In a recent article I highlighted how the quality of debt issued is declining whilst the quantity of debt outstanding is increasing. (Is a Debt Bonfire Building? http://www.narrowroadcapital.com/memos/debt-bonfire-building-issues-quality-quantity-debt-outstanding/) This trend is consistent across many sectors and countries. Across the US, Europe and Japan economic growth is almost non-existent. Ultra-easy monetary policy has failed to restore growth to the 3-4% levels previously thought to be normal for developed countries. The concern is not just that lower interest rates, more debt and larger deficits are not working, but that growing levels of public and private debt limit the capacity of governments to provide additional stimulus if conditions worsen. Governments and investors have failed to correctly diagnose the symptoms and therefore the wrong medicine is being prescribed. The correct diagnosis is that the world has long been addicted to debt, and that the treatment should therefore be less debt and not more.
The idea of the world being addicted to debt may seem far-fetched at first reading. But like the frog in boiling water, the use and abuse of debt has become part of our daily lives such that we no longer see it as anything to be concerned about. Television and internet sites are plastered with advertisements for short term loans, mortgage brokers, home loans, business loans, credit cards, car financing and retailers offering interest free periods. Credit cards are available to many as soon as they get their first adult job, and for some university students a small credit limit can be obtained solely based on the degree they are studying. Many university students finish with substantial debts, whether it is in the form of HECS in Australia or more punitive student loans in the US. Car buyers are offered financing as a standard part of purchasing (do you want debt with that?) with financial institutions and car manufacturers competing to lend money. Many of the major rites of passage upon reaching adulthood often involve debt.
Whilst some might call it quaint, the experience of many baby boomers in obtaining their first home loan is very different from today. Dressing up in their best clothes, having a strong record of budgeting and saving, and being able to contribute at least 20% of the purchase price (plus costs) was needed to impress the bank manager and obtain a loan. Home loans were rationed and potential borrowers had to prove to a credit focussed person that they were a low risk. Today home loans are cheap and freely available, and sold by commission incentivised sales people who encourage potential borrowers to take on as much debt as the loan calculator says they can. If someone can’t meet the fairly relaxed requirements of a bank, lenders mortgage insurance or non-conforming lenders can probably help.
It’s not just corporations and popular culture pushing the more debt bandwagon. Barack Obama has stated that increasing lending to small and medium sized business is the way to get the US economy going again. Anti-austerity economists are quick to say that the slow recoveries experienced in many developed economies have been due to deficits being too small. Politicians the world over now seem to be allergic to the idea that governments should have balanced budgets during their time in office. Special interest groups seem to be louder than ever with every vested interest arguing they should be exempt from spending cuts. The idea that the developed world may have squandered a period of prosperity and ended up with a substantial debt burden is simply not considered. That apparently only happens to developing nations, even though Greece and Japan are clearly showing otherwise.
It is not only the visible debt to be concerned about, but also the often forgotten liabilities that matter. It is now a standard part of M&A due diligence to check whether the target company has unfunded pension liabilities, but government pension obligations are subject to far less oversight. (Remember Detroit’s bankruptcy and expect pension issues in the coming decade to negatively impact many more US state and local governments.) Demographics in developed nations dictate that without major structural changes there will be more demand for government services as citizens grow older whilst the proportion of income tax paying citizens will decline. Younger generations have paid significant amounts for their university education but are finishing university with lower job prospects and often meaningful debt burdens. The demographics demand that they must work for longer and fund more of their own retirement. These generational imbalances are set to become key policy and election issues.
Diagnosing the addiction is not hard, but the treatment will be painful. Debt meets a basic human desire to have more and have it sooner, with debt allowing future spending to be brought forward to today. Balancing budgets and reducing debt means that some current and future planned spending will need to be deferred or eliminated and more revenue needs to be raised. For those who believe there must be another way – remember that debt must always be dealt with. It can be defaulted on or restructured, reduced by inflation, or repaid via increased revenues and decreased expenses, but every option is painful. There is no easy way out of debt, it will always hurt someone.
Increasingly the problems relating to debt are becoming more about government borrowing and deficits rather than the finances of companies and individuals. The growth of public sector debt and the inability of governments of almost every type and jurisdiction to routinely balance budgets adds a huge tail risk to future economic growth. The monetary and fiscal effort expended since 2008 to avert a meltdown is not capable of being repeated. On its own, Greece is possibly small enough to default again and not cause a global recession. However, if Italy or Japan default or restructure their debts there is unlikely to be enough stimulus capacity left to offset the global damage they will cause.
Hyman Minsky detailed the use of monetary and fiscal policy to balance out economic downturns caused by reductions in private sector credit. I suspect that if he were still alive he’d be screaming about the risks we face when the next downturn comes given there’s little monetary or fiscal ammunition left. How can a government be the great stabiliser when they have no capacity to borrow more because they forgot that stabilising means having a surplus and reducing government debt in normal times?
Public Sector Treatments for Debt Addiction
The three public sector treatments put forward will cause material pain in the short and medium term. This is simply a correction to the excess of the past, which must be paid for in one way or another. The focus needs to be on the long term health of economies, with a view to creating a more stable system in the future. Pragmatically though, I recognise that governments and their citizens will almost certainly choose to kick the can further down the road, being primarily concerned with short term impacts.
First Treatment – Correcting Risk Free Rates
The creation of negative real interest rates in many developed economies has enormously distorted investment markets. Without publicly acknowledging it, central banks have consciously made a decision to punish the prudent and reward the reckless by making debt too cheap and saving too costly. In Minsky’s terms, hedge lending has declined with speculative and Ponzi lending increasing due to central banks bullying investors.
The correction to this problem is simple, overnight cash rates (the best proxy for a short term risk free rate) should be set such that an investor on the top marginal tax rate can earn at least a zero real return. As a formula this is:
Setting a floor such that all investors can earn at least a break-even return on a theoretically risk free investment will remove much of the impetus for poor risk/return investing. Investors should be encouraged to take on risk by the prospect of higher returns, not bullied into taking on higher risk because safe options have negative real returns.
Second Treatment – Reforming Tax Systems
The demographic changes coming are arguably the most predictable part of the economic future. If you know what life stages people will be going through it is fairly simple to figure out what goods and services they are likely to demand and what taxes they will be paying. In light of an increasing proportion of the population aged over 65, reforming the tax system will need to be squarely focussed on one priority, increasing the incentive for people to work and earn taxable income. Tax rates for income earned on work (as opposed to income earned from investments) will therefore need to fall incentivising all capable adults to be employed in some capacity.
Decreasing income tax rates for work obviously requires that tax rates in other areas will increase. Increases in land taxes, sales taxes (GST or VAT) and capital gains taxes will be the largest offsetting items. Loopholes on tax collection, particularly for corporate and high wealth individuals will need to be eradicated.
These changes will have long term positive externalities in other economic and social areas. The correlations between unemployment and a range of social issues such as crime and mental health issues is strong. The prospect of more people being employed should result in lower levels of wider government spending beyond unemployment benefits. Increasing employment levels also creates more employment itself, as new services are demanded by both employers and employees who are now more engaged in the economy.
Third Treatment – Making Budget Surpluses the Norm
Whilst the first two treatments may be difficult to build a consensus for, they at least are somewhat politically saleable as they offer an immediate benefit to some at the expense of others, with the overall outcome being positive. However, establishing a process whereby governments run surpluses in the majority of years so that they are able to act as a stabiliser in difficult years requires politicians and voters to buy into long term financial management and put aside short term self-interest. As the old saying goes, “always back self-interest, at least you know it is trying.”
One option is to legislate that governments must not run a deficit budget for more than one year in the typical three or four year election cycle. This is restrictive if a particularly harsh downturn occurs where a two or three year deficit is desirable to balance out reduced private sector spending, but it works against governments leaving the difficult decisions for the next government to fix. An alternative would be that any deficit budgets must have a co-legislated offset measure that begins no later than immediately following the next election. In this case, all sides would face an election having to acknowledge the future financial pain from the deficits incurred during the most recent term.
The level of public discourse about the merits of expenditure needs to substantially change. Too often, cuts are rejected out of hand as “unfair” or “unreasonable” with no alternative offered. Rooting out waste and negotiating down the cost of supply should be standard processes across all government programs. Politicians should advertise their successes in reducing costs, demonstrating that they are properly managing other people’s money.
Conclusion on Public Sector Treatments
The three public sector treatments proposed will over the long term reduce instability and give back to governments the ability to act as a stabiliser in difficult economic times. Whilst it is better that they are implemented now whilst governments still have control over their debt levels, it is likely that short term self-interest will continue to prevail and no meaningful change will occur. It may only be when the next major downturn comes and reform is forced upon governments by their lenders that necessary reform will be implemented.
Private Sector Treatments for Debt Addiction
To solve debt issues in the private sector, it is necessary to address both personal responsibility for debt incurred and the lender’s responsibility for providing that debt. For individuals there are three basic principles of financial management to keep in mind:
- Spend less than you earn
- Pay off all your debts
- Take advantage of the tax benefits of retirement plans/superannuation to save for retirement
I sometimes think these are laughably simple and therefore not worth mentioning. However I keep meeting people, typically under forty years old, who’ve never had anyone give them such basic financial wisdom. Older generations are not without fault either, as too many company directors and senior management teams haven’t followed basic financial management principles and have ended up presiding over insolvent companies.
Having covered the personal responsibility for those borrowing, we now move to discussing the lender’s responsibility.
Responsible Lending Principles
The Australian government introduced legislation in 2009 that requires lenders to act responsibly towards their consumer borrowers when making loans. In layman’s terms, if a reasonable person wouldn’t have made the loan the lender is primarily to blame when a default occurs, not the borrower. This legislation addresses the inadequacies most obviously seen in the US subprime housing loan crisis, where lenders approved loans they knew the borrowers were very unlikely to ever be able to repay.
Responsible lending carries legal and moral implications and these are important. More important though is that responsible lending is an imperative for long term business survival for any bank, loan originator or funds manager. Even in situations where there is no legislative override (e.g. lending to businesses or sovereigns), or when a loan originator is passing on all of the risk, responsible lending should be practiced regardless. Profits are earned from credit investing by lending money and getting it back. Lending to borrowers with low prospects of repayment is the surest pathway to poor returns. Whilst borrowers should be expected to take responsibility for their actions, lenders are the party best informed about the proper use of debt and therefore best placed to mitigate their risk of losing principal.
One way to summarise responsible consumer lending is:
“Lend only when the borrower has the means to repay the loan within the reasonably useful life of the expenditure”.
Two examples come to mind where this criteria is being stretched or broken. The increasing availability of short term lending, whether by finance companies, banks with credit cards or peer to peer lending discourages basic financial management by consumers. Borrowers are typically incurring debt to pay bills from the past, rolling over existing debt or being encouraged to spend on lifestyle items. (Holidays, entertainment, clothes etc.) Unless the debt is accompanied by assistance with budgeting and financial management, the lender is discouraging the borrower from having a basic level of savings and encouraging future expenditure to be brought forward. Many users of short term lending facilities end up in a debt spiral, using new loans to repay old loans or to fund basic life expenses they cannot afford after debt repayments have been made.
The second example is the riskier end of US auto lending, where loan tenors and subprime borrowers (those with limited ability to pay and/or patchy credit histories) are increasing. One recent article pointed to no credit standards being applied at all as the applicant apparently stated to the dealer “I don’t have any income” but was still granted a loan1. The issue with longer tenor loans is that the borrower may only amortise 20-30% of the debt in the first three years, whilst the value of the car depreciates by 50%. It is common in the US for car buyers to trade in an existing car after three to five years with the expectation of using the trade in to repay the loan that remains. As pointed out by an executive at Honda, limiting car loans to four years is good practice2. It allows borrowers to be return buyers when they can clear the existing debt from the trade in before purchasing a new car with a new loan.
In both of these examples, not only is the form of debt dubious but the likely recovery rates are low if a default occurs. Conversely, lending for residential property purchases has high recovery rates (typically 60-100% of the amount owed) and is for an asset with a clear useful life well into the future. Very high LVR/LTV lending is not good practice, nor is interest only lending when the net cashflows from the property are less than the cost of borrowing. However, when good lending practices are applied (primarily a solid equity cheque/down-payment and a clear ability to amortise the debt) residential lending has shown to be very low risk.
For many credit investors, lending to large businesses is far easier than consumers and sovereigns. Information is typically freely available allowing investors to make an orderly assessment of the risk including the probability of default and loss given default. The assessment method Narrow Road Capital uses encompasses volatility, financial ratios and a structural review of the instrument. When all of these bases are covered, an estimated loss per annum (risk budget) can be derived. When the debt investment pays at least three times the assessed risk budget, an instrument can be considered for portfolios.
The point where business lending becomes irresponsible is usually at the B or B- rating levels. At these ratings and below, lenders have a fair chance of being caught up in a workout or insolvency situation. They should therefore be pricing the debt with one eye on the potential recovery rate. These are situations where Narrow Road Capital doesn’t buy at the initial issue as these credits often start out as “performing” before migrating to “distressed”. In the most part, distressed situations participated in are where the liquidity and complexity of the situation has caused the price to fall, rather than where the financial performance of the borrower has dramatically changed.
Compared to consumer and business lending, sovereign lending is often the most difficult to manage and the least financially rewarding. Many credit investors underestimate the risk of lending to a sovereign wrongly assuming that governments always pay their debts. Unlike a home loan or a business loan, there’s very little for a government to lose if they repudiate their debts in difficult times. If a country is struggling to service debt now who would lend them more anyway? Who should be paid first, police and hospital workers or faceless international creditors who don’t have a vote at the next election?
Whilst outright default hasn’t been common in Western countries for a prolonged period, printing money to deflate away the debt has been. Issuing debt in a stronger foreign currency is one way to try to deal with the inflation risk, but this just makes the servicing issues even more severe as currency collapse is usually accompanied by financial collapse.
The lack of a clear ability to enforce sovereign debt and gain control of assets means that lenders are at a profound disadvantage. Another risk for sovereign debt is the lack of covenant protections. Business loans typically have covenants that allow lenders to compel borrowers to de-risk the business once thresholds are breached. Lenders to sovereigns are placing an excessive amount of trust in a government, without protections to enact change if risk increases or recover on their debt if the borrower fails to pay.
From a responsible lending perspective, lending to sovereigns is usually encouraging bad behaviour. Even when loans are made for the purpose of infrastructure or other projects with long term benefits that is still allowing governments to avoid the tough decisions needed to balance budgets. As the last decade has shown, it is very easy to ramp up deficits when times are tough, but very difficult to reduce deficits as the economic situation improves.
Conclusion on Private Sector Treatments
Given the elevated levels of sovereign debt, investors should be very careful with lending to governments. Whilst the risk of default is currently not high for most developed nations, the risk is underestimated by most. The preferred alternatives are AAA rated tranches of property securitisations or AAA and AA loans and bonds. In each of these alternatives the borrower has a strong equity position which provides a large margin of safety to lenders.