FOOL ON THE HILL
An Investment Opinion
The Death-Spiral of Private Debt Bill Mann (TMF Otter)
January 21, 2000
This week's issue of The Economist brought an absolutely galling statistic to my attention about the expansion of American corporate and personal debt. As I have postulated previously, a rapid increase in the debt load taken on by households may be the single most dangerous threat to the health of the equities market and our economy.
Debt levels should represent an economy's efficiency in deploying the excess savings of some to those who need to borrow. In times of rapid economic expansion, debt levels are likely to increase in concert with the belief that the rate of future growth in income will increase. In down times, companies look to retire debt, as they are no longer so assured of future growth. In other words, on a corporate basis, a slight rise in levels of debt can be a sign of stability and perceived potential for future growth.
So it should be a really good sign that American corporations (non-financials) have added more than $900 billion of debt in the last two years. And it also should be a good thing that households are in debt on average 103% of personal income. But this all depends on how this debt is deployed, and how it is secured.
For example, the Economist mentions that of the additional $900 billion that has been added in corporate debt, a net of $460 billion has been used to retire equity. This is not the proper use of debt, as it adds no working capital to the company. It's just debt that the company has taken on in order to do something that makes the shareholders feel good. An even worse use would be if a company takes on debt to retire shares in order to balance out its options. In doing so, a company is effectively borrowing from the future to meet current benefit obligations. Not good long-term fiscal management.
But hey, times are great now, right? If we compare the level of debt-to-equity ratios for American companies, they have dropped significantly over the last decade, now to an all time low of 0.35, according to the Federal Reserve. But this misses the simple fact that although debt is a fixed amount, asset value is not. This means that the propriety of using this number means making an assumption that equity is at a reasonable level. And that is the million -- no, the $900 billion dollar question.
It is pretty unlikely that an unhealthy level of debt will cause an economic downturn, but it can make a severe decrease in equity value much more dangerous to the economy, even for households with a much lower debt level. For example, the Federal Reserve estimates that the level of margin debt (debt loaned by brokerages to investors to buy securities) in the U.S. has tripled in the last three years. Fortunately, in this time span there has not been a protracted market downturn serious enough to cause huge numbers of margin calls. Instead, the long-lasting bull market and the Fed's apparent defeat of inflation have given people confidence that the economic boom will go unabated forever. In such an event, borrowed money at current interest rates would in fact be extremely cheap. But should interest rates rise, should asset prices decline, or should the overall economy decline, this cheap capital could become much more expensive, not only to those who hold the debt, but to everyone operating within the same economy.
Think about it for a minute. In 1929, fewer than 4% of all Americans owned stocks. But the market crash and the ensuing Depression affected the whole economy, not just those participating in the equity markets. It was the level of debt, and the severe decrease in securitization that wreaked havoc on the economy.
This is the reason why people are afraid of a "bubble," not so much because people are afraid that Yahoo! (Nasdaq: YHOO), for example, would drop 50%, but that such a drop in enough companies would cause additional equity to be removed from the market, thus a domino effect. It's not just the depression and the panic, it is the forced selling by those who have borrowed too much. And although you may have been careful about taking on additional debt, particularly margin debt, let me paint a picture as to how you would be affected as well.
Let's just say that the total margin level is currently at 10% of the total value of shares held by individual investors. This means that each $1 of margin debt is secured by $10 in assets. These margins are fixed, they do not slide up and down with the level of equities. In the event of a 30% devaluation of those assets, each $1 would be secured by only $7 in assets. At some level, the amount of risk to the entities holding the note for these margin loans will exceed its marginal propensity to maintain the loan without additional securitization. And so they make a margin call, which means that the individual investors must at that moment either choose to sell the margined security or to put up sufficient cash to meet the creditor's security requirement.
This situation, of course, happens all the time -- either a private individual or a corporation has some debt that is written against the value of an asset, the asset decreases in value, thus the creditor requests additional assets.
This is dangerous in a situation where too many people have too much debt. And again, it may be counterintuitive, but the time when people and corporations take on the most debt is normally when times are best. It is the so-called "wealth factor," when people are convinced that they have enough money to buy a luxury car, buy a larger house, and take loans against the value of their portfolios. This increased propensity to borrow comes at a cost when conditions worsen, because when a downturn comes, only the assets lose value -- the debt remains constant.
So let's get back to the scenario -- the average stock has dropped 30% in value, and as a result a wave of creditors make margin calls. Margin calls have the effect of creating more downward pressure on a stock, because a certain subset of people liquidate rather than add more money. More shares for sale, lower demand, lower prices. If this happens at a time when there is soft buying interest, the vicious cycle can collapse upon itself, turning a market downturn into a long-sustained rout.
This is just a "what if" -- it may not happen. But the belief that an economic boom can go on forever is pretty aggressive. If we borrow at a level with the assumption that it will, we open ourselves up to an incredible risk that the fall from grace will be spectacular, painful, and harder to extract ourselves from.
In the end, the level of debt spending that other people engage in is ultimately your concern as well. Investors looking to leverage their stock market gains who are unprepared to pay the consequences of bad timing, bad decisions, or both, put not only their own capital at risk, but yours as well.
Fool on, and Fool off margin!
Bill Mann, TMFOtter on the boards
The Anatomy of a Bubble, Fool on the Hill 12/15/99