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Monday, 7 October 2013

The corrosiveness of debt (and how we got into our current global predicament)

Debt can be a useful tool.  But it can also be corrosive.  So corrosive, in fact, that it can destroy hope, prosperity and, ultimately, even lives.

Debt is defined on Wikipedia as an obligation owed by one party (the debtor) to a second party (the creditor); usually this refers to assets granted by the creditor to the debtor.  In order words, someone lends you money (among other things) and you are expected to pay back this money, with interest included.

Debt comes in many forms, some ‘acceptable’, others less so.   A mortgage, secured by a property and a person(s) is a commonly accepted form of debt that has enables millions to ‘own’ a home (note – you truly only own the home when the mortgage is repaid…).  The traditional mortgage is relatively low cost (secured against the underlying property) and is, most times, a reasonable exchange between debtor and creditor. 

In the world of corporate finance, bank loans and bonds are secured against corporate assets and/or cash flows and, in the case of project finance, secured against a project’s cash flows and the equity capital of a sponsor.  These forms of debt are useful in a capitalistic society as they enable companies to leverage their activities with more capital than they would otherwise have at their disposal – and they do so by promising a portion of future value in some way, shape or form to repay the debt in the future.  But it’s a fair trade.

Prior to the year 2008 (perhaps even by 2006-07, when signs of over-indebtedness began to appear), debt was generally a useful - and non-manipulated - tool for capitalists to fund growth.  Yes its use increases financial risk of a company but, used prudently, it can be an effective lever to growth.  Even in the junk bond era in the late 1980s, when companies of dubious standing were able to raise a lot of debt in the high-yield bond markets, most of the resulting losses that occurred were suffered by sophisticated investors.  They knew the risks they were taking when they bought the junk bonds and if they lost money, well, that’s how a functioning capitalistic system should work.

Whereas the corporate sector maintained some semblance of reason leading up to the current debt crisis, unscrupulous mortgage brokers, borrowers, commercial & investment banks, federal agencies all worked in concert to effectively & completely “screw the pooch” at the retail level (excuse the American idiomatic phrase as I realize I have many non-American readers – it means that these actors have has made it difficult for the rest of us). 

This has, in turn, caused this New Recession that we still find ourselves in, 5 years later, after the start of the debt crisis.  I wouldn’t call our current predicament a depression….yet.  We seemed to have dodged this particular bullet with extremely loose monetary policy (think a lot of very low cost credit from institutions like the US Federal Reserve and the European Central Bank).  The level of societal debt has increased, dramatically, since 2008, as hundreds of billions of dollars in bad loans were covered by governments around the world (and, ultimately, tax paying citizens like you and I).  Look around you – do you think we’re in a better situation now that we were pre 2008?  I think not.

As many others have written about, this housing crisis was caused by a dishonest alliance of people who couldn’t afford loans; brokers who only wanted that upfront transaction fee; lenders who didn’t do the required due diligence because they didn’t intend to keep the loans on their balance sheet; the investment banks on Wall Street who took said loans, packaged them into CDOs (i.e., collateralized debt obligations – a fancy way to say a lot of loans jammed into an investment portfolio), and… stuffed them to stupid investors.  I should say there were also various enablers involved – think credit agencies like Moody’s, S&P, etc – who rubber stamped these CDOs, indicating they were solid investments.  In fact, most were a giant piles of sh!t…And we, as a global society, are still paying the price. 

So, this was (is?) clearly bad debt.  The original borrower had no capability to repay it (possibly even no intention of repaying it), brokers collected their fee and moved on, not caring about the loan’s performance, the lending banks also didn’t care as it sold this ‘asset’ into CDOs, the investment banks collected their fee as they found, with the credit agencies help, the sucker at the end of the line who thought they were buying a quality, yielding investment.  A dishonest alliance.

However, this only tells half the story of our current debt predicament.  As mentioned earlier, various governments around the world helped bail out the banks to restore solvency – leaving you and I to ultimately pay for others’ bad judgment & dishonesty.  And we’ll still be paying this bill for a generation (or more).  But what is this only half of the story?  Ironically, the damage of debt continues afoot in two other areas where debt, on the one hand, should be used a tool of flexibility, and on the other to benefit society at a macro-level.  Rather, corrosion has set in and may derail the United States (note – each of the two have much less impact in other parts of the world; so there is that).  I’ll address these forms of debt in my next blog entry.

One final point to make today:  you may ask yourself, why is, a website that aims to help young and novice investors get on the road to financial independence via simple & proven investment strategies, discussing problems with debt?  Simple.  If you have too much debt – of any kind – you must eliminate it before you can turn to investing.  If you don’t, you are merely taking capital from one pocket & shifting it to the other – BUT, you are taking all of the investment risk while “between pockets”.  What I mean by this is that you would be taking 100% of the risk that you can earn more from your investments than the cost of your debt.  And you probably cannot do this long term.  Warren Buffet can – and he has.  But you’re not Buffet.  Check out Finding the $ on to see what I mean.