The Four Horsemen for Corporate Misconduct?

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A fair amount of corporate misconduct has been discovered during economic downturns. When times are good, meaning the economy is booming and stock prices are headed up, certain issues within companies are covered up or dealing with them is pushed off in order not to disrupt the company. In a downturn, it’s harder for a company to hide its problems as economic pressure exacerbates accounting problems and the government comes looking to apportion blame among those at fault for the economy’s woes.

CNBC has commentary by Ron Insana today titled “For stocks — the Four Horsemen of the Apocalypse?” The four issues identified are Greek bonds, the Chinese stock market, the Federal Reserve’s potential September interest rate hike and Puerto Rico’s announcement that it can’t pay its debts.

Let’s look a bit deeper at each:

Greece will vote on July 5th on whether to accept the terms of additional bailout funds. A default on a $1.5 billion euro payment to the International Monetary Fund is now expected. The country has suspended its stock market and closed its banks. This has already spilled over into bond yields from Italy, Spain and Portugal.

Puerto Rico
The New York Times called the restructuring of Puerto Rico’s debt an “unprecedented test of the United States municipal bond market.” Bankruptcy is not an option for the country, and the island has more municipal bond debt per capita than any American state, according to the New York Times. As a result, investor appetite for municipal bonds by local governments could be impacted.

Federal Reserve
We wrote last week about the potential problems in the bond market that a selloff spurred by fear of interest rate increases could create given the liquidity issues. Nevertheless, the New York Fed President says an increase in interest rates is still on the table if the U.S. economy remains strong. The Financial Times called William Dudley a “key voice” in the discussions about whether the Federal Reserve should raise rates.

The Shanghai stock market plunged 7 percent on Friday and is down 20 percent over the past two weeks. Although it is still in positive territory for the year, there are fears that this could be the start of a pullback due to tighter margin restrictions and excessive valuations. Today’s New York Times called China “a Bear Market.”

The combination of the four makes it a precarious time for the economy and the market. The first three, of course, directly implicate the bond market. And since our previous post, I’ve discovered two more things that put the bond market at risk:

1. ETFs

Exchange Traded Funds have become a popular way to invest in the bond market. If money starts flowing out of them, it could create problems. The funds are traded on a minute-by-minute basis, while the assets that they hold are not easily sold and could take days to dispose. The flood of supply into an illiquid market could create serious issues.

2. Concentrated Holdings

The top 20 fund managers account for 40 percent of all assets, according to a Bank for International Settlements report. If they were to start reversing out of their positions, liquidity could be destroyed. Even if they believed in their positions, redemptions may require them to liquidate assets and create an order imbalance that would send prices plummeting.

If these conditions were to occur at the same time as the falling Chinese market drags down international companies who had been projecting revenue growth because of their operations in China, the economy would be in trouble. On the other hand, we could definitely see the exposure of more corporate misconduct.

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