People sometimes ask me what finance is, exactly. I say very simply that finance is about fundraising, and it can be broken down into two parts: debt and equity. And that’s it!
Everything else is just an expansion of that.
On Tuesday this week the Australian share market fell by nearly 4 per cent.
I always say a fall of over 2.5 per cent suggests there’s panic in the market and something is seriously amiss. So what was going on?
Well apart from a classic rush of funds out of the market as the ‘herd’ changed direction, there were concerns about the valuations of some of Australia’s biggest companies.
The reason for that was based on one of the two parts of finance: debt.
When debt becomes a dirty word
Debt is a wonderful concept if you follow the rules. If you don’t, it can be crippling.
The basic idea is that you’re given assistance to buy something you can’t otherwise afford by someone who has more money than you do.
They give you money in return for ‘ownership’ of the asset you purchase.
You still get to use the asset but technically it’s not yours and you’re still required to pay for the money you’ve received… it’s called interest.
Companies all around the world use debt to grow and expand their businesses. If you take on debt, and then buy an asset that helps you to grow as a business or generate more cash, you can easily pay back the debt and expand at the same time.
It’s basic capitalism and economic growth at work.
In the wake of the global financial crisis, however, policy makers needed a way to get businesses spending again. The system had frozen or ground to a halt.
They did that by sending interest rates around the world to record lows.
Even in Australia – a relatively robust economy – interest rates have been held at historic lows for several months now.
For most corners of the economy, all it’s really done though is encourage asset bubbles.
There has been one space, however, that has seen low interest rates been put to ‘good’ use – the resources sector.
Resources companies in Britain and here in Australia have taken on large amounts of debt as the prices of commodities have risen.
It’s a risky idea but if commodities prices keep rising and revenues rise with them, it’s a perfectly reasonable idea to take on more debt to accelerate your expansion.
Problems of course arise when the prices of the products you sell start to fall and keep falling. Ultimately you get swamped by the debt repayments.
There’s an old saying in economics that ‘when the tide runs out you find out who’s been swimming naked’.
This week we have seen a real life case study of a company, Glencore, that’s been caught out holding too much debt, or swimming naked.
Earlier this week shares in Glencore were punished. The stock fell 29 per cent in one trading session to a record low price on London’s FTSE. And for good reason too.
The company has US$30 billion in one measure of its debt and a market value of only $16 billion.
Credit default swaps for the company (a measure of the riskiness of a company’s debt load) have soared. Investors are genuinely worried about the real value of their asset.
Australian companies have been caught out too.
I interviewed stock broker Marcus Padley yesterday and he took no time to sound the alarm bells for Origin Energy and Santos. Both are struggling with their debt loads.
In Origin Energy’s case, the company announced on Wednesday it’s going to try to rectify its precarious position by selling new shares to investors, engaging in asset sales, cutting capital spending by $1 billion, and slashing its dividend to 20 cents per share.
For energy companies, at the core of the problem is the falling oil price. In just the last few months the price of crude has gone from over US$60 per barrel to around US$45 per barrel.
Demand of course has dried up from the world’s largest importer of the commodity, China.
And the slowdown in China’s economy is at the heart of much of what’s going on here.
It’s creating large holes in the balance sheets of some of the world’s biggest economies.
Australia’s biggest miners, BHP Billiton and Rio Tinto, are no exception.
The prices of some of their key commodities have fallen too (iron ore being an obvious example), and analysts are trying to work out how much both companies are really worth.
Looking again at the books
So essentially what happened earlier this week is that investors said, ‘hang on, if Glencore is a commodities producer, and, because of the fall in in commodities prices, and a heavy debt load, has found it hard to pay its bills, who else is in trouble too?!’.
The reality is that BHP Billiton and Rio Tinto do have their books in order, while other companies like Santos and Origin now have to do some serious restructuring in order to pick themselves up again.
But that’s almost beside the point. The reason why there have been comparisons to the Lehman Brothers disaster in October 2008 is because of the risk of financial contagion within the resources sector.
Trust and panic
Much of the financial crisis was exacerbated by panic.
Banks stopped lending to one another because there was a fear that they were lending to an institution that was worthless and couldn’t pay the money back.
That’s because most banks were loaded with ‘toxic ‘assets that were connected with the subprime mortgage market.
Lehman Brothers was made an example of (left to fail) after its share price crashed to zero.
Glencore’s share price didn’t crash to zero but it was rubbished by the market in London.
Investors have been unimpressed by its book keeping and the idea that its debt load has been created on the premise that commodities prices could only rise.
Remember what they said in America leading to the financial crisis? That house prices could only rise!
October 2008 investors lost confidence in the US banking system. On Tuesday, albeit only for 24 hours, investors lost confidence in the resources sector.
Given the significant slowdown in China’s economy, it’s hard to see global commodities prices rallying significantly from this point on.
That means that some resources companies are effectively swimming ‘naked’. That will at some point be digested further by the market.
Now while a ‘financial crisis’ in the resources sector doesn’t really have the capacity of creating a financial markets contagion, it does have the capacity to put the Australian share market into a deep bear market.
It’s produced by a combination of already existing frayed market nerves, and a resources sector that’s been found to be significantly overvalued.
The banks now too are in sharp focus given their exposure to mining loans.
Doing your homework
Stock broker Marcus Padley says despite Tuesday’s big sell-off, he's not advising clients to jump back in the market to buy resources stocks.
Indeed last week we saw $US17.3 billion go into money markets or cash. That's actually the first time in 25 years cash has beaten bonds and equities in terms of popularity.
So spend some time working out where your money is going to work hardest for you. You might be surprised by what you find out.