Debt is a scary word for many people. Debt means that you are at the mercy of someone (or some entity) and will always have a cloud of stress over you until you pay your debt back.
Sometimes that debt is so big that you feel like you can never pay back what you owe. You can never really relax, as you always have a feeling of pressure. Some people just can’t handle that feeling.
However, some use debt to their advantage. Debt can allow people to make bigger gains by leveraging their investment. Of course, if the investment goes wrong, then you can be in an even worse position than where you started.
Regardless of how you personally feel about debt, I want to show you how supply and demand can influence debt markets.
Let’s look back to the housing crash…
Around 2007, America’s housing market reached a top because of easy lending. Borrowers (home buyers) were obtaining loans as long as they had a heart-beat. These loans even had a nick-name: NINJA loans. No Income, No Job, No Assets.
A NINJA loan is absolutely crazy. Would you loan money to someone who is almost guaranteed not to pay you back? I didn’t think so. But, that’s what banks were doing.
Mortgage brokers, bankers, escrow companies, realtors and everyone buying homes at the time were absolutely killing it. They were raking in big bucks and didn’t care about the long term affects. It’s like everyone was in on a game that they knew was going to end disastrously; BUT, no one wanted to say anything because they were all individually profiting so much.
We all know how it ended.
The reason why it ended so badly is because of supply and demand. Loans were in big supply, which made homes in big demand. As buyers demanded more homes, housing prices skyrocketed. Then loans became easier and easier to get, which made homes more and more expensive.
Eventually, the supply of loans became so easy that demand fell off a cliff. Home prices went up too high and in turn shut off demand. Home owners that bought at the top of the market were left holding the bag.
Nearly the same exact thing is happening with bonds right now. Cheap money has been widely available to nearly everyone – even major corporations.
This cheap money has allowed all kinds of businesses to borrow lots of money in order to expand production with the hopes of making larger profits. However, there’s a problem with this idea…
When there is a large supply of cheap money, many businesses can expand their operations. This means that there is more competition and more production hitting the market. When there is lots of supply, demand eventually falls.
Falling demand means lower prices, which also means that those corporations that borrowed big money can’t repay loans. They just aren’t profiting enough to pay back their debt.
This isn’t some secret – the data is out there. I wrote about it a couple months ago, as we can actually see loan delinquencies rising.
As investors, you and I can see this coming like a tsunami out on the horizon. We don’t know then this huge wave is going to hit the shore, but it’s out there coming towards us.
(We can even make money from this event, if we intelligently position ourselves.)
In theory, if we look at much of the world economy, it’s as if everything is a house of cards. In order to pay back debt, people and corporations must be making profits. When profits fall, debt obligations do not. Sometimes those debts simply cannot be paid back, and that’s when the bankruptcies start.
It’s an interesting predicament that we’ve gotten ourselves into. On one hand, debt has allowed many economies to expand faster and larger than ever possible. On the other hand, debt has exposed those same economies to massive risk and enormous downside potential.
I say this while I am sitting in Panama. A place where property loans can cost over one percent. PER MONTH.
Obviously a 12% loan in today’s environment is absurdly expensive. In the US and much of Europe, consumers can get home loans in the low single digits.
But, there is an upside to high loan costs – it keeps property prices very low. Many properties here in Panama (and much of Latin America) aren’t leveraged, which means there isn’t much risk of a big property bubble.
Now, I didn’t say there isn’t any debt. Many foreign corporations also have access to cheap capital, which has allowed lots of debt to pile up.
However, for property owners down here in Latin America who own their real estate out right, there is no over hanging stress of a debt burden. The economy could crash and property prices could fall as well, but property owners will not lose their home.
I’m not suggesting you should run down to Latin America to buy a home. What I’m pointing out is that debt can be good or bad. Right now in our world economy, there is lots of bad debt. Toxic debt that will eventually turn a lot of economies upside down.
Thanks for your great articles and insights.
I was wondering if you have an opinion on the ideas exposed in Nassim Nicholas Taleb’s books, and if you think they can be applied to make better investments.
What specific ideas/opinion are you referencing?
I think pretty much all his books are variations on the concept of anti-fragility (ex: book antifragile).
I think it could be summarized in that people have a tendency to underestimate to probability of extremely unlikely and unpredictable events (which he calls “black swans”). He criticizes investors that think that a diversified portfólio of stocks with low volatility implies “low risk” (they all go down at the same time when an extreme event happens).
His investment strategy involves “losing a small amount of money” during most days, and “making a killing” in the case of extreme events.
Right… I’m familiar with Nassim’s books; I just didn’t know what exactly you were referring to.
Your last sentence, “His investment strategy involves “losing a small amount of money” during most days, and “making a killing” in the case of extreme events,” is definitely one of my personal strategies.
I also agree that many ‘safe investments’ are not actually so. (as illustrated by the ’08 housing crash). The bond market looks similar right now in regards to ‘risk free investments.’