Image: John M Crowther.
Growing up in Canada, I always heard my grandfather Paul say, “Debt is a four-letter word.” I knew early on what a “four-letter word” meant, but really wanted to know about this thing called “debt,” and why it was so bad.
Like many successful business people, my grandfather was a self-made man. He came to Montreal at age 9 from Poland, and started work very young, sweeping floors in a dress factory. Years later, he came to own the dress company and its building, and invested in a couple of other office buildings to secure cash flow and hard assets for the family. On one of the buildings there was a small mortgage, but on the other a larger one with a high interest rate that could not be renegotiated. So, despite being very successful, he ended up handing over the second building to the bank when occupancies and the value of the building declined and the cash flow could not keep up with the interest costs.
Since the financial crisis of 2008, this has become a more common tale, in both residential and commercial real estate. However, there are some notable differences between then and now. For instance, the underwriting standards in Canada are pretty high, and banks usually extend loans to those with the means, plans and assets to support them. In the US, as evidenced by the exposition of lending practices in the media, courts and in front of Congress, banks issued debt fast and furious, without the usual regard for the likelihood of repaying, as they could book fees on the loans, then more fees to repackage pools of debt, market and sell them to other buyers, thus freeing up more regulatory capital to underwrite more loans…lather, rinse and repeat.
The banks held quite a bit of the debt on their balance sheets as well, as most of the firms traded securities actively for their own accounts. So, when asset values on real estate declined, the risk of the loans increased, credit spreads widened, bond and loan prices fell, and thus so declined the assets of the banks. In financial companies, loans are assets. Banks also borrow money—their liabilities—but the mortgages they held on the books were on the asset side of the balance sheet, held for income and potential capital gain. Banks funded themselves through short-term commercial paper and used the assets as collateral to get up to 30x as much debt so they could trade more and buy more securities. I’m pretty sure that this leverage has a four-letter synonym.
On a Balance Sheet, Assets = Liabilities + Equity. The Assets of the banks include the securities they hold for return and those they cannot sell. Liabilities include customer bank deposits. Equity is the retained earnings of the firm. So, with asset values declining, and customers wanting to deposit more cash for safety, the banks were forced to write down the equity value, and thus began the mad scramble to sell equity, convertible debt and entire companies to potential investors from Omaha to Osaka.
Through the credit crisis, confidence declined, business activity dropped and employers, from corporations to the government laid off workers. This impacted their ability to repay debt, especially as real estate prices dropped. Whichever bank held the mortgages on individuals’ homes and buildings had to decide whether to foreclose on the property, and thus take a permanent write-down of assets, negotiate with the tenant or just do nothing until they had the reserves to deal with the problem. Given the transgressions of the underwriters, and the pain to their citizens, several states issued moratoria on foreclosures. That is why after its expiration, New Jersey reported a more-than 100% increase in foreclosures this month.
In 2010, major reforms like the Dodd-Frank Wall Street Reform and Consumer Protection Act forced banks to reduce risks like proprietary trading, and tighten underwriting standards. Since then, lending standards have become much more stringent (and since banks have laid off tens of thousands of employees, the process of obtaining a mortgage can be frustrating at best). Banks are extra-cautious, as borrower may cite excessive fees, restrictive terms or a lack of ability to repay at underwriting as defenses in a foreclosure proceeding, without any regard to any stature of limitations.
Despite the potentially nefarious side of credit, can you imagine a world without it? Car buyers would walk into dealerships with “fat stacks of Benjamins” (my favorite Breaking Bad reference) or Bugs Bunny sized gold nuggets to pay for carrots. The only way to live in an apartment would be to pay cash for it…there would be no such thing as a lease. The only ecommerce would be by debiting one’s bank account for purchases, and banks would do little more than administer debits and credits. Governments would (gasp) have to balance income and spending, and only be able to spend once it received or saved the income. No debt ceiling debates in Congress anymore!
On a broader scale, in a “Cash Only” environment, the global economy would grind to a snail’s pace and the disparity between “haves” and “have not’s” would be enormous; the crumbling infrastructure would continue to crumble, (Ghostbusters: “cats and dogs, living together”) and then eventually, taxes would rise and prices drop to a low enough point to level-set the value of goods and services, and everyone would live within their means. That sounds either utopian (if you are an organic farmer), or apocalyptic (if you are a Wall Street trader, investment banker, tort lawyer, pharmaceutical company or anyone that provides high cost products and services or use capital markets), but given how ubiquitous credit is in our society, we should assume it is here to stay. So, assuming a little debt is a good thing, the next point of order is to flesh out the good aspects of debt. To Be Continued…