Debt: Still Cheap, and Getting Looser


Doug French, who also features regularly in Laissez Faire Club, takes a look at the comeback of debt. (Actually did it ever really go away?) In this piece he looks at sovereign debt, corporate debt and even the return of subprime mortgage debt. Scarily, across the globe we look to be repeating, to some degree at least, the not yet very distant past…

Debt: Still Cheap, and Getting Looser

By Doug French, President of the Mises Institute

Suddenly, borrowing and lending is all the rage again.

The financial crash was five years ago this fall, and nobody is letting us forget it. According to ex-FDIC Chair Sheila Bair, financial soundness isn’t much improved. She says, “I think our system is still somewhat fragile, a lot more needs to be done.”

Indeed. Wall Street hasn’t really been reformed, although it operates with a bit less leverage.

Meanwhile, Bernanke’s ZIRP medicine may finally be seeping into the economy’s vital organs. No, job growth hasn’t been all that.  But per the Fed chair’s wish, investors are taking more risk. Paper assets prices are high and stocks are rockin’.

With apologies to James Carville, drag cheap money through a trailer park and you never know who might borrow.

Junky Sovereign Debt

For instance, less-than-financial-juggernauts Russia and South Africa borrowed $9 billion between them this week. Putin’s Place took the majority with $7 billion. Investor response was overwhelming, with orders for $16.5 billion of the dollar-denominated Russian debt at a rate of 5.1%.

South Africa sold $2 billion in debt with orders for $7.5 billion. The notes have a 12-year term and yield 6%.

The two countries have several things in common. Both Russian and South African debt is rated a junky BBB by Standard & Poor’s. Both countries are run by thugs, and both economies depend heavily on mineral extraction.

Being mineral dependent isn’t necessarily a bad thing, except neither country executes particularly well. Resource investment legend Rick Rule points out that South Africa “produced 73% of the platinum and 37% of the palladium in the world in 2012, but the mining industry there is going broke.”

Dirt-Cheap Corporate Debt

A considerably better-quality borrower, Verizon, recently made news with the largest bond offering ever, floating $49 billion of debt. That’s larger than Luxembourg’s GDP. Verizon had intended to sell $20 billion worth, but the orders kept coming in—to the tune of $100 billion—and the telecommunications company couldn’t say no. After all, it needs $130 million to buy Vodafone Group out of their Verizon Wireless joint venture, and will be borrowing another $12 billion from banks.

The 10-year bonds were priced to yield 2.25% over Treasuries (T + 2.25%), or about 5.2%, but quickly traded down to T+ 1.90%. This despite Verizon now having nearly $100 billion in bond debt outstanding.

Apparently that doesn’t matter, because investors couldn’t wait. “The demand for bonds is coming in part from investors who have spent months keeping their investments in cash or cash equivalents while interest rates hovered at record lows,” reports the Wall Street Journal.

Imagine, investors licking their chops over a 5% yield.

Subprime Mortgage Debt

There’s also evidence that the more, shall we say, “creative” mortgage lenders are back in business. The jump in mortgage rates and increased government pressure has put the kibosh on the refinance frenzy. Plenty of mortgage grunts are getting the axe. Wells Fargo announced that it is cutting 2,300 jobs, Citi 2,200, BoA 2,100, and Chase as many as 19,000 through 2014.

But The Center for Public Integrity is keeping track of the management teams that ran the top 25 lenders that originated $1 trillion in subprime loans. Editor Daniel Wagner speculates a new housing bubble is on the way. He writes, “Today, senior executives from all 25 of those companies or companies that they swallowed up before the crash are back in the mortgage business.”

Since the crash, mortgage origination has been plain vanilla, and has conformed to government lending standards. But as interest rates and home prices rise, lenders will have to offer more specialty loan products.

The days of stated income, pick-your-payment, 100% financing are over. But as mortgage company entrepreneur John Robbins says, the new environment “creates some opportunity to lower the bar a little bit and allow consumers the opportunity to buy homes [who] really deserve them.”

On a year-to-date basis, jumbo originations were up 17.7% from the first half of last year.

And while non-prime debt originated by non-bank lenders is just 5% of the market, the industry is again “mushrooming in size,” according to Wagner. “Companies are expected to issue more than $20 billion of the non-guaranteed bonds this year, up from $6 billion in 2012, according to an April report from Standard & Poor’s.”

That’s a far cry from the $1.19 trillion in unbacked mortgages bundled in 2005, but the industry is clearly rebounding. Guy Cecala, publisher of the trade magazine Inside Mortgage Finance, says, “You’re going to see a little more risk coming into the system” as lenders permit smaller down payments and finance more investment properties.

“Five years down the road and we’re back in the thick of it again. It’s a weird place to be,” says Cliff Rossi, who was a high-level risk management executive at Countrywide, Washington Mutual, and Freddie Mac before the crisis. “In that intervening 20 years, we forgot what we learned in the ’80s,” he says. “I fear right now, human nature being what it is, that downstream we could find ourselves in the same situation.”

And Of Course, Uncle Sam

Finally, the biggest borrower in history—the United States government—is currently borrowing for less than 3% for 10 years. Its obligations, says hedge fund titan Stanley Druckenmiller, are not the $12 trillion or $16 trillion the government shows on its books, but $200 trillion. That number includes the present value of the obligations made to America’s seniors. It cannot be repaid.

There are a number of pins searching to pop the debt bubble. At the top of the list is the Fed. Druckenmiller told Bloomberg that without the Fed’s QE, asset prices have to fall. He is laying low until he gets a sign the Fed is done buying $85 billion in bonds a month. “It is my belief that QE has subsidized all asset prices, and when you remove that, the market will go down,” said the billionaire investor.

James Grant of Grant’s Interest Rate Observer likes to say, “Knowledge in finance is cyclical, not cumulative.” Druckenmiller echoes this view with, “…a necessary condition to have a financial crisis, in my opinion, is too loose monetary policy that encourages people to take undue risk and go on the risk curve and do silly things.”

Big bets with low rates always make sense until reality bites. Then, what made sense suddenly looks silly. These high bond prices and low rates are an illusion created by the Fed. Soon, Bernanke or his successor will be viewed as having no clothes.

No one will escape this debt crisis unscathed, says famous investor Doug Casey, but you can make sure you’re doing better than most others.

To find out how to best protect your assets and make double-digit yields, you need to know how the global engine of interlaced economies, central banks, and governments works… and how to profit from the market distortions it’s creating.

Click here to learn how to stay on top of the American debt crisis.

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  1. Pingback: Another warning on interest rates and the NZ dollar | Gold Prices | Gold Investing Guide

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