of 2008 does not seem to have reoccurred. Still, when a long period of low interest rates ends, as appears to be the case now, all the borrowers and lenders who have grown used to cheap credit may retrench in ways that may not be initially obvious. In other words, debt has a propensity to bite the economy on the behind just when it least expects it.

But problems may be brewing. Credit card debt has been rising, burdening some borrowers. But this debt does not right now pose the sort of systemic threat that mortgages did a decade ago.

The more a bank relies on shareholder funds, or equity, the less leveraged it is. And, crucially, it is also at less risk of the sort of bank runs that threatened the global financial system in 2008. The good news is that banks are using a lot more equity these days. As the Fed noted after conducting stress tests of large lenders last year, banks had common equity capital, a metric regulators use to assess the strength of a lender’s balance sheet, that was equivalent to 12.5 percent of their assets, which was more than double the 5.5 percent they had at the start of 2009.

One of the reasons investors have kept buying corporate bonds is that, while some measurements of indebtedness flashed warnings, plenty of others did not. But there are signs that the binge had gone too far, even for these easy money times.

The yield on junk bonds, as measured by BofA Merrill Lynch’s high yield index, was close to historic lows last year, making the market vulnerable to any interest rate rises. What is more, in recent months the cost of corporate borrowing, on an inflation-adjusted basis, has sunk to what looks like an unsustainable low. In December, the yield on a bond rated Baa by Moody’s was 2.1 percent after subtracting the rate of inflation for that month. That figure was well below the average since 1950, but also significantly smaller than averages for the last five or 10 years.