Photo Credit: jshrive It is why I tell everyone to avoid debt, or pay it down rapidly. Debt is a curse , as the Bible says, and you must fight it, or it will fight you.

When does a debtor look his best? Immediately after he has received the loan.

Eric Hovde, a beloved boss of mine who said many intelligent things.

We are in the midst of the biggest expansion of debt that the US and the world has seen. At present the credit markets are calm, as few are defaulting relative to expectations. Part of that is that the stock markets are high, and that credit is flowing freely. Defaults in the corporate bond market tend to come three years after corporate issuance has peaked.

In the same way, refinancing and defaults on residential mortgages start small, and 2-3 years out reach a normalized level in absence of a financial crisis like 2008-9. Most asset-backed lending is similar, with defaults arriving 20% of the way into the life of the loan.

Why is this? After the loan is made, a person or corporation has a new asset or cash, and his/its income is typically unchanged from when the loan decision was underwritten. WIth cash, there is new flexibility. WIth a new asset, there is often a lowering of maintenance costs versus older assets.

But that’s just for a time. Assets deteriorate without maintenance, and to some degree, even with maintenance. Cash usually gets used, but the debt is still there… did the debt fund something productive, or was the cash squandered?

We’re in an unusual situation now where there is a lot of fresh debt, and few defaults aside from areas where C19 is killing off certain businesses. With low interest rates and credit spreads, I expect most surviving corporations to term out their debt (replace short-term debt with long-term debt) and wait until the next recession hits. Most companies that default don’t choke on refinancing, but on making interest payments.

But what about government debts? Think of the nations of the world that have genuine failures. There aren’t that many of them, but they are all cases of governments that have borrowed too much in hard currencies, and the export sectors of their economies can’t produce enough hard currencies to service their debts.

But what of the hard currencies themselves? Can they not fail? I’m sure they can, but it will take a failure of confidence to the degree where other nations don’t care whether the failing nation exists or not… and this applies to all of the developed nations and China. Remember that the other nations will have to accept that the debts from a nation that is failing will hurt those in their nation that hold those debts. If they hold a lot of the debts, they will be unlikely to write them off so fast. Think of the LDC debt crises in the early 1980s.

In closing, I would encourage all readers to think hard about what they own, and avoid highly indebted firms. As for governments, the “cleanest dirty shirt” idea applies, unless you want to go for gold — which embeds a bet on inflation. It is quite possible that the next President of the US will struggle with deflation, and the Fed will remain impotent, inflating assets, but not goods and services.

So be careful, and only invest in things that have a significant provision against adverse deviation.