How Bad Debt is Resolved, Hint…it is Not Good!

Debt Hangs Above Us Ready To Explode!

It is only prudent that we again come back and address the issue of where bad debt goes. This exercise has gained urgency in light of recent information released by the Bank of International Settlements concerning the growth of debt across the globe.  It now appears that the suspicions many of us held for some time are true. Contrary to the previous speculation that emerging markets were deleveraging indications are that not only were the conclusions wrong, but developed nations have been stealthily loading them up with more debt. The reason this was not picked up by many analysts is that it has been accomplished by methods that are off book. We now are finding huge amounts of debt largely hidden from the public eye have accumulated in the form of swaps and forwards.

I have written about the subject of debt on a number of occasions because it has many facets. One very important issue is who gets hurt in the end, ultimately, regardless of how it is resolved someone draws or is given the short straw. Writing off bad debt will be a painful process and I don’t mean for the debtor, but for the creditor, meaning the person, business, or institution that holds the paper. A debt default generally constitutes an unplanned and involuntary financial adjustment. While it appears much of the financial community is relatively unfazed by the mountains of debt growing throughout the world we as individuals should be concerned as to the many ways it might spillover and affect our lives.

With low-interest rates many companies have borrowed a great deal of money to buy back stock, this has been one of the forces driving the market ever higher. A comment from a reader several months ago highlights this and why it might be a big problem when he wrote;  It is fairly obvious that not all IOU’s are deemed as trustworthy, and as trust drains from this over-indebted system, shakiest issuers’ debt will lose value fastest. Junk debt is thus a Hindenburg in search of a spark all its own. Wait until corporations discover how difficult it may be to roll over all this share-buyback debt of the last few years.

Artificially low interest rates tend to skew all markets especially the credit and debt markets. This creates a debt explosion that extends into everything including consumer spending and the statistics surrounding their effects on the economy. We should remember debt takes many forms and shapes, it is not contained in auto and student loans. Clever sounding terms like “transitory” are often used to mask growing debt problems and in an effort to brush reality aside. Sometimes a person presenting the case that growing debt is under control will even go so far as asserting some of it is “good debt” or declare the positive effects of more growth outweigh the negatives of loose lending standards.

It should be noted that currently, a great deal of what is being seen as deflation flows from a loop being created from lower interest payments on things like autos, sadly this is a one-off and only goes to mask deeper trends developing under the surface. The fact is debt that cannot be repaid tends to be hidden away and corrupts the true worth of those owed what often amounts to non-collectible sums. Even now we are hearing calls by many people to write off and forgive student debt without any real understanding of the implications such a policy would entail.

Again, I caution those who think this writing off of debt will be an orderly and even process. By that, I’m saying not all debt is created equal. One major difference is whether it is backed by assets or collateral. Many other factors affect the strength or impact of defaults. One example of this is when it becomes payable, some debt is stretched over decades while other obligations are short-term and paid with a balloon payment or all at one time.  Also, debt is computed at different interest rates and this can affect its long-term impact. Another often forgotten issue is whom the debt is owed to and the impact default will have on their ability to honor their current and long-term obligations. I have seen several businesses forced into bankruptcy when a large customer defaults and cannot pay its bills.

The Reality Is We Have Not Deleveraged!

The world of bankruptcy and unpaid debt has become a complicated place where protection for one party can leave another totally exposed. We have seen things like “clawbacks” or the government making an exception and changing the rules as in the case of shafting the bondholders of General Motors during the bailout. Yes, writing off debt can be a slippery slope. Dept that is written off takes something with it when it leaves this world and that is the wealth of someone else! In today’s low-interest rate easy money environment it is much easier to hide under-performing assets and the inability to repay debt. Low-Interest rates tend to foster an extend and pretend attitude that becomes apparent and crystal clear only after rates climb and put stress on the system.Because of QE and low-interest rates, we have seen increased speculation and with it the creation of leverage or carry trades that multiply risk. This also tends to move demand forward and cause an increase in the improper allocation of capital, both of these actions have a way of causing problems that linger for years. Another issue is that across the globe after 2008 the central banks and governments of the world have played a giant game of “hide the debt,” much of it has been disguised by transferring obligations from the banks and individuals onto the backs of the general population by growing what is termed as government debt. The problem is massive debt still hangs above our heads as a Hindenburg in search of a spark.

It is important to consider how this will all play out or shakedown, this is yet to be determined but the ramifications remain powerful. Often unpaid debt shifts the pain or obligation to another party and acts as a wealth transfer, usually, this is not a voluntary act unless the note is being forgiven by the holder. I see bad debts on the rise and the effect to both the economy and the lives of many will be massive and undeniable in coming years. It will show its ugly side by pensions being cut, inflation edging higher, or simply lowering our overall standard of living. The fact is some way, shape, or form the piper must be paid and we will be reminded that there is no such thing as a free lunch.

H/T: Bruce Wilds

Former BIS Chief – “System Dangerously Unanchored”

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