How Much Debt is Too Much?

It seems limitless.  The amount of debt that a AAA firm can guarantee.  But it really isn’t.  It seemed limitless to AIG.  So limitless that they were willing to hire a bunch of traders to trade off the AAA of AIG to make an extra $25 or $50 million a year.  Eventually, AIGFP became a major part of the firm’s profits.  But to keep contributing to the growth of the earnings of AIG, they had to take on more and more.  To put the AAA more and more at risk.  Until, one day, it was too much.

So it seemed for a AAA country.  There seems to be no evidence that anyone thought that there was any limit to the amount of debt that the US could take on or guarantee.  At least not since Rubin was in charge at Treasury.  Wars and Tax cuts and Prescription Drugs and bank bailouts and auto bailouts and stimulus spending and taking on the debts of Fannie and Freddie.  No end, and seemingly no consideration that there was any limit.

Source: IMF World Economic Outlook

People also operated as if debt does not matter.  They were living high off of the “house as ATM” thinking.  Without thinking that they were adding debt.  Few people realized that if you have a $1 million house and a $1 million mortgage that you were not the same as someone without a house and without a mortgage.  The 100% leveraged house had tremendous percentage upside for the homeowner, but also tremendous downside.  Again, few realized that they were $1 million exposed to housing price fluctuation and that they were also exposed to a huge amount of earnings risk.  If their earnings went down, they were still liable for the mortgage.

It was all what Minsky called Ponzi thinking.  During the Ponzi phase to the economy, many people would make choices to expand their debt with the presumption that they would take out future loans to pay off the debt.  During this phase, some or if the phase lasts long enough, most of the investments are not at all self supporting.  New debt can only be sustained by future borrowing that is needed for both the payment of principle and interest.  Sounds crazy, but a significant amount of the mortgage debt that has given so much trouble was written on exactly that basis.

Minsky had two more phases.  The speculative phase is where normal investment activity in the economy could support the interest payments on the debt that financed it, but the loans would need to be rolled over to provide support for the principle.  Commercial real estate is usually financed on this basis, in good times and bad.

The hedge phase in where the business investments are able to support repayment of both principle and interest.

Minsky described the economy as shifting between the three phases.  He thought that the Fed had enough control over the banks to keep the economy from staying in the Ponzi phase for too long.  The Ponzi phase would often be accompanied by inflation so the Fed, even if they did not buy into Minsky’s theories, would move to put a stop to the extreme overleveraging of the Ponzi phase.  (But if you remember, they did not this time.)

So how much debt is too much?  Certainly when the amount of debt gets into the Ponzi stage, it is too much.  Personally, I like to keep my personal debt in the Hedge range.  But businesses and countries that are more eternal than RISKVIEWS may think it best to maintain a Speculative level of debt.

RISKVIEWS would suggest that businesses and countries need to look at their debt levels over a cycle.  So that they should avoid the excesses of Ponzi borrowing in good times and in fact stay closer to the Hedge end of Specultative borrowing in the best of times so that the borrowing increases in the worst of times does not push things into the Ponzi phase.

That is really the underlying issue that is facing the US and EU about sovereign debt levels.  They ran up too much debt in the good times, towards the Ponzi end of Speculative and the extra spending and lower income of the bad times have run them into Ponzi levels.  And at the bottom of the cycle, it is difficult to envision getting back to a lower speculative level.

‘This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble–fueled success and say, as their predecessors have for centuries, “This time is different.”  from This Time is Different: Eight Centuries of Financial Folly, by Ken Rogoff and Carmen Reinhart

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