A MOUNTAIN OF DEBT TO SCALE: HOW WILL IT AFFECT YOU?

English majors will likely remember the advice Polonius gave to his son, Laertes: “Neither a borrower nor a lender be. . .” How old-fashioned that admonition seems in today’s world when many countries are “loading up” on debt. Borrowing is so easy and lending has become a major source of profit for the financial markets. Americans have accumulated a record $4.5 trillion in debt in recent years. At the same time, our government is paying down the national debt, and anticipating its elimination. Household borrowing is at a $6.5 trillion level, having risen 67% in the past five years. Many economists agree that debt can be good for the economy. It encourages consumers to spend and corporations to expand and invest in future earnings. The major concern however, is that the riskiest borrowers, those least able to repay debt, are piling it on. Lower income consumers, who in the past, have had a problem borrowing money, are now finding it easy.

Only a dramatic cultural change can account for today’s laissez faire attitude about debt. In the early days of our country, many Americans were suspicious of debt. “Consumers” paid cash or did without. Even borrowing to buy a home was considered risky. This attitude was reinforced by the Depression, when many businesses and people went bankrupt. There was a time when “retiring” a mortgage was a cause for celebration. With the introduction of credit cards in the 1960s, the concept of buying—and paying later—was born. Initially, people used one or at most two cards, and these were primarily for business travel and entertaining. Marketing combined with financial innovation and a continuous decade of prosperity, has combined to dramatically alter consumer attitudes about debt.

“Securitizing” debt “spreads the risk.” Securitizing is packaging debt including mortgages, car loans, and credit card debt, and selling the packages, called “asset-backed securities” to investors, primarily mutual fund companies, pension funds, and insurance companies. For banks and finance companies, it enables them to use their capital more efficiently. They can wipe the loans off their books, and they receive more money to make additional loans. Auto companies are big users of securitized debt. It gives them more financial flexibility and less risk. The success of securitization has created a potential market for asset and mortgage-backed securities that is posed to overtake the U.S. Treasury market as the larges fixed-income sector in the world.

Debt has become a very circular process in which consumers become both borrowers and lenders. While they borrow money from banks and finance companies, consumers are receiving interest from money market funds, bond mutual funds, and pension funds, all of which invest in consumer debt. These institutional investors favor this type of investment because it can be bought in large amounts and may pay a better yield than U.S. Treasuries.

Companies are borrowing at record levels, and that could be the source of greatest concern, if the economy contracts. Fixed-income investors with longer memories may recall the Russian debt default that froze the world’s capital markets. In similar fashion, a series of defaults by corporate borrowers or a string of problems among individual borrowers could severely impact the credit markets and individual investors. Perhaps Polonius (or more accurately, Shakespeare) knew more than we thought about financial management when he penned his oft-quoted maxim concerning debt.