Editor's note: Each day it seems that we see a new report of consumers gaining confidence and spending more. This would be wonderful, but for one thing: American consumers are already leveraged to the hilt. In September 2000, Bill Mann penned this classic Fool article detailing how rising corporate debt levels threatened continued economic growth. He picked on an industry that many predicted at the time would continue to grow apace: telecommunications. Some of the facts have changed, but the message is still very, very real: spending money you don't have is a long-term plan that is destined to fail.
OK, I don't know when the good times come to a stop, but I know HOW they do. I'm spending some time running through the Annual Report (pdf file) of the Office of the Comptroller of the Currency (mercifully abbreviated as OCC) on the lending practices of the largest American banks. Simply put, in spite of the tightened Federal interest rates, the quality of the corporate and personal debt portfolios, according to the findings of the OCC, has grossly deteriorated. On the commercial side, $100 billion in commercial debt, out of $1.9 trillion, is now considered "troubled."
So we're all here deep in thought about what implications the Intel
It's the debt, stupid. What's going to happen is that some company, or a slate of companies -- not even big ones -- are going to default on their debt obligations to banks and vendors, pulling down a huge house of cards that has been built on the fact that we as a nation are overleveraged. We don't need some big event, just some little Thailand-ish company to fall, leaving an overextended creditor or two in the lurch.
Now, you might be thinking, "Well, $100 billion in troubled business loans, that's not that high." After all, General Electric
The survey only encompassed banks. It did not even consider vendor financing, which adds significant additional leverage. Some of the largest companies also provide significant financing to their corporate customers: GE, Intel, Lucent
Don't think it can happen? Every single recession in this century has had at its roots the tendency of people and companies to leverage themselves too heavily. In 1929, it was margin debt; in the 1980s, it was a slew of bad real estate and commercial loans; in 1997, it was the Thai Baht that triggered a global economic crisis. If the economy slows down quickly, the number and value of troubled loans could dramatically increase, with more of them falling from "troubled" to "defaulted."
This pattern repeats itself over and over in financial history. Late in the 19th century, the U.S. came within a day of having its government default on its obligations. At the time, we were considered the "emerging market" of choice for European investors. Our growth was backed largely by their gold, which was held here on the perceived safety of the strength of the U.S. dollar. Europeans, who believed (credibly, as it turned out) that there were powerful forces in the U.S. who were willing to devalue the dollar by printing more of them, reacted by transferring their gold deposits out of the United States. In a four-year period, the U.S. currency went from being backed by gold reserves of $3 billion to less than $9 million.
Our currency is no longer tied to a gold standard, but commercial and personal obligations must still be backed by something. If that something moves just a little bit, our economy's tanks are going to be stirred, but good. And if the OCC report is a good indication. Our banks are currently at the equivalent of the eighth go-round in Twister -- a left hand green is all that is needed to cause disaster.
Why are we at this point? Some members of the OCC believe that earnings pressure on banks is highly complicit. Investors have grown to expect consistent earnings growth and quarterly improvements in loan book size and profitability. But there is really a fixed amount of gilt-edged debt out there, so the banks are forced to soften their creditworthiness standards to increase their books, both to commercial and individual borrowers. The OCC points at the aggressive marketing for home equity loans by banks as one such result. And these loans are increasingly being taken on not for capital projects such as home additions or education, but for regular spending needs.
As such, we have a situation where large swaths of the commercial and individual debtholders are overleveraged. In the past, consumer loans were thought to be a good hedge against commercial downturns, since the banks could loosen consumer debt standards to weather short-term problems on the commercial side. But not now. Banks have no place to go but to write more risky loans. And with mortgage debt now taking up a full 77% of total consumer debt, in an economic slowdown, that last source of cash for many will not be available.
This is all to say that you should be very, very careful. Debt implosions come very quickly, as a few defaults at overextended institutions can expand very quickly. The only direct tool the government has, interest rates, takes considerable time to flow through to make a difference in the overall loan mix. The bully pulpit, which Alan Greenspan has used to some success, helps, but when banks bow to investor pressure and sacrifice long-term fiscal prudence for short-term growth, then we're dancing with fire.
I even see a Thailand out there: the Competitive Local Exchange Carriers, which have seen massive lowering of their credit ratings, a fire sale in Intermedia Communications
The point is not to scare, but rather to say that credit and economic factors go in cycles. The best offense is a good defense. We cannot foresee when the economy will take a downturn -- we only know that it will, eventually, and that it will be caused by macro-scale factors far outside of any of our individual controls. But on the same token, those who spend lavishly using borrowed money during the high times are going to be at greatest risk during the low times. We see this now even, as dot-com companies that blew through their capital during times of seemingly limitless access to capital are scrambling to stay afloat now that their sugar daddies have cut them off.
Be very careful out there, dear Fool. Because, just as only you can prevent forest fires, only you can prevent a credit crunch. How 'bout keeping that credit card holstered -- as a service not only to yourself, but to us all.
Fiat Fool!
Bill Mann, TMFOtter on the Fool Discussion Boards
This article was originally published on September 22, 2000.
