|
In this respect Leithner & Co. is a proudly, profoundly and irredeemably ’un-Australian’ enterprise. It applauds Warren Buffett’s sagely indiscreet dictum (“if you’re smart, you don’t need debt. If you’re dumb, it’s poisonous”) and suspects that Shakespeare’s Polonius (“neither a borrower nor a lender be”) possessed better business and financial acumen than most of today’s highly-paid and jargon-babbling advisors, consultants and bankers. This circular challenges the axiom that The Way To Wealth Is Debt. It also justifies Leithner & Co.’s antipathy towards gearing and sets out a case for caution with respect to Australia’s highly leveraged condition.
A Revised and More General Axiom
Developments which transpired during the fourth quarter of the twentieth century, together with some other events which have not yet occurred but are not beyond the bounds of possibility, point to the need to revise and generalise the axiom that The Way To Wealth Is Debt. This amended axiom – an Australianised version of the one proposed by Grant – has three parts: “(1) In a Bull Market, Debt Is a Possible Route To Wealth; (2) In a Bear Market, Debt Is a Probable Route To Oblivion; and (3) You Cannot Anticipate – and Nobody Can Reliably Tell You – When a Bull Market Ends and a Bear Market Begins.”
Debt, as Grant and many others have emphasised, is a quintessentially fair-weather friend. It is a blessing when the market price of a security you own rises – and a curse when it falls. Given a particular level of indebtedness, the greater the increase (decrease) in the price of the security the greater the pleasure (pain) endured by its owner. Results of research in the field of behavioural finance indicate that the pain is felt more acutely than the pleasure; and more than a century of history indicates that the pleasure is often transitory but that the pain is not infrequently permanent. The appraised value of assets, in other words, is usually a rather pliable opinion but the extent of debts and other liabilities is an indisputably hard fact. Hence the use of the terms ‘gearing’ and ‘leverage’ as synonyms for debt: borrowed money magnifies the extent of any gain or loss derived from an outlay of capital. And it comes as no surprise that debt, the speculative desire for capital gain and an obsession with short-term price movements comprise the three horsemen of contemporary investment practice.
Two Simple Examples
Consider as an example an investor, John, who uses $50,000 of his own funds (‘equity’) to purchase a security (stock, bond or title over real estate). Because no borrowed funds are used to finance its purchase, John’s investment is unleveraged. If its market value rises by 10% to $55,000 then John earns a return of 10% (i.e., [55,000 – 50,000]/50,000) on his investment; and because that investment consists entirely in his own equity, he also earns a return of 10% on his equity. Similarly, if its market value falls by 10% to $45,000 then he earns a return of -10% on both his equity and investment. Absent debt finance, in other words, the return on equity always equals the return of the investment.
As another example, let us say that Jane uses $25,000 of her own funds and borrows $25,000 in order to purchase a security priced at $50,000. Because borrowed funds finance half of its purchase (and equity finances the other half), Jane’s investment is 50% geared. If its market value rises by 10% to $55,000 then, as in John’s case, the investment earns a return of 10%. But Jane’s equity increases from $25,000 to $30,000, and she earns a return of 20% on her equity. Similarly, if its market value falls by 10% to $45,000 then her return on equity is minus 20%. Under these latter conditions gearing increases to 56% (i.e., 25,000/45,000). If Jane’s creditor were prepared to lend an amount equivalent to a maximum of 50% of the asset’s original purchase price, and if it subsequently fell by 10%, then she would have to take immediate steps to reduce gearing. In practice she would either have to inject an additional $5,000 of equity into the investment or repay $2,500 of debt. If she were unable to do so then she might be forced to sell the entire investment and endure a permanent loss of capital.
Leverage, ROE and ROI
Clearly, then, given the leverage induced by debt the return on equity (ROE) no longer equals the return on the investment (ROI). Note as well that if equity finances one-half of an investment then the ROE will be twice (i.e., the reciprocal of 1/2) that which would obtain if it were unleveraged. If equity finances one-third of an investment then ROE will be three times that of an ungeared investment; if equity finances only one-quarter of an investment then ROE will be four times that of an investment purchased without debt, and so on.
All else equal, then, the greater the leverage and the greater the increase in the security’s market price the greater the growth of one’s equity. Hence the first part of James Grant’s modified injunction: in a bull market, debt is a possible route to wealth. It thus comes as no surprise that debtors have a vested interest in the inflation of asset prices and that they have in effect formed a coalition to promote policies and developments which achieve this end. The greater the leverage and the greater the decrease in an asset’s return, on the other hand, the more spectacular the destruction of one’s equity. (The same debtors’ coalition which promotes the inflation of asset prices also vociferously opposes policies and developments which might permit asset prices to decrease.) Hence the second part of Grant’s modified injunction: in a bear market, debt is a probable route to oblivion.
It follows that the use of debt is most advantageous during times when the prices of securities have been depressed below their intrinsic value, debt finance is unfashionable and difficult to obtain and asset prices subsequently rise considerably and for an extended period of time. The early 1940s, mid-1970s and early 1980s were such periods. Conversely, its use is most dangerous when the prices of securities are inflated well above their intrinsic value, debt finance is fashionable and easy to obtain and asset prices subsequently fall considerably and for an extended period of time. The late 1920s, late 1950s and late 1960s were such times, and I wonder (but obviously cannot know) whether today is another. If the successful timing of debt-financed investments sounds difficult and probably impossible to achieve in practice, that’s because it is: as the third part of our Australianised axiom reminds us, one cannot reliably anticipate – and nobody can reliably tell you – when a bull market ends and a bear market begins.
Australians’ Leveraged Condition
Easy access to credit, as Part I noted, facilitates the marginal transaction. It makes possible the sale of the n’th product to the n’th buyer. It enlarges GDP, expands the debt industry and creates the rationale for a future relaxation of lending standards. But when the cycle eventually turns, as it hitherto always has, the process reverses itself. Marginal transactions financed with unserviceable debt are unwound through sale, foreclosure, liquidation or bankruptcy. Asset values – hitherto inflated by debt-induced confidence – fall, thereby reducing other asset values in a chain reaction. It is in this context that it is instructive to reflect upon the extent of Australians’ highly-leveraged condition.
Exhibit #1: the Creation of Credit
Although they have relented from the frenetic activity associated with fears about Y2K at the end of 1999, central banks have continued to create credit in large quantities. Barron’s editor Alan Abelson stated irreverently but accurately on 11 September that “the Fed is quietly priming the pump... Mr Greenspan, reverting to type, is doing the old backwoods-preacher routine of delivering sermons from the front porch and peddling moonshine out back. As Robert Parks, the somewhat apocalyptic and occasionally apoplectic economist (a welcome contrast to his dead-fish brethren) sums it up neatly: ‘the mix of U.S. fiscal and monetary policy is still highly expansionary and swamps the tiddlywink boosts in the Fed funds rate.’”
A broadly similar policy stance, it seems to me, has been adopted in Australia. Earlier this year the Reserve Bank Governor told the Victorian branch of the Economic Society of Australia that few (apart, presumably, from those eager to borrow) recognised just how expansionary Australian monetary policy was during 1999. This policy continued into mid-2000. Its quarterly economic statements have noted that inexpensive and freely available credit is driving Australia’s rapid growth. Those statements, in the words of the Australian Financial Review, have “portrayed an economy reaching its speed limit, fuelled by loose credit and rising asset prices.”
Exhibit #2: the Consumption of Debt
Australians are willingly consuming this increased supply of credit. As a result they are becoming indebted as never before. Rates of housing credit growth have been accelerating almost without interruption since 1992, and are presently increasing at a rate of approximately 16% per annum. The rate of growth of personal credit has abated from the level achieved in the mid-1990s (23% per annum), but still stands at 15-16% per annum. Both rates of credit growth outstrip by a considerable margin the rate of growth of income registered during the past decade. Hence the inexorable increase in the average level of household debt. During the late 1970s, household debt in Australia was approximately 40% of annual household income. Today it is slightly more than 100%. Household savings rates have fallen in a roughly lockstep fashion.
The Reserve Bank’s Report on the Economy and Financial Markets, published in August 2000, noted the sharply rising proportion of household disposable income which consists in debt interest payments. It currently stands at the highest level since the sky-high mortgage rate days of 1990-91, and is likely to rise further in the coming months. Whether or not interest rates rise in the foreseeable future, easy access to credit and the aggressive assumption of debt may be creating significant strains upon many Australians’ finances.
Exhibit #3: the Inflation of Asset Values and the Promulgation of Moral Hazard
The prices of Australian industrial equities increased by 175% during the 1990s. Decreases in ‘risk free’ interest rates account for 100 of these 175 percentage points. Increases in company earnings cannot account adequately for the remaining (75 percentage point) increase. What can? It seems to me that mass psychology – and particularly speculation masquerading as investment – is a major factor. Once an across-the-board increase in the market prices of a particular class of asset (‘bull market’) commences and continues for an extended period of time; once the point is reached at which many people’s paper wealth increases without great effort on their part; and once painful memories of the destruction of paper wealth dissipate, a crowd – indeed, an increasingly greedy crowd – is attracted into financial markets.
Members of today’s crowd seem neither to consider nor to respond consciously to fundamental factors such as ‘risk free’ interest rates and company earnings. Rather, they respond to the fact that investment returns are seemingly as substantial and permanent as they are effortless. In effect, members of the crowd adopt an ‘I-mustn’t-miss-the-party’ attitude. Like Pavlov’s dogs, they learn that when the bell rings – in this case the commencement of trade on the Australian Stock Exchange – they are usually fed (sometimes lavishly so) and rarely smacked on the nose. As this daily ritual is reinforced over months and years, they become convinced not just that there is a God and not just that God has decreed that they will become rich: in a blasphemy that would have shocked our forebears, some are effectively demanding that today’s secular deity, the Commonwealth Government, both promote the increase in asset prices and protect them from and compensate them against losses.
Challenges and Opportunities
These reflections on Australia’s leveraged and inflated condition bring to mind a conclusion that resonates as much today as it was when James Grant uttered it in the aftermath of the U.S. boom of the 1980s: “in markets, everything has its season, and borrowed money is no more likely to prove a permanent sure thing than one-decision stocks, portfolio insurance or bags of silver coins. The habits of a long prosperity have bred the conviction that asset values always appreciate: they don’t. Well-intended academics have contended that a well-diversified portfolio of high-yield bonds will always outperform a portfolio of government bonds: it won’t. Years of easy money have popularised the balmy idea that you can always get a loan:... sometimes you can’t.”
In a way completely alien to Churchill’s original meaning, then, it does not stretch reality unduly to say that seldom have so many [debtors] owed much [money] to so few [creditors]. This situation poses challenges to debtors and spenders and may thereby present opportunities to creditors and investors – particularly those who possess much cash, a bit of acumen and no debt. To borrow Warren Buffett’s words, “when much of the rest of the investing world, burdened by debt, encounters some crisis forcing a panic, [they] are standing there with no debt and a loaded gun of cash ready to bag rare and fast-moving elephants.”
 
Designed & maintained by
Artist Web Design
©1999-2008 All Rights Reserved |
