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The Trouble with Debt

July 1, 2002

Last week, headlines around the world were screaming out the sad tale of WorldCom--or, as a host of copy writers have come to call it, WorldCON--and its $4 billion or so misstatement of earnings.

But should we really be surprised that another poster child of the boom--especially one whose growth has come through rapid-fire acquisitions led by a rock-star CEO--has been revealed to be a hotbed of malpractice?

No, we shouldn’t be, because inflations--i.e., vast infusions of surplus, dishonest money--always lead, via fervent speculation, to rampant corruption. Always. If you doubt this, go check the historical record.

But there is a wider point here, which will be lost in the scandal and the immediate financial disillusionment this splash has already caused.

The whole Greenspan New Era productivity myth was based upon his false syllogism that if profits were up and costs were subdued, then heightened investment--in shiny new technology, naturally--was generating increased productivity and so monetary policy could remain accommodative.

Devotees of the Austrian School will have spotted a certain circularity here, for easy money was artificially stimulating investment (and eventually malinvestments), and the two together were boosting the prices of financial assets.

Those higher prices were themselves vital to much of the surge in accounting profits for a host of reasons mostly unrelated to the generation of real economic wealth.

The Fed’s intrinsically meaningless price indices, meanwhile, were well behaved, not just because plunging sales stickers in tech were being progressively overweighted in the statistical calculations (like a sort of reverse Nasdaq effect), but because foreigners were happy to swap their cheap goods for a piece of the American action, instead of asking for goods (or selling their dollars) in return.

But there is another wrinkle: GDP growth had also seemed so extraordinary, primarily due to two main impetuses; that reverse Nasdaq effect of what are known as "hedonic" adjustments to the raw numbers of technology spending (to take account of supposed quality improvements), and the novel inclusion of elements such as software as an investment, not an expense.

This latter mattered because the GDP, or gross domestic product, numbers are in fact not really "gross" at all, but a mishmash of net expenditures with a partial gross addition in the critical, but largely arbitrary, category of investment. Reclassifying an activity as "investment" rather than mere business-to-business spending thus swells the aggregate--especially if "real" values are reckoned to be far outstripping actual dollars spent, thanks to those wondrous hedonics.

So it seems ironic that, just as the Bureau of Economic Analysis shifted software from expense to capital expenditure to boost the bottom line--to the disapprobation of such august bodies as the Bundesbank, who famously recalculated the European data on the basis of the BEA methodology and found Germany came out way ahead of the States!--WorldCom was practicing the same game.

But if WorldCom--and, no doubt a host of imitators yet to be identified--was artificially reporting capex, should we go back and revise all those GDP numbers lower, too?

The answer is clearly in the affirmative.

Thus, another tenet of the Greenspan Model proves to be invalid. Not only were profits often fraudulently overstated--as well as being falsely, if legally, enhanced by stock-options accounting--but "growth," too, was slower than reported in the boom years.

Do you know what was real, though? Incontrovertibly, unimpeachably, and rigorously recorded? Debt--even if the ultimate title to much of it has been obscured by Wall Street’s skills in financial engineering. Debt. Liabilities. Owing money. Claims on yet-to-be-earned income. A lien on the future. A mortgage on Tomorrow. Debt. The real, four-letter legacy of Alan Greenspan and his former accomplice, Bob Rubin.
 
In a week when Adelphia--in the supposedly safe, "utility-like" cable TV business--filed for the fifth largest bankruptcy in U.S. history, and when, abroad, FIAT was cut to one notch above junk and left with the threat of being tipped into that inglorious category by Moody’s, the status of much of that debt is again a vexed question.

Moody’s itself was relatively sanguine in its latest overview. Noting the speculative grade default rate was stable at 10.3 percent in May, the agency merely remarked that there had been a "slower than expected decline" in that proportion, though spokesman David Hamilton did admit that "credit remains a concern."

FitchIBCA painted a somewhat bleaker picture, posting a 13.4-percent default rate on its high-yield universe, with any improvement in overall ratings a mere statistical artefact resulting from the fact that even as so many CCC and lower-grade bonds had defaulted--fully $34 billion out of $120 billion late last year--several "fallen angels" had been newly included, as they in turn dropped out of the investment grade rankings.

S&P was perhaps the most sombre, noting that "the second half of 2002 continues to be challenging." Standard & Poor's also pointed out that, while 60 percent of U.S. ratings outlooks were currently stable, negatives, at 35 percent, outpaced positives 7:1.

Moreover, the firm was at pains to point out that pressure was not restricted to tech, telecom, and energy, but that the malaise was much more widespread.

Autos were characterized thus: "financial performance deteriorated precipitously." In capital goods: "the extent of the weakness cannot be overstated." Banks? "The majority of the 25 percent subject to change have a negative outlook." Energy: "Dismal."

Chemicals, forestry & mining, auto supply, consumer goods, media & entertainment, airlines--all had more companies with negative outlooks than with positive. Only health had parity between the ups and the downs (thank you, socialized medicine!).
 
As for those banks, while earnings were a record $21.7 billion in the first quarter--largely due to the Fed’s largesse and the corresponding aid to net interest income--the FDIC warns of two major risks; that high loan-to-value consumer loans are not performing as well as their grantors’ models predicted (Capital Insight Rule I: The Model is NOT the Market) and that there are heavy exposures to commercial property in some of the districts worst affected by the bust.

For thrifts, there are other worries. For the first time in four years, loan-loss provisions do not fully cover noncurrent loans, and there has been a sharp jump in problem thrift assets to a $15 billion level not seen since 1994.

At the personal level, the ABI showed record filings for bankruptcy in the last four quarters, with more than 1.5 million, mostly individual, filings being logged for the first time ever. Also, despite secularly low interest rates, we know debt service as a proportion of disposable income is already at a record, even without adding in the personal sector's equivalent of a "special purpose vehicle"--a consumer lease agreement whose contingent cash-flows underpin financial market debt somewhere else in the system.

But, hey, why worry? Just buy a house, and all your problems will be solved. Or, at least, that’s what the data continue to tell us is the preferred solution for many.

Existing home sales this year so far are up 18 percent in dollar terms from the first five months of 2001, with average prices rising 9 percent nationwide to top the $200,000 mark. A record average/median ratio also suggests the distribution is being sharply skewed to high-end purchases, to boot.

New home sales, too, topped the one million annual rate last month for the first time ever, and overall housing turnover is now a record 18 percent of disposable income--significantly above the 13-percent average since the last cycle peak in 1989, and twice the 9-percent low seen in the 1990 property bust. 

Moreover, consider that, if we knew that in a nation the size of, say, France, there had been a median home price increase of 25.5 percent in a year and that this, far from deterring purchasers, had led to a 22.7-percent increase in sales, would you say this represented a Bubble--a good old debt-fueled Bubble--and that this might pose risks to financial stability, especially when so many people involved were dependent for work, whether directly or indirectly, on the most battered industries?

In which case, what are we to make of the extraordinary 57-percent dollar year-on-year increase in spending on the California Real Estate Rush?

Houses are nonproductive assets, financed with a great deal of leverage. What is more, though they release their services in small increments to the owners, they deliver a large dollop of uncompensated purchasing power up front to their builders or to those cashing out of the market, as well as to the Realtors, who netted around $1,200 for each loan originated in the record $2 trillion total last year.

Therefore, houses are, perhaps, the ultimate engines of created credit on the upswing, and are among the more dangerous deflators on the way down.

As this last, fully functioning monetary engine accelerates its revolutions--with the wholehearted endorsement of Dr. Debt, Alan Greenspan himself--bear in mind that real estate did not pop until nearly two years after the Nikkei’s 1989 peak and that land values ran up nearly 20 percent in the interim, even as stock prices were falling by half.

Consider also that it was the fall of 1931--again, almost two years after the stock market crash--when real estate woes started to exact a heavy toll on banks’ loan portfolios and on the mortgage bonds they had issued previously.

As Benjamin Anderson put it, by 1931-32, many were wondering whether they would not have done better in 1929 to have sold mortgages and invested the money in stocks, even at the height of the mania. Many of the latter were still paying substantial dividends, Anderson noted: many of the former--even those issued by prime mortgage guaranty companies--had long ceased to pay interest.

Dr. Debt may well find it will not just be equity investors and overseas dollar holders who come to curse him. Overburdened homeowners and even those who count these debts and their derivatives among their own savings may well come to do likewise before the crisis passes.


Sean Corrigan is a principal of www.capital-insight.com, a London-based economic consultancy. See his Mises.org Articles Archive, or send him MAIL.


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