Extracted from Morning Notes
Aug 18, 2011
The Debt Bomb
Michael Berry
Posted Aug 19, 2011
When I was a professor at the
University of Virginia in the 1980s the established academic
dogma stipulated that there is an optimal capital structure for
a company, Miller and Modigliani be damned. The idea was that
a tax shield on a company’s debt creates value by reducing
the weighted average cost of capital up to a certain level of
debt. Once past that level of debt which is industry or company
specific, the risk of bankruptcy will rise and with it the cost
of debt and the cost of capital. The theory is intuitive and
appealing and appears to be borne out empirically in the real
world.
Almost every family understands
this reasoning about borrowing and taking on debt. For a Canadian
or American family the gold standard has been the banker. Historically
no family has been able to borrow more than it can reasonably
pay back – a central tenet of commercial and personal banking.
Most Americans and Canadians have assumed debt on homes and cars
and paid them down over time.
However the last three administrations
in the US (Clinton, Bush and now Obama) pushed very hard on deregulation
of the financial industry (Glass Steagall) and strove to make
mortgage debt available to everyone, everywhere to stimulate
home ownership under the rubric that every American ought to
own a home. Fannie Mae and Freddie Mac – now wards of the
government with hands out recently for more taxpayer dollars.
Freddie Mac requested $1.5 billion and Fannie Mae requested $5.1
billion this past week. Fannie who financed many mortgages lost
$2.9 billion in the quarter. Fannie and Freddie jointly have
drawn down about $170 billion in taxpayer aid from the Treasury.
Today the extensive leverage has morphed up from mom-and-pop’s
mortgage to sit menacingly at the taxpayer level as Fannie and
Freddie plead for another round of Treasury drawdowns. Everyone
in charge hopes that somehow economic growth will re-emerge and
take care of the massive debt overhang. We do not see that eventuality
likely.
So debt has been shifted up
from the household level to the country level. That’s right
I said country not company. Therein lays a horrific problem that,
not treated, properly metastasizes.
It occurs to us that the overwhelming
weight of debt, borrowing at every level of society – particularly
government but also mom and pop – has snuffed out the oxygen
of this economic cycle. In the past 71 years the federal government
has increased the debt ceiling 86 times to a mere $16 trillion.
Because of this leveraging (partly a result of the reserve currency
status of the US dollar) the dollar is now in question.
It would also seem that government
has been wary of dealing with the leverage situation. We harken
back to a quote by Bernice Cohen (The
Edge of Chaos) whose prophetic book from 1997 should
be read by everyone including the Solons in Washington and every
concerned citizen.
"Again, the debt deflation
takes a predictable form. The massive inflation of the boom is
followed by the crisis of the crash and demands for cash become
overwhelming. This triggers the liquidation: a massive selloff
in financial and other assets to convert everything as quickly
as possible into cash. This phase follows hard on the heels of
the crash crisis because, the matter how inadequate, borrowers
and lenders must agree on the reckoning. Every debt must be settled.
Loans will either be repaid and the Borrower suffers, or the
borrower will default and the lender bears the loss. In the scramble
to repay debt, property, commodities, precious metals, antiques,
art objects all will be sold, even at rock-bottom prices to eliminate
debt.
"New in-words take
center stage; restructuring and refinancing. In Chaos theory,
this phrase is termed self-organization. It represents scattered
islands of order emerging within the chaos of the collapse. At
this stage, thousands of careworn speculators and investors now
develop a new revulsion; they become debt averse. As confidence
in the credit system reaches an all-time low the recession tightens
its grip, accompanied by a drop in interest rates and commodity
prices. As this grueling phase unfolds the wily investors, who
sold out in good time, may slowly begin to reinvest their hoarded
cash piles. Base building phases on charts mirror this recuperation
process. With the glacial slowness, confidence returns and depression
lifts.
"No matter how harrowing
the crisis and liquidation, the onset of the deep depression
actually marks the dawning of a new credit cycle and the turning
point for new up wave. This usually requires months of painful
base-building. The economy shows intermittent signs of revival
amongst the gloom. Prices oft or of shares or a national index
begin to form a floor base level. The human urge to rebuild takes
hold.”
Are we facing Cohen’s
vision of the future? I do not know but there is a growing likelihood
that given the evident failure of the world’s central bankers
that such a scenario may unfold.
In fact many believe that a
second Great Contraction is underway. Harvard’s Professor
Kenneth Rogoff (see The
Second Great Contraction, -Toronto Globe and Mail, Aug
3 2011) asks:
“Why is everyone still
referring to this as the great recession?”
Rogoff believes this is not
a typical recession with a cyclical springboard. The real problem
he notes is that “the economy is badly overleveraged.”
He suggests a more accurate term for our coming double dip “recession”
is “the Second Great Contraction” a phenomenon
that occurs he says only once every 70 to 80 years.
He claims today’s malaise
is something “completely different” than the Great
Recession. We are fighting the wrong economic war with ineffective
weapons. What we need is moderate Inflation. But demand-based
inflation has not been forthcoming. Real wages are falling, banks
have stopped lending and home prices are still declining. And
interest rates, unbelievable, a Ten Year yield of 2.047% this
AM.
Deal With the Debt
Dealing directly with bad debt,
as Cohen suggests above, and implementing bouts of 4% to 6% inflation
may be the only effective tools left. Resolution will be months
at best, years if we keep pushing the debt ball down the road.
###
Aug 18, 2011
Michael Berry
email: info@discoveryinvesting.com
Copyright ©2008-2011.
Michael A. Berry, Ph.D.. All rights reserved.
The material
herein is for informational purposes only and is not intended
to and does not constitute the rendering of investment advice
or the solicitation of an offer to buy securities.
321gold Ltd
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