• Stuart Fowler

Drowning in debt: can it be true?

Like the angler who drowned in a river with an average depth of 4 inches, debt problems arise at the margin, not the mean. The strength of personal balance sheets is widely dispersed in the UK, ranging from households with large holdings of unencumbered property and richly-priced financial assets to households with little hope of surviving further interest rate increases or interruption to earnings.

The same dispersion is to be seen in the UK company sector. The average position for balance-sheet gearing and liquidity ratios is better than usual. But in private equity, gearing levels are higher than public companies would ever countenance. Finally, we do not know where ‘credit derivatives’ have ended up, but they have allowed bank lending to grow far faster than when constrained by bank capital.

It is these pockets of debt, not the average balance sheet strength, that risk dragging down the economy. Knowing they are there may not tell us what we want to know about the timing of the next recession but they tell us a lot about the chance it will be severe and prolonged.

Consumer debt It is not surprising that borrowing levels are at unprecedented levels. Confidence about incomes and employment is high after nearly 15 years without a real recession. Confidence in house prices is also high, because people do not understand the cyclicality of real house prices and the low level of long-term real growth in prices. They confuse the cycle for the trend. People may not realise that their own expectations may rely on continued easier access by others to credit, even though as a nation we are already heavily borrowed.

About £1 trillion of the £1.2 trillion outstanding debt in the UK is accounted for by secured lending, mainly mortgages. Many do not see this as cyclically vulnerable. Because real house prices are so far above trend, weakening the security, I do.

Most of the rest is credit card debt. Far more widely used in the UK than other nations, this is not itself a sign of danger as most people are smart enough to pay off the balance in full every month. We pay for the privilege of interest-free credit in other ways, as it certainly will not be free.

I do not have the time to research personal debt problems thoroughly. The area that interests me is young people handicapped by poor reasoning skills as well as poor financial literacy. If I spent time in a Citizens Advice Bureaux office, I am sure I would find that both are also associated with low self-esteem. This crushes the value of human capital which is actually far more important in explaining lifetime financial well-being – money in the head rather than money in the bank.

The majority of problems are apparently arising not in the category we might expect, single mums, but childless singletons. These are caught up in all the pressures of a consumer society but without the benefit of strong educational preparation.

Traditionally, debt problems mainly surface because of changes in circumstances. Some of these go with the economic cycle (mainly loss of up to about four months of employment income) but others, like divorce, show a secular trend.

Problems are increasing, but from the low levels we should expect given the state of the economy. Very little of the available data records the impact of the most recent increases in interest rates but they do reflect big rises in utility bills and council tax. There has been a significant increase in the squeeze on real incomes at the bottom of the scale over the last year or so and, even without any change in joblessness, this has caused problems to increase.

It is only speculation, but it seems likely that the data pointing to rising debt levels also point to debt problems exacerbating the next downturn in the economy, whenever it comes.

Corporate debt The UK company sector is not where the extreme sector imbalances are to be found. Years of strong profits growth and weak capital spending have left companies flush with cash. They have been returning it to investors rather than investing it. The net supply of equity in the UK stockmarket usually rises by about 3% pa but recently has been negative by that amount.

The shrinking of equity is one response to new tenets of finance theory that are now gospel in the world’s finance capitals. For an increasing number of public companies, that process has included borrowing more.

We do not question the theory of ‘optimal’ balance-sheet structure. In fact, as wealth managers we include gearing as part of our own portfolio optimisation model, where it serves to remove an artificial restriction on taking enough risk. When we model this, we are confident that our assumptions about the range of possible paths and outcomes are realistic. We are not nearly so confident that the increase in the volatility of corporate cash-flow paths arising from much higher gearing has been sensibly estimated, either by investment bankers or boards.

Moreover, in a wealthy household any errors in estimating the variance in financial-asset returns do not necessarily change long-term wealth outcomes. In a company, long-term outcomes are ‘path-dependent’, because of impacts such as access to and cost of new capital, investment levels and changes in its competitive position.

Private equity Private equity is a key driver of the process of optimising capital structures. The process can be collapsed into a simple description: it involves buying companies with other people’s money secured on the assets of the target company. Debt used to buy businesses will typically result in total borrowings that are sub-optimally high but they are then rapidly reduced by fairly conventional finance activities, such as reducing working capital requirements and selling off ancillary assets.

There is then a more stable level of gearing that the management aims at. This level is only optimal if correct assumptions have been made about the stability of cash flows.

Private equity houses argue that the interests of managers and shareholders are fully aligned. This is always an oversimplification of complex structures. The managers’ incentives are not the same as the fund principals’ who hire them and the latter are not the same as the outside shareholders (individuals or institutions) putting up most of the money.

If ‘insiders’ can rationalise assigning more value to upside potential than downside risk (which is certainly true of management contracts in public companies), it will lead to sub-optimal decision-making for other investors. This will affect perceptions of both the probability of adverse economic conditions and the impact of these on the company’s profits.

From the viewpoint of the general economy and employment (which is now significantly in the pay of private-equity owners), a large private-equity sector is a destabilising force in a recession.

From the viewpoint of investors in private equity, expected returns are very sensitive to the ability to sell on within a relatively short time frame. Holding investments after profitability has been ‘normalised’ very quickly normalises the ‘internal rate of return’ which is the chosen metric for their investment. The exit routes that secure above-normal returns are trade sales, sales to other funds or back to the public market. Each of these is easily blocked off in a recession.

The feedbacks from private equity in a downturn are negative. Pressure to wind up funds within agreed periods means the holdings that cannot easily be sold back into the public market do not get the same level of attention and may even be wound up prematurely. If the big investing institutions backing pivate equity take fright and withdraw new commitments to the strategy, which is what normally happens in the committee-based asset allocation process, these parcels of poor-performing companies cannot simply be passed to other private equity funds.

It is possible that other specialist funds will pick up the pieces. We note, for instance, the current rounds of capital raising by hedge funds specialising in distressed securities. However, these are shareholders keen to impose losses on others, whether existing equity owners or the debt holders. They are certainly not a pure stabilising force.

Credit derivatives We have enjoyed a long period of much stronger growth in money and credit than the economy as a whole. One of the features of this massive monetary expansion is that credit creation has not been constrained by bank capital.

Until this present cycle, and in all the previous manuals on central banking, asset growth on bank balance sheets was assumed to be constrained by the rate of increase in their shareholders’ funds. In a ‘modern’ world where loans (or separate elements of the risk exposure) can be packaged and passed on to the likes of hedge funds and insurance companies, liquidity outside the banking system (itself expanded by bank credit growth) becomes an almost unlimited base of equity to support new loans.

This process has been great for borrowers and for financial institutions eager to find new assets with different income streams. It has been great for financial intermediaries able to bundle the highest risks in an obfuscated product and flog it to wealthy individuals (not our clients, of course). But the process is a nightmare for central banks and bank regulators because it weakens their control. The banana skin they most fear is always the one they may not be able to do much about.

We can only speculate whether this loss of control means central banks have to raise interest rates further to achieve their targets than would otherwise be the case. We can note that interest rates in real terms are historically low, not high. We can also note that increases in rates to date have had no apparent impact on corporate balance sheets and liquidity preferences.

Conclusions Enough speculation. We are not economists but we know that we cannot anyway rely on economists to warn us what is going to happen.

We are living through a period of unprecedented debt-driven liquidity growth that is making a lot of us a lot of money, even if many trying to keep up have failed in trying and should never have tried. Debt-fuelled expansion contains the seeds of its own reversal. We do not know when or why but we will surely benefit from being alert to the consequences. These are directly related to the level of accumulated debt, even if only in particular pockets.



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