Tonight’s post could be one in the “rules” series, but since I did not get this idea prior to 2003, when I started investment writing at RealMoney.com, it does not qualify for me. But here it is:
At the end of the day, the world as a whole is owned 100%. There are people with short positions, calls, puts, etc., and even things more exotic. Those are noise around the real economy that produces the goods and services of our world.
Beyond that there are debt transactions in order to own assets, or purchase products and services. But every debt is an asset to another party, and cancels out across the globe. There are no debts on net in the world.
Does that mean that debts are irrelevant? No. Debts are relevant for two reasons: 1) Highly indebted economic systems are inflexible, because there are too many fixed claims. They are far more prone to crises. 2) The debt of financial companies is very important because they often borrow short-term to finance longer-term assets. In the current crisis, repo funding is the great example of this.
A financial firm thinking long run would not do repo financing because it can be easily pulled. It would float long debt equal to the term of the assets that they want to finance. But that might make their margins inadequate. Don’t you know that short rates are volatile, and that they tend to be lower then long term rates most of the time?
Well, maybe. But when debts increase, parties step forward to finance long credit via short borrowing. That is an essential element of the credit system when it is in bubble mode. (Side note: the exception to this is lending against sticky checking and savings account liabilities. Those liabilities are sticky only because of deposit insurance. The policy question there is whether the insurance premium is set too low. In hindsight, the answer is yes, though at my prior employer, we talked about the inadequacy of the FDIC, and bank reserving regularly.)
Though all debts net out to zero across the global economy as a whole, a lot depends on who owns the debts. If the debts are owned by those who are borrowing money, risks of a debt crisis rise. The layering of debt upon debt, and borrowing short to lend long decrease financial system resilience.
Finally, the willingness to make loans to marginal borrowers is really a statement that lenders are willing to make an equity investment in someone they are lending to, or some property that they are lending against. Formally, it is all a loan, but economically the lender is betting on prosperity, much as a stock investor might.
When I wrote my piece on the residential housing bubble at RealMoney back in May of 2005, I did not focus on the high prices much; instead, I focused on the financing issues:
- Amount of debt vs assets
- Borrowing short term to buy a long-lived asset, a house.
- Quality of the debt underwriting
And, much the same when I wrote my piece on subprime mortgages in November 2006, too much leverage, the teaser rates are short term borrowing, and the loan underwriting was horrible. As with residential mortgages generally, subprime mortgages were even more set up for failure.
If you want to find a bubble, focus on the financing. The rise in asset prices is not sufficient, assets must be misfinanced for there to be a bubble.
When I was writing at RealMoney, I did a series of four articles to illustrate market dynamics:
I wanted them to have similar titles, but it was not to be. Even for managing equities, understanding the balance sheets of companies, and those that own companies can make a difference. When stocks are owned by those that can truly buy and hold, downside is limited. When stocks are owned by those who are under pressure to earn money in the short run, upside is limited.
But what of liabilities for which there are no assets? What of underfunded municipal and corporate pension plans? With the corporate plans there is bankruptcy and the PBGC. With municipalities, and the Federal Government it is more questionable. There are few assets to lay claim to, even if there were a right to do so. They rely on increased taxation, and the willingness of the courts to enforce pension promises. This will prove politically difficult, and perhaps prove to be a greater challenge to the constitution than anything previous, because the economic demands are far greater than what the US taxpayer has been willing to bear.
Still, the greater challenge for countries is the ability to continue to manage debt issuance. As we see with Greece today, that is not a simple thing. Countries can be misfinanced, as much or more so than corporations.
Risk management is primarily management of liquidity, and planning to avoid liquidity risks over the long haul. Easy to state, hard to do. The siren song of the short-run is so compelling, but the long–run eventually arrives, and when it does, it comes to stay. Plan your life, or your corporation’s life such that you control your destiny, and are never in a spot where you are forced to do anything. That takes discipline, but the man who controls his own soul is ready to rule things far greater.