Mickey Kim
Individuals, businesses and governments borrow to buy (“consume”) goods or services when they don’t have sufficient funds. Borrowers pay interest to pull future consumption forward to today. Lenders receive interest to compensate them for delaying consumption to the future.
Thus, debt is an indispensable tool for both borrowers short on cash and lenders with excess cash to meet and fulfill each other’s needs. Borrowers are able to consume (the easy part) and usually able to make contractual payments on time.
But what if subsequent events render the predictions/assumptions of the borrower and/or lender invalid? In his recent memo, “The Impact of Debt,” Oaktree Co-chair Howard Marks provided a useful framework for thinking about debt.
Marks doesn’t eschew the use of debt (aka “leverage”) in favor of postponing consumption until you have sufficient funds, but states two obvious facts. First, “clearly, all else being equal, people and companies that are indebted are more likely to run into trouble than those that aren’t.” Second, “it’s the presence of debt that creates the possibility of default, foreclosure and bankruptcy.”
The challenge is determining an “appropriate” or responsible level of debt or leverage. Marks referenced an excellent post from Morgan Housel, “How I think About Debt,” where he discusses the types of potential “volatility” one can encounter, not just market volatility (which we’re all keenly aware of), but “world and life volatility: recessions, wars, divorces, illness, moves, floods, changes of heart, etc.”
According to Housel, “as debt increases, you narrow the range of outcomes you can endure in your life.” Think of it this way; if you have little or no debt, it’s highly unlikely you’ll be carried off the field on a stretcher, no matter what. However, with a very high level of debt, your financial situation is held together by a gossamer thin thread of assumptions and one small tug can cause it to unravel.
Behavioral finance teaches the importance of recognizing our inherent biases, the most insidious of which is overconfidence, our tendency to overrate our abilities, knowledge and skill, leading to a false sense of security. Marks observed “we base our decisions on what we think probably will happen. In turn, we base that to a great extent on what usually happened in the past. The problem is that extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen.”
As Mark Twain said, “It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.” In probabilistic terms, a “thousand-year” flood may be a “tail-end” (i.e. extraordinarily low probability) event, but that doesn’t mean it can’t happen tomorrow.
In fact, Warren Buffett said in Berkshire-Hathaway’s 2014 shareholder letter, “We will always be prepared for the thousand-year flood; in fact, if it occurs we will be selling life jackets to the unprepared.” During the Great Financial Crisis, corporate titans including Goldman Sachs and General Electric were forced to turn to Buffett for financial life jackets.
Because Buffett understands low probability events can and do happen, he avoids debt, even as corporate America binged on nearly “free” money to juice returns for over a decade. “Unquestionably, some people have become very rich through the use of borrowed money,” he said. “However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade—and some relearned in 2008—any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero.”
As a society, we’re programmed to want to consume more, right now and worry about paying for it later. We’re constantly comparing ourselves to our friends and neighbors and the “fabulous” lifestyles of strangers on social media in an unwinnable consumption arms race.
It’s true what Theodore Roosevelt said, “comparison is the thief of joy.”
According to the New York Fed, U.S. credit card debt has increased to $1.115 trillion and automobile debt to $1.616 trillion. Unfortunately, consumers’ ability to service this debt has decreased, with almost 7% of credit card debt and about 3% of automobile debt “seriously” (90-days or more) delinquent, the highest rates in a decade.
Our federal debt has exploded to $34.6 trillion, with interest expense now exceeding spending on defense and approaching Medicare expense. Yet in an election year, all politicians promise is more spending and tax cuts.
Using an auto racing analogy, Buffett said, “to finish first, you must first finish.” “Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on Dec. 6, 1941 or Sept. 10, 2001). And if you can’t predict what tomorrow will bring, you must be prepared for whatever it does.” Finally, “in our view, it is madness to risk losing what you need in pursuing what you simply desire.”
Mickey Kim is the chief operating officer and chief compliance officer for Columbus-based investment adviser Kirr Marbach & Co. Kim also writes for the Indianapolis Business Journal. He can be reached at 812-376-9444 or [email protected].
