Carrying the weight

Should the world worry about America’s corporate-debt mountain?

It is not like the subprime crisis. But it could make the next recession worse

AMERICAN HOUSEHOLD debt set off the global financial crisis in 2007. But for much of the subsequent recovery America has looked like a paragon of creditworthiness. Its households have rebuilt their balance-sheets; its firms have made bumper profits; and its government goes on providing the world’s favourite safe assets. If people wanted to look for dodgy debt over the past decade they had to look elsewhere: to Europe, where the sovereign debt crisis dragged on; to China, where local governments and state-owned firms have gorged themselves on credit; and to emerging markets, where dollar-denominated debts are a perennial source of vulnerability.

Should they now look again at America? Household debt has been shrinking relative to the economy ever since it scuppered the financial system. But since 2012 corporate debt has been doing the opposite. According to the Federal Reserve the ratio of non-financial business debt to GDP has grown by eight percentage points in the past seven years, about the same amount as household debt has shrunk. It is now at a record high (see chart 1).

This is not bad in itself. The 2010s have been a rosier time for firms than for households; they can afford more debt, and a world of low interest rates makes doing so attractive. Moreover the firms are not borrowing the money for risky investments, as they did when a craze for railway investments brought about America’s worst ever corporate-debt crisis in the 1870s. In aggregate they have just given money back to shareholders. Through a combination of buy-backs and takeovers non-financial corporations have retired a net $2.9trn of equity since 2012—roughly the same amount as they have raised in new debt.

For all that, a heavy load of debt does leave companies fragile, and that can make markets jittery. In 2018 concerns about over-indebtedness began to show up in financial markets. The average junk-bond investor ended the year with less money than they had at the start of it (see chart 2)—only the second time this had happened since the financial crisis. In February Jerome Powell, the chair of the Fed, told Congress some corporate debt represented “a macroeconomic risk...particularly in the event of the economic downturn.” Might American firms have overdone it?

Thanks to low interest rates and high profits, American companies are on average well able to service their debts. The Economist has analysed the balance sheets of publicly traded American non-financial firms, which currently account for two-thirds of America’s $9.6trn gross corporate non-financial debt. Their combined earnings before interest and tax are big enough to pay the interest on this mountain of debt nearly six times over. This is despite the fact that the ratio of their debt, minus their cash holdings, to their earnings before interest, tax, depreciation and amortisation (EBITDA) has almost doubled since 2012.

But life is not lived on average. About $1trn of this debt is accounted for by firms with debts greater than four times EBITDA and interest bills that eat up at least half their pre-tax earnings. This pool of more risky debt has grown faster than the rest, roughly trebling in size since 2012. All told such debts are now roughly the same size as subprime mortgage debt was in 2007, both in absolute terms and as a share of the broader market in which it sits.

That a trillion dollars might be at risk is not in itself all that worrying. The S&P 500 can lose well over that in a bad month; it did so twice in 2018. The problem with that $1trn of subprime debt was not its mere size; it was the way in which it was financed. Mortgages of households about which little was known were chopped up and combined into securities few understood. Those securities were owned through obscure chains by highly leveraged banks. When ignoring the state of the underlying mortgages became impossible, credit markets froze up because lenders did not know where the losses would show up. Big publicly traded companies are much less inscrutable. They have to provide audited financial statements. Their bonds are traded in public markets. Their debt does not look remotely as worrying, even if some firms are overextended.

Give me your funny paper

But there is a second way to cut a subprime-sized chunk of worry out of the corporate-debt mountain. This is to focus on the market for so-called “leveraged loans”, borrowing which is usually arranged by a group of banks and then sold on to investors who trade them in a secondary marketplace. Borrowers in this market range from small unlisted firms to big public companies like American Airlines. The stock of these loans has grown sharply in America over recent years (see chart 3). They now rival junk bonds for market size, and seem to have prospered partly at their expense. Unlike bonds, which offer a fixed return, interest rates on leveraged loans typically float. They thus appeal to investors as a hedge against rising interest rates.

Europe has a leveraged-loan market, too, but at $1.2trn, according to the most commonly used estimate, America’s is about six times bigger. It is hard to judge the overlap between these leveraged loans and the debts of fragile public companies. But it exists.

The rapid growth of leveraged loans is what most worries people about the growth in corporate debt. The list of policymakers to have issued warnings about them, as Mr Powell has done, include: Janet Yellen, his predecessor at the Fed; Lael Brainard, another Fed policymaker; the IMF; the Bank of England; and the Bank for International Settlements, the banker for central banks. On March 7th the Financial Times reported that the Financial Stability Board, an international group of regulators, would investigate the market.

These worries are mostly based on three characteristics the growth in leveraged loans is held to share with the subprime-mortgage boom: securitisation, deteriorating quality of credit and insufficient regulatory oversight.

The 2000s saw an explosion in the bundling up of securitised mortgages into collateralised debt obligations (CDOs) which went on to play an infamous role in the credit crunch. In this context the collateralised loan obligations (CLOs) found in the leveraged-loan market immediately sound suspicious. The people who create these instruments typically combine loans in pools of 100 to 250 while issuing their own debt to banks, insurers and other investors. These debts are divided into tranches which face varying risks from default. According to the Bank of England, nearly $800bn of the leveraged loans outstanding around the world have been bundled into CLOs; the instruments soak up more than half of the issuance of leveraged loans in America, according to LCD, the leveraged-loan unit of S&P Global Market Intelligence.

For evidence of a deterioration in the quality of credit, the worriers point to the growing proportion of leveraged loans issued without “covenants”—agreements which require firms to keep their overall level of debt under control. So-called “covenant-light” loans have grown hand in hand with CLOs; today they make up around 85% of new issuance in America.

There are also worries about borrowers increasingly flattering their earnings using so-called “add-backs”. For instance, a firm issuing debt as part of a merger might include the projected efficiency gains in its earnings before those gains materialise. When Covenant Review, a credit research firm, looked at the 12 largest leveraged buy-outs of 2018 it found that when such adjustments were stripped out of the calculations the deals’ average leverage rose from 6.1 times EBITDA to 8.7.

Regulatory slippage completes the pessimistic picture. In 2013 American regulators issued guidance that banks should avoid making loans that would see companies’ debts exceed six times EBITDA. But this was thrown into legal limbo in 2017 when a review determined that the guidance was in fact a full-blown regulation, and therefore subject to congressional oversight. The guidance is now routinely ignored. The six-times earnings limit was breached in 30% of leveraged loans issued in 2018, according to LCD.

In 2014 regulators drew up a “skin in the game” rule for CLOs—a type of regulation created by the Dodd-Frank financial reform of 2010 that requires people passing on risk to bear at least some of it themselves. But a year ago the skin-in-the-game rule for CLOs was struck down by the DC Circuit Court of Appeals. The court held that, since CLOs raise money first and only then buy up loans on behalf of the investors, they never really take on credit risk themselves. Their skin is safe before the game begins.

In the middle of negotiations

Despite these three points of comparison, though, the leveraged-loan market does not really look like the subprime markets of the mid 2000s. CLOs have more in common with actively managed investment funds than with the vehicles that hoovered up mortgage debt indiscriminately during the mid-2000s. Those securities typically contained thousands of mortgages; those selling them on had little interest in scrutinising the details of their wares. The CLOs pool fewer debts, their issuers know more about the debtors and their analysts monitor the debts after they are bought. They need to protect their reputations.

Unlike the racy instruments of the housing boom, which included securitisations-of-securitisations, CLOs have long been the asset of choice for investors wanting exposure to leveraged loans. And they have a pretty solid record. According to Goldman Sachs, a bank, in 2009 10% of leveraged loans defaulted, but top-rated CLO securities suffered no losses. The securitisation protected senior investors from the underlying losses, as it is meant to.

And the rise in covenant-light lending “is not the same thing as credit quality deteriorating,” says Ruth Yang of LCD. It may just reflect the sort of investors now interested in the market. Leveraged loans are increasingly used as an alternative to junk bonds, and junk-bond investors think analysing credit risks for themselves beats getting a promise from the debtor. Ms Yang points out that loans that lack covenants almost always come with an agency credit rating, providing at least some degree of guaranteed oversight—if not, perhaps, enough for those badly burned by the failure of such ratings in the financial crisis.

Even if these points of difference amount to nothing more than whistling in the dark, the prognosis would still not be too bad. America’s banks are not disturbingly exposed to leveraged loans. The Bank of England estimates that they provide only about 20% of CLO funds, with American insurers providing another 14%. It also notes that the banks’ exposures are typically limited to the highest-quality securities. The junior tranches of CLO debt—those that would suffer losses should defaults rise—are mostly held by hedge funds, credit investors and the CLO managers themselves. Even if a lot of them went bust all at once access to credit for the economy at large would be unperturbed.

That said, defaults on loans are not the only way for corporate debt to upset the financial system. Take investment-grade corporate bonds. In 2012 about 40% of them, by value, were just one notch above junk status. Now around 50% are. Should these bonds be downgraded to junk—thus becoming “fallen angels”, in the parlance of debt markets—some investors, such as insurance firms, would be required by their mandates to dump them. One study from 2011 found that downgraded bonds which undergo such fire sales suffer median abnormal losses of almost 9% over the subsequent five weeks.

Another possible source of instability comes from retail investors, who have piled into corporate debt in the decade since the crisis. Mutual funds have more than doubled the amount they have invested in corporate debt in that time, according to the Fed. The $2trn of corporate debt which they own is thought to include around 10% of outstanding corporate bonds; the IMF estimates that they own about a fifth of all leveraged loans. Exchange-traded funds (ETFs), which are similar in some respects to mutual funds but traded on stock exchanges, own a small but rapidly growing share of the high-yield bond market.

In both sorts of fund investors are promised quick access to their money. And although investments in mutual funds are backed by assets, investors who know that the funds often pay departing investors out of their cash holdings have a destabilising incentive to be the first out of the door in a downturn. Some regulators fear that if ructions in the corporate-debt market spooked retail investors into sudden flight from these funds, the widespread need to sell off assets in relatively illiquid markets would force down prices, further tightening credit conditions. There is also a worry among some experts that the way in which middlemen, mostly banks, seek to profit from small differences in prices between ETFs and the securities underlying them could go haywire in a crisis.

Neither a widespread plummeting of angels nor a rush to the exit by investors would come out of nowhere. The system would only be tested if it began to look as if more corporate debt was likely to turn sour. There are two obvious threats which might bring that about: falling profit margins and rising interest rates.

Wipe that tear away

Until recently, interest rates looked like the bigger worry. One of the reasons markets sagged in late 2018 was that the Fed was expected to continue increasing rates steadily in 2019. Credit spreads—the difference between what corporations and the government must pay to borrow—rose to their highest since late 2016. Leveraged loans saw their largest quarterly drop in value since 2011 and a lot of money was pulled out of mutual funds which had invested in them. By December new issuance had ground to a halt.

But in January Mr Powell signalled that the central bank would put further rate rises on hold, and worries about indebtedness faded. Stocks recovered; credit spreads began falling, leveraged loans rallied strongly. In February CLO issuance exceeded its 12-month average, according to LCD. It no longer looks as if high interest rates will choke the supply of corporate credit in the near future.

The more significant threat is now falling profit margins. Corporate-tax cuts helped the earnings per share of S&P 500 firms grow by a bumper 22% in 2018. But this year profits are threatened by a combination of wages that are growing more quickly and a world economy that is growing more slowly. Profit forecasts have tumbled throughout the first quarter; many investors worry that margins have peaked. Should the world economy continue to deteriorate, the picture will get still worse as America’s fiscal stimulus wears off. The most indebted businesses will begin to run into trouble.

If the same growth in wages that squeezes profits leads the Fed to finally raise rates while the market is falling, the resulting economic squeeze would compress profit margins just as the cost of servicing debt rose. A wave of downgrades to junk status would spark a corporate-bond sell-off. The junior tranches of CLO debt would run into trouble; retail investors would yank their money from funds exposed to leveraged loans and corporate bonds. Bankruptcies would rise. Investment would drop, and so would the number of new jobs.

That worst-case scenario remains mild compared with the havoc wrought by CDOs a little over a decade ago. But it illustrates the fragilities that have been created by the credit boom, and that America could soon once again face a debt-driven turn in the business cycle that is home grown.

After all, though the current rise in corporate debt is not in itself a likely cause for a coming crash, the past suggests that it is an indicator both that a recession is on its way and of the damage it may do. Credit spreads have in general been shrinking, a quiet before the storm which tends to presage recession, though the link is far from certain. And recessions that come after borrowing rates have shot up tend to be worsened by that fact, perhaps because when people are lending a lot more they are, more or less by definition, being less choosy. In 2017 economists at the Bank of England studied 130 downturns in 26 advanced economies since the 1970s, and found that those immediately preceded by rapid private credit growth were both deeper and longer. That does not prove that the growth in purely corporate debt will be as damaging. But it is worth thinking on.

Will the US Capitulate to China?

The most important problem that a bilateral deal between the United States and China needs to resolve is Chinese theft of US firms’ technology. Unless the Chinese agree to stop stealing technology, and the two sides devise a way to enforce that agreement, the US will not have achieved anything useful from Trump's tariffs.

Martin Feldstein

us china trade negotiations

CAMBRIDGE – It’s beginning to look like US President Donald Trump will yield to the Chinese in America’s trade conflict with China. The United States threatened to increase tariffs on imports from China from 10% to 25% on March 2 if no agreement was reached. But Trump recently said that the date is flexible and may be postponed because of the progress being made in the ongoing bilateral talks.

Fair enough, but progress is in the eyes of the beholder. The most important problem that needs to be resolved is not America’s massive bilateral trade deficit with China. It is that the Chinese are stealing US firms’ technology and using it to help Chinese companies compete with those same firms in China and around the world.

The Chinese do this in two ways. First, US firms that want to do business in China are required to have a Chinese partner and to share their technology with that firm. That compulsory sharing of technology is explicitly forbidden by World Trade Organization rules. Since joining the WTO in 2001, the Chinese have ignored this rule and disingenuously claim that US firms voluntarily agree to share their technology because they want to be active in China.

Second, the Chinese use the Internet to enter the computer systems of US firms and steal technology and blueprints. Chinese President Xi Jinping agreed with then-President Barack Obama in 2015 that his government would stop doing this. But, after a temporary decline, such cyber theft has resumed, presumably because state-owned companies and others have the ability to reach into the computer systems of US firms.

Despite Trump’s upbeat talk about progress in the talks, there is no suggestion that the Chinese will agree to stop stealing technology. Instead, China’s chief negotiator, Vice Premier Liu He, has emphasized that the Chinese will reduce their large bilateral trade surplus by buying US soy beans and natural gas. A sharp reduction in the US trade deficit with China would enable Trump to claim victory and give him something to celebrate when Xi visits him at his home in Florida sometime in the next few months.

There are easy bragging rights in a dramatic reduction of the US trade deficit with China, which, year after year, has been the largest of America’s bilateral trade deficits. In 2017, the deficit with China was $375 billion, or two-thirds of the total US trade deficit. So the Chinese are clever to offer to buy enough US commodities to cut that very visible imbalance.

But while that would reduce the bilateral trade deficit with China, it would have no effect by itself on the total US trade deficit. As every student of economics knows, a trade deficit reflects the fact that a country chooses to consume more than it produces. And as long as a country consumes more than it produces, it must import the difference from the rest of the world.

If the Chinese do buy enough to reduce the bilateral trade deficit, the US would end up importing more from other countries or exporting less to other countries. The total US trade deficit will not decline unless the US reduces total demand by saving more. That is a matter for US policymakers; it is not something the Chinese can do for America.

US Treasury Secretary Steven Mnuchin has emphasized another largely irrelevant Chinese offer: a promise to prevent the value of the renminbi from declining relative to the dollar. While a stronger renminbi would make Chinese goods less attractive to US buyers, thereby reducing the bilateral trade deficit, it would not reduce America’s global trade imbalance.

Moreover, although the renminbi-dollar exchange rate does vary from year to year, the variations have been small. Today, a dollar buys CN¥6.7; a year ago, the dollar exchange rate was CN¥6.3, and two years ago it was CN¥6.9. A decade ago, in February 2009, a dollar bought CN¥6.8. In short, there is nothing to celebrate if the Chinese agree to stabilize the value of their currency relative to the dollar.

The key issue is technology theft. Unless the Chinese agree to stop stealing technology, and the two sides devise a way to enforce that agreement, the US will not have achieved anything useful from Trump’s tariffs.

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

Reform the credit default swap market to rein in abuses

Windstream’s fight with Aurelius highlights complexities of ‘empty creditors’

Henry Hu

US securities regulators have called for a clean-up but need not wait for industry-wide changes. There are concrete steps individual companies, investors and judges can take to address the problem © Bloomberg

Credit default swaps are the banking equivalent of home insurance. Much as property owners buy coverage for fire and other disasters, banks, bondholders and other creditors purchase CDS protection against losses in case a corporate borrower runs into trouble.

But this valuable financial innovation is susceptible to opaque gaming and counterintuitive incentives. We badly need reforms, as was underscored when Aurelius Capital Management scored a court victory that may push telecoms company Windstream into bankruptcy.

When creditors are faced with an overstretched borrower, they often choose to work with them. They may waive breaches of contract or agree to out of court restructurings because they ultimately want the debt repaid.

But the CDS market has created a category of investors, which I dubbed “empty creditors” in 2007. In extreme cases, they stand to make more money on CDS if a company defaults than they would if it repaid its debts. These “net short” creditors are motivated to grease the skids to insolvency, even when bankruptcy makes no sense.

In the Windstream case, Aurelius owns some of the Arkansas-based company’s bonds, but it is widely believed to have a far larger investment in Windstream CDS. In September 2017, the hedge fund sent a formal notice to Windstream complaining that the telecoms group had breached a provision of a debt contract two years earlier — something no other creditor had complained of.

Windstream warned that if this breach counted as a default, it might have to declare bankruptcy. Aurelius pressed ahead. A judge, unpersuaded by the CDS issue, found for Aurelius on all counts. He ordered Windstream to pay a $310m judgment. The company’s share price fell by nearly two-thirds.

The case highlights another problem: CDS positions do not have to be disclosed. Debtor companies and investors must guess whether a net short creditor might be lurking.

The CDS market is also plagued by other gaming. In 2017, homebuilder Hovnanian agreed to intentionally default on an interest payment as part of a deal with Blackstone’s GSO arm, which had bought CDS protection on the company. GSO helped Hovnanian refinance up to $320m of its debt at a favourable interest rate in return for a missed payment that would have triggered a payout on the CDS. After a CDS seller sued, the manufactured default was called off.

US securities regulators have called for a clean-up, but we do not have to wait for regulatory changes or industry-wide changes. There are concrete steps individual companies, investors and judges can take to address this problem.

Publicity would help. As soon as a troubled company has a reasonable basis for believing that some of its creditors are motivated by their outsized CDS holdings, management should say so and present evidence for the claim.

Loan agreements and bond indentures could limit the rights of net short creditors, since they are motivated to cause firms to default. Limiting their ability to do so could benefit companies, normal creditors, shareholders, third parties such as CDS sellers, and overall market efficiency.

Judges can also rein in net short creditors, as they have started to do with shareholders. Net short shareholders benefit from falling share prices because their short positions outweigh their equity holdings. These “empty voters” with negative economic exposure have incentives to use their rights to destroy value, by, for example, voting to elect Mr Bean to the board.

In 2012, the hedge fund Mason Capital sought to block Canadian telecoms group Telus’s planned recapitalisation. Based partly on my affidavit, a judge in British Columbia found that Mason Capital’s likely status as an empty voter was relevant to considering its opposition. The court approved the Telus plan.

A judge faced with an empty creditor with negative economic exposure should consider doing the same. The world is already economically uncertain. There is no reason to allow CDS gaming and extreme empty creditors to make it more so.

The writer teaches at the University of Texas Law School and has written about the role of CDS in role of CDS in corporate defaults

A transatlantic front opens in the Brexit battle over derivatives

Britain is caught in the middle of a regulatory tussle between the US and the EU

Gillian Tett

A view of Bank underground station in view of the Bank of England. Splitting up the clearing business would be very costly for financial players, as Mark Carney, central bank governor, has pointed out © Bloomberg

Another week, another round of baffling Brexit political farce. But if you want a different perspective on these dramas, ponder a topic that (almost) no British politician ever bothers to discuss: the state of London’s gigantic derivatives market after leaving the EU.

For while this topic is arcane, it matters deeply — not just because derivatives have financial stability implications, but also because the issue is sparking some extraordinary behind-the-scenes battles, now with transatlantic consequences.

The issue at stake revolves around the clearing of derivatives trades. In recent years, the London Clearing House has dominated the swaps and futures sector, regularly clearing more than $3tn of trades each day, of which a quarter are euro-denominated and almost half in dollars.

Continental European politicians have always hated the fact that so much euro business sat in London. But they tolerated this because the UK was in the EU. And while American regulators were also uneasy about so much of the dollar market sitting outside their shores, they accepted it because the UK authorities gave the Commodity Futures Trading Commission sufficient oversight of the LCH dollar business.

No longer: European politicians have declared that if LCH wants to clear euros when (or if) Brexit occurs, that business must either move to continental Europe, or be regulated by the European Securities and Markets Authority, the Paris-based entity.

In one sense, that is no surprise. And what has come as a relief for the City — and banks — is that Esma declared last month that it will let London’s clearing houses perform these functions, even after a hard Brexit, as long as they accept Esma rules. This matters since splitting up the clearing business would be very costly for financial players, as Mark Carney, Bank of England governor, pointed out last month.

However, there is a trillion-dollar catch that sits completely outside the British parliament’s control: the US. The CFTC has told Europe that it will not accept Esma controlling London’s swaps business insofar as it impinges on dollar markets and US banks.

This is partly about national pride. But there is an ideological battle, too. British and US regulators tend to trust market forces, and believe private sector entities should be free to decide how much collateral market participants must post against trades, to cope with default risks. “We have almost two decades’ worth of experience working with the Bank of England and we rarely have any dust-up,” says Christopher Giancarlo, CFTC commissioner.

European regulators, however, do not like the idea of the market alone deciding when to demand more collateral for a transaction in a financial crisis. That is because during the 2011 euro crisis entities such as LCH (and others) imposed such “margin calls” on Spanish and Italian assets — European officials blame this for the dramas (never mind that this was admirably prudent risk management).

The net result, then, is that European regulators and politicians want to impose more intrusive controls. “We need to have a clear legal competence that, importantly, should cover both EU and third-country CCPs [central counterparties],” Benoît Coeuré, a member of the board of the European Central Bank, recently observed.

However, the Americans vehemently oppose this. And last autumn Mr Giancarlo warned — in an astonishingly tough speech — that if Esma meddles too much with the LCH dollar business, the Americans will consider “a range of readily available steps to protect US markets and market participants”. Privately, some US officials suggest this could include kicking European participants out of the Chicago Mercantile Exchange. Yes, really. This is very alarming stuff.

Is there a solution? Not obviously. Right now the protagonists are playing nice(ish) in public. After the EU recently outlined a broad political framework for handling European clearing, it promised to turn this into tangible rules by 2021. The CFTC and Brussels announced that the CFTC will take part in these preparations.

But the real battle is probably delayed, not resolved. Until the EU unveils its rules in 2021, it is unclear how far LCH will adhere to Esma’s principles for clearing when (or if) Brexit actually occurs. This uncertainty is not visible when markets are calm. It would be, however, if another crisis hits — and the volume of margin calls increases.

In the meantime, investors should draw two lessons from this saga. First, it shows the degree to which Brexit is not just a cross-channel affair — the fiendish logistics in finance affect transatlantic ties too. Second, it reveals London’s political weakness. The participants notably unable to throw their weight about in this drama are the British regulators. What happens next will be decided by the ideological and territorial fight between Washington and Brussels. So much for “taking back control”.

Putin, Khrushchev and the Lessons of the Cuban Missile Crisis

Putin has invoked the crisis to revive the perception of Russia as a superpower.

By George Friedman


In October 1964, Leonid Brezhnev, Alexei Kosygin and Nikolai Podgorny removed Soviet leader Nikita Khrushchev from office, supposedly because of Khrushchev’s “harebrained schemes.” Most have assumed that this referred to Khrushchev’s plan to turn Siberia into an agricultural heartland, but I have always believed it actually referred to his attempt to slip missiles into Cuba. Given how that plan ended, it would be a logical fit. It is therefore fascinating that Russian President Vladimir Putin announced last week that he’s ready for another Cuban missile crisis if the United States decides to deploy medium-range missiles in Europe. Given his comments, it’s important that we understand how the crisis unfolded and its relevance, if any, to what’s happening today.

During the 1960 presidential election, John F. Kennedy sought to discredit the Eisenhower administration by claiming that the Soviet Union’s missile capabilities exceeded those of the United States. The claim was a lie; the U.S. had a substantial lead in deployed missiles and was rapidly deploying nuclear submarines. The U.S. also had an enormous advantage in strategic bombers; the Soviets had only a small number of Bear strategic bombers, which were far inferior to the American B-52s.

Indeed, the U.S. would have an overwhelming advantage in a nuclear exchange. That, combined with its satellite imagery capabilities, meant the U.S. could theoretically launch a first strike on the Soviet Union’s relatively small missile force and render it useless. Theory and practice are very different things. Still, in the Soviets’ worst-case scenario, the U.S. might launch such an attack and force a Soviet surrender. The Soviet intercontinental ballistic missile capability was limited, and the Soviets needed an interim weapon that could guarantee a counterstrike against the U.S. regardless of how successful a U.S. first strike would be. The solution was to put intermediate-range nuclear weapons within range of the United States, and the only possible location was Cuba.

The whole strategy rested on smuggling the missiles in and making them operable before the U.S. could detect them. It was in many ways a harebrained scheme because not only was detection possible but the U.S. response was utterly unpredictable. The U.S. might determine that other installations existed and launch a sudden and powerful attack to destroy them. Moreover, the need for this deterrent was dubious. True, the U.S. had a strategic advantage over the Soviets, but using it in a first strike would be an enormous risk. Given the Bay of Pigs fiasco, Kennedy didn’t have much confidence in U.S. intelligence, and certainly not enough to bet the house on a first strike.

Robert F. Kennedy and others have portrayed the crisis as a showdown between two equal powers that was managed with diplomatic brilliance to avoid a disastrous end. However, transcripts of meetings held by the Executive Committee of the National Security Council, which advised John F. Kennedy during the crisis, tell a very different story (see Sheldon Stern’s “The Cuban Missile Crisis in American Memory” for more details). Certainly, it was a serious episode, but it did not put humanity in danger of nuclear annihilation.

In terms of the nuclear balance, the Soviets had a very weak hand. That’s why they tried to slip missiles into Cuba. The U.S. was running heel-and-toe surveillance on Cuba so the chances of the missiles not being detected by U-2s or human intelligence were low. Once detected, Khrushchev had to back down for the same reason he tried the maneuver in the first place: The Soviets were weak.

The Kennedy narrative of the crisis was that Khrushchev capitulated just before a U.S. invasion. In reality, both sides understood that, unless Khrushchev was nuts, the game was over the minute Kennedy announced the blockade of Cuba following the discovery of Soviet missiles. Indeed, Khrushchev did back down in return for a clever offer to withdraw obsolete U.S. missiles from Turkey and Italy (though the offer was only revealed at a later date). The fact was that Khrushchev had no choice but to capitulate.

Few have acknowledged, however, that Khrushchev won a huge point in his handling of the crisis. For the heroic narrative of the Kennedy brothers to work, they could not admit the truth – that U.S. nuclear capabilities far exceeded those of the Soviet Union. The Soviet Union had to be treated as a peer with enormous strength that was compelled to back down not by superior force but by the skills of the negotiators. If they acknowledged that there was no missile gap, and that the Soviets could not match U.S. nuclear power, then the crisis would no longer be seen as a stunning moment in history.

The Kennedy administration needed the heroic tale and therefore had to give something of extraordinary value to Khrushchev: the myth that the Soviet Union could stand toe to toe with the United States on nuclear capabilities. (The Soviets would become peers to the U.S. later on, but they were not in the 1960s.) The Soviets wanted this acknowledgment for three reasons. First, the American public would force caution on U.S. politicians. Second, other powers, especially those in Europe, would question the reliability of the U.S. security umbrella. Third, the Soviet public, enthralled by Sputnik and Yuri Gagarin, would believe they were witnessing another Soviet triumph. Yes, the Soviets conceded, but they could write that off as simple prudence. Every self-congratulatory memoir written by in the U.S. about the crisis reinforced the notion that the Soviet Union was a nuclear peer. Obviously, no one in his right might would risk nuclear annihilation over such trivia, but then no one actually did.


I do not know if this is what Khrushchev intended or if it was the result of unexpected political needs in the U.S., but I suspect the latter. Khrushchev likely wasn’t clever enough to have planned this scenario the way it played out. But regardless, Kennedy kept the missile gap story in place and conceded equality to the Soviets.

Which brings me to Putin’s recent comments on the Cuban missile crisis. At the moment, Russia is in no way a military challenge to the United States. Any U.S. medium-range missiles stationed in Europe would be meant as a deterrent or possibly used in case of a Russian incursion into Ukraine. It’s unlikely tensions there would escalate to the use of nuclear weapons. And that’s what makes it so attractive to Putin. Putin wants a showdown with the U.S. because it could end with the U.S. treating Russia as a dangerous peer and U.S. allies increasing their importance by maximizing the Russian risk. At a time when your own hand is weak, having your opponent declare you dangerous and powerful is a huge gift. The Soviets received this gift once before. Putin, faced with economic problems at home, a lackluster performance in Ukraine and a growing force to Russia’s west, may be looking to receive it again.

Khrushchev didn’t fully understand the game. But Putin does. He must take the world to an imaginary nuclear brink that will force a negotiation, if in nothing but appearance. The world will breathe a sigh of relief when it ends. And every deputy at the U.S. National Security Council will dine out for the rest of their life on how close the U.S. came to the abyss and how brilliantly the U.S. worked to avoid war with a fearsome superpower. And with that, the thing Putin has always decried, the geopolitical disaster of 1991, can be reversed. But considering that Khrushchev was ousted for such harebrained schemes, the downside could be political oblivion.